Statistical Possibility of Poor Quality Financial Reporting by Some Large Corporates - India Ratings

Mumbai, July 23, 2014: The underlying financial health of at least some BSE 500 corporates (excluding banking and financial services) is not reflected through their key reported financial numbers such as EBITDA, PBT and PAT, tentatively concludes India Ratings & Research (Ind-Ra). The agency has used Benford’s law for analysing the quality of financial reporting of large Indian corporates for the period between FY02 to FY13. This approach has been used globally for forensic accounting purposes.
The tentative conclusions on the quality of financial reporting are based on a statistical analysis. As with any such analysis, Ind-Ra does not rule out the chances of both false positives and false negatives.
The study does not imply fraudulent reporting. It however endeavours to highlight to investors that a disproportionately higher focus on margins and earnings than on cash margins could lead to a very limited understanding of the health and performance of the corporates. The results of the analysis also support the agency’s focus on cash-based metrics such as cash flow from operations as opposed to accrual-based calculations involving EBITDA, PBT and PAT.
The key findings of the analysis are as follows:
Existence of ‘Bad Apples’ in Large Caps: As a group, corporates ranking between 100 and 200 based on market capitalisation have lesser discrepancies in financial reporting than the 100 corporates with the largest market capitalisation.
Bad Years, Bad Reporting: The quality of financial reporting deteriorated sharply in years where there was a sudden economic shock or when the ‘markets’ were not anticipating a poor performance. Financial numbers for FY09, followed by FY13 raise the highest number of statistical flags attributable to possible poor reporting. The number of financial entries which were statistically flagged off reduced in FY10 and FY11; however, there is a strong likelihood of discrepancies in reporting PAT for both these years. A limited analysis of P&L variables of FY14 suggests that the quality of reporting particularly the earnings variable may have improved.
Caution on Promoter Holding: The study supports Securities and Exchange Board of India’s endeavours to restrict promoter holding in listed entities. Deterioration in the quality of financial reporting increased in tandem with an increase in promoter holding. Additionally, the study did not find any significant difference in reporting quality based on the type of promoter (Indian or foreign).
Sectoral Issues Come to the Fore: Each industrial sector has several corporates, which are anecdotally known for corporate governance. However, when corporates are grouped by sectors, statistical flags are raised against variables, some of which are critical in capturing the performance of corporates in the specific sector.
- Sales-driven Sectors: FMCG, pharmaceuticals, fertilisers are the sectors where over the years the highest number of financial entries has exhibited a high likelihood of discrepancy, as per the statistical test. The variables flagged included gross sales, inventory, debtor, bad debt and provisions.
- Capital-intensive Sectors: Sectors such as oil & gas, infrastructure and construction have flags for discrepancy raised against variables such as net fixed assets, depreciation, COGS, debtors and loans & advances.
- Surprise Entry: IT is widely considered as a safe sector in terms of corporate governance. While the number of financial entries with possible discrepancies is in the middle of the range, the variables that have been flagged are worrisome. These variables are employee cost, selling & distribution expenses, depreciation, changes in working capital, capex, deferred tax and net fixed assets.
Ind-Ra has undertaken a comprehensive evaluation of the quality of financial reporting. It expects to come up shortly with further analytical details so as to enable investors to assess the quality of financial reporting within their portfolio.
(Source: Manager - Corporate Communications and Investor Relations, India Ratings & Research- A Fitch Group Company.)