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Fundas : Financial Shenanigans Part 2:

Manipulating Expenses
Chetan Chhabria
Aug 17, 2019
Fundas
In the first part of this series, we wrote about how companies could manipulate earnings. We
continue here with examples on how companies manipulate expenses.

Expenses: Cutting them in the Statements

Ways in which companies can tweak with expenses to manipulate earnings are –

 not recording expenses,

 shifting the expenses to a later period and
 shifting in the expenses in the P&L to Balance Sheet

For instance, commodity companies see fluctuations in inventory prices. If the cost of raw
materials fall down then the company takes a hit on the inventories that it has on its books. It
needs to write down the inventory on the balance sheet and book a loss on the P&L. This should
be ideally adjusted with the cost of goods sold, hence the gross profits and operating profits are
impacted when such an event occurs. However, some companies may shift these losses below
the operating profit line, hence while comparing the operating profits, we do not see the impact.
It is important to check where such kind of expenses are being recorded in the P&L.
 Companies resort to shifting expenses to a later period, some of the ways in which they can do
so are

 Capitalizing operating expenses

 Depreciation/Amortization over longer periods of time
 Not Checking regularly for impairment of assets

When companies incur expenses, the benefit to be received is either immediately or in the future.
If the benefit is received immediately – salaries, marketing and promotion expenses they should
be recorded in the P&L. For benefits that the company will receive over period of time –
typically acquiring assets, an asset is created on the balance sheet and expenses are spread over
the life of the asset. The problem arises when normal operating expenses, those required to run
the day to day operations are not expensed but put on the balance sheet as assets. The company
by following this practice reduce the expenses for that period, which gives a boost to the
earnings.

For instance take the case of customer acquisition costs, these should be expenses in the period
in which they are incurred. However companies will spend the cash but instead of expensing
them will create a deferred asset account on the balance sheet. In the course of time they will
record the expense and reduce the asset account on the balance sheet. These type of assets are
recorded in other current assets and it is very important to go thorough the notes to accounts to
check if the company is following any such practice. Another way to check this is to look at the
free cash flow, since the company is spending the cash, it has to be recorded and this appears as
spending on assets in the cash flow from investing section. FCF which is the difference between
the cash flow from operations and investments would be low in this case.

Some of the checks to see if companies are capitalizing expenses are

 Unwarranted improvement in profit margins with large jump in assets

 Unexpected decline in FCF with sizeable increase in cash flow from operations. One
needs to check what kind of assets the company is buying. There may be a case where the
company is in a genuine CAPEX spending mode, benefits of which it will reap in the
future
 Increase in CAPEX when business environment is dull or there is a slowdown across

Lot of company’s resort to capitilizing the interest costs to the assets that it acquires. While this
is permitted under accounting standards, it is better to be aware the extent to which the company
is capitilizing its interest costs.

Recording amortization/depreciation costs slowly over longer periods of time will also boost the
earnings. We should look at the depreciation schedules and see if the depreciation policy
followed by the company is permitted as per the accounting standards. Another way of boosting
earnings through this way is assigning higher residual value to the asset.

For instance let us assume two companies buy the same asset for Rs 1,000. Company A assigns a
residual value of Rs 200 and company B Rs 300. Residual value is the expected value of the
asset after its useful life, say for instance the life of the asset is 5 years. Depreciation in the case
of company A will be Rs 160 ((1000-200)/5) and in case of company B Rs 140 ((1000-300)/5).
Assume all costs are the same (Rs 700) and there is only change in the depreciation expenses,
both these companies generate sales of Rs 1000. In the case of company A the net profits will be
Rs 140 (1000-700-160) and company B will post net profits of Rs 160 (1000-700-140).

There may be instances where the inventory may turn obsolete and it is still carried on the
balance sheet. Companies need to write down the inventories and book the losses on the P&L. It
is advisable to check the inventory turnover ratio and inventory days for longer periods to time.
In case the inventory days is constantly going up, we need to check if the company is pilling up
on inventories. In other cases companies may keep fixed assets on the balance sheet even though
they have lost its value, these need to be checked for impairment.

There may be instances where companies create special charges to boost earnings. For instance a
company is taking up a restructuring exercise of Rs 25 Cr. It will record an expense of this on the
P&L and create a reserve on the liability side of the balance sheet. Few months down the actual
charges amount to Rs 20 Cr, what happens to the balance of Rs 5 Cr that was accounted for at
the start of the period? The 5 Cr is reduced from expenses on the P&L and there is no liability on
the books of the company. The 5 Cr reduction in expenses provides an instant boost to the
earnings.

Other expenses like warranty, pension and lease also can be used to boost earnings. It is
important to go through the methods in which these expenses are recorded on the P&L.

Observations from a Travel Company

We now look into a company that was recently in the news, the company defaulted on its CPs
despite having cash and bank balances on its book. The company is Cox and Kings and we
looked into the FY18 annual report.

The first thing we noticed was the announcement of the companies FX business division being
demerged into a separate entity Cox and Kings financial services limited (CKFSL). Companies
do carry out demergers in the course of their business to create shareholder value. But in this
case the demerged business CKFSL will also commence business as an NBFC. The company is
moving away from its core competence by entering the NBFC space.

The company has 136 subsidiaries and 12 associates, it is going to be quiet a task for one to
understand and read their financial statements with so many subsidiaries and associate
companies.

Below is the share holding of the company for the last three years, we have even included the
shareholding for March 2019
One can observe that majority of the shareholding is by institutions and shares pledges have
increased from 2017, 63% of the promoter holdings was pledged in 2018 and 2019. Anthony
Burton Meyrick Good who is the chairman of the company had 60 lakh shares in 2017, he sold
34 lakh shares during the course of the year and his shareholding at the end of 2018 was 26 lakh
shares.

