How to Smell a Rat? An Introduction to Financial Shenanigans

Contributed by: Ashok M , CFA


Saurabh Mukherjea, CFA enthralled the audience with his presentation on Forensic Accounting, at the IAIP event in Bangalore, held on 03rd August, 2017.

How many of us knew that misreporting or fictitious accounting can be found even among companies that are part of the Nifty Index? This put the audience on notice! Among BSE 500 index constituents he put the comparable number at 150.

Ambit has studied and catalogued companies according to its accounting quality. Investment return chases accounting quality. Their study shows that over a 5 year period, the top decile companies in terms of accounting quality outperform the bottom decile companies by 10% on an average.

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Good quality stocks outperform bad quality stocks in the long run. Barring exceptional periods, good quality stocks perform well even in the short term. It is a myth that traders make money in the short term at the expense of long term investors. The opposite is true.

The best analogy that most of us understand well is Cricket. Saurabh brought out a little known trivia relating to the scores of the ‘Wall’ Rahul Dravid, and the ‘Legend’ Virendra Sehwag. In the longer version of the game, Dravid averages 55, while his counterpart’s is at 49. In the shortest form the game as well, the ‘Wall’ outperforms the ‘Legend’! While Saurabh didn’t give out detailed statistics, I did go back and check. To my pleasant surprise both in ODIs and T20s the averages are in favour of the more consistent Rahul Dravid. This is one analogy that many wouldn’t forget for a long time.

However, markets can be unfair to serious investors. Investor’s who sift through tons of annual reports and market research can sometimes see their efforts go unrewarded for particular durations in the market. The last 12 months in one such time period. The bottom decile, low quality, ‘rubbish’ stocks have run up quite a bit.

How does one detect fraudulent accounting? Few of the drivers for misreporting are

  • Hiding the damage caused by pursuing unviable mergers and acquisitions
  • Exaggerating Revenues
  • Theft by Promoters
  • Extortion by powerful third parties.

Saurabh briefly touched upon the macro environment in the context of accounting. He persuaded us to see the disconnect between economic realities, such as low plant load factors, falling occupancies in luxury hotels and juxtaposed this with the exuberance in the financial markets.

The speaker again drilled down in the audience minds that some of the largest companies (part of the Nifty index), have patently false balance sheets. Some of the management commentaries, in the eyes of the seasoned analyst, are worthy of laughter. Some of the balance sheets are so asset-heavy that they hesitate to write-down unworthy assets. A write-down would trigger loan default and the company would collapse like a house of cards. To keep the charade going, the management would weave new stories and figures in its annual reports each year.

The Nifty complex is crowded with companies that derive mileage by its proximity to the government. About 70% of Nifty companies operate in traditional sectors which are monopolised by the government in terms of licenses and access. For instance, companies in power, infrastructure or financial services. It is an indication that these companies are under great pressure to manipulate the presentation of facts and figures.

As a test experiment, one can look at the quarterly results in the run up to a QIP or IPOs. Revenues and profits would be boosted. Once the IPO/QIPs materialised, the result in the following quarters would fall precipitously – as the unwinding of inflated figures takes place.

Another illuminating finding is that IPOs have barely made money for Indian investors. Yet, the frenzy around IPOs hardly abate. As per Ambit research, barely 15% of IPOs, makes inflation adjusted return. Nevertheless, the public chases IPOs with a frenzy that is unwarranted.

How do you spot cooking the books?

There are four approaches to spot cooking of books

  • Profit and Loss Misstatement
  • Balance Sheet Misstatements
  • Pilferage of cash
  • Audit quality checks

CFO/EBITDA is a helpful ratio to detect overstatement of profit figure in the P&L statement. A unitary result is ideal. Less than unitary points to profit overstatement.

Provision for doubtful debts / Debtors greater than 6 months is another ratio to test overstatement of Sales and overstatement of current assets. The speaker showed real examples of companies which have very low provision rates but carry a disproportionate amount of debtors greater than 6 months.

Sometimes it is possible to game cashflows as well. The company could move cash to the balance sheet from a related entity closer to year end. To detect this, a clever test could be to calculate cash yield percentage. If the yields are lesser than money market rates, then quite likely cash has come into the balance sheet towards the close of the year.

Entries directly made into ‘Changes in Equity/Reserves’  instead of routing through the Profit and Loss Statement need to scrutinized. Saurabh cited the example of a prominent FMCG company that amortised the intangible value of the brands that it acquired directly in the ‘Changes in Reserves’ statement instead of the Profit and Loss Account.

To guard against gaming of CFO, by routing certain outflow transactions through CFI, one could look combining CFO and CFI and dividing the same by Revenue to check free cash flow accrual.

A healthy discussion took place on the topic of auditor remuneration. Saurabh showed some of the metrics that one could use to detect compromise in audit quality or collusion between auditor and management. He asked us to keep an eye on audit remuneration increase compared to sales, audit fee as a percentage of revenues. However, care should be taken to compare companies of like industry and like quality.

To check antecedents of directors on Board a useful site is

What are some of the Red flags that one usually comes across

  • Unusual volatility in depreciation
  • Low proportion of independent directors
  • Intermittent spike in travelling and business promotion expenses

Saurabh showed us a real life case of a wrong classification of Capital Reserves and Securities Premium Accounts in the capital structure of a company in one year and how the rectification took place a year later with a concomitant increase in auditor fees!

Suggested Books for reading:

Terry Smith: Accounting for Growth

Howard Schmidt: Financial Shenanigans

To an audience question of an instance of good accounting practise, Saurabh referred to Tata UK’s pension accounting methods following UK GAAP as a fine example of transparent accounting. But such practise is not pervasive across the group. Tata Motors, for instance, capitalises its R&D expenses, which is not the practise with other global auto motive majors.

Again, the myth to be busted is that small companies are infested with fraudulent accounting while the larger counterparts have pristine reporting practises.

In final, Saurabh referred to the cyclicality and predictability of irrational exuberances, the scandals, the pains that investors go through. Yet, lessons learn are little and the process repeats itself. He referred to the low yield in the Commercial Paper market (about 6%) because of excess funds to be loaned out. The rating agencies have liberally assigned highest rating to 90% of the issues. The Bond funds have been receiving healthy inflows as investors shift savings from bank deposits and other non financial savings to financial savings.

The discussion concluded with some reference to regulatory frictions such as the ban on short-sale and restriction on security lending by mutual funds, and lack of institutional strength in other parts of the market (such as auditor supervision, rating agency remuneration issue). Some of which, if corrected can go a long way in improving the integrity