Some of the observations of the auditors on the companies consolidated numbers are as below
The auditors haven’t audited financial statements of subsidiaries who generated revenues of Rs
3,813 Cr, the financial statements for these have been provided by the company and have been
audited by other orders.

Balance Sheet
Goodwill stood at Rs 2,468 Cr, 23% of the total assets. Goodwill as we know is the recorded
when the acquisition price paid is in excess of the book value of the target company. Nearly
quarter of the assets of the company are in goodwill, these need to be checked for impairment, if
carrying value is found be less than the actual value these have to be written down.

Trade receivables is the next biggest item on the balance sheet. It forms 21% of total assets and
39% of current assets. We also found that receivables as % sales for FY18 stood at 35% versus
25% in the previous year. Consolidated sales for FY17 and FY18 stood at Rs 7176 and 6450 Cr.
In other words this means that out of the total sales of Rs 6450 Cr, 35% were on credit for which
monies were to be collected. As we will find out later some of these receivables are to be
received from related parties.

Company has healthy cash balance of Rs 1640 Cr at the end of FY18.

Other current assets have increased by 62% and form 14% of the total assets. Below is the
breakup of the other current assets

There are some advances that have been made to related parties, however the biggest jump is
seen in the others line item, increase of 84% from Rs 446 Cr to 819 Cr. There is no detailed note
describing why have these increased drastically, we only know that these are towards prepaid
expenses, staff advances and others.

On the other side – the equity and liabilities section, we can see that the owner’s equity has
increased by 34% from Rs 3,206 Cr to Rs 4,286 Cr. Owner’s equity funds 40% of the assets. If
we deep dive into how the equity capital has seen such a drastic jump, we find the below
Equity has primarily increased on the back of increase in the retained earnings account and
increase in non controlling interest. If we observe the retained earnings break up above, we see
that profits during the year and profit on sale of an investment – on the back of sale of shares in
subsidiary, which should be a non recurring event have contributed to the increase in equity. The
profits for the year have more than doubled and we will look at the P&L statement later in the
post to see what has resulted in such an increase.

On the borrowings front the company had a total debt of Rs 3,906 Cr, the debt to equity ratio of
the company stood at 0.91.

Other current liabilities constitute 16% of this section and comprise of the below
The major component is the income received in advance, these are monies that the company has
received, however they are yet to record revenues as they haven’t rendered their services, these
will be booked in the future. One point to ponder over is if the company is receiving monies in
advance from its customers, why are the receivables going up? Receivables as discussed above
have increased by 23% and form 35% of sales.

Profit and Loss

Revenues have decreased by 10%. The company derives revenues 4 segments – leisure,
education, hybrid hotels and others. Revenues from the leisure segment form majority of the
revenue – Rs 4,180 Cr versus Rs 5,114 Cr in the previous year. It is primarily this segment has
lead to the degrowth in the revenues.

Cost of tours – costs that the company incurs to arrange for various tours for its customers has
decreased by 19%. We will have to dig deep into why the cost of tours have fallen 2X the fall in
revenues. Ideally the cost of tours should fall in line with the revenues. However this has resulted
in increase of gross revenues by 10% and improvement in gross margins from 30% to 37%.

Operating profits or EBIT have increased by 58%, OPM stand at 14% versus 8% in the previous
year. This is majorly on the back of decrease in other expenses from Rs 753 Cr to Rs 569 Cr. The
company has recorded a FX gain of Rs 138 Cr and this has been reduced from the other
expenses.
PAT of the company has increased by 110% to Rs 444 Cr, margins stood at 7% versus 3% in the
previous year. The effective tax rate has decreased from 42% in FY17 to 31% in the current
year. We need to adjust for these events and look at the normalised earnings of the company.

Related Party Transactions (RPT)

As we can observe from the above, sales to RPTs stand at Rs 2,334 Cr, 36% of the consolidated
revenues of the company. Majority of the sales are to “Others” – which is a JV and enterprises
over which key personal have significant influence. Sales to RPT have increased by a whooping
174%, from Rs 851 Cr to Rs 2,334 Cr.

Receivables from RPT stood at Rs 460 Cr, 21% of the total receivables. These have increased by
57% from Rs 293 Cr to Rs 460 Cr.

Cash Flows
We see that the cash flow from operations (CFO) in the above statement is Rs 161 Cr, however a
deeper look at this should reveal that the CFO for the year is – 161 Cr and not positive. There
have been inflows of Rs 118 Cr on the back of movement in other bank balances, which have
helped in increase in the cash flows from investing, we do not have the exact details of this line
item. The company has also made inter corporate deposits to the tune of Rs 162 Cr during the
year.

After looking at the above analysis, one should have been wary of investing in the company.
There are many moving parts and lot of developments – RPTs, increasing receivables, jump in
margins visible in the FY18 annual report, which should have been enough for any investor to
not invest in the company. However the retail shareholding has gone up in the company since the
last year. Below is the retail shareholding as on 30th June, 2019 versus what it was exactly a year
ago.

As on 30th June, 2019

As on 30th June, 2018

Final Thoughts

We hope that readers would benefit from the above analysis and this would enable them to look
at the finer details while going through financial statements in the future. In our next post we will
cover the cash flow shenanigans.

NOTE: As a disclosure some Capitalmind authors may own the above company in their stock
portfolios. There is no other relationship between Capitalmind and the above company. Please do
not consider this article as a recommendation, It is purely for informative purpose only.

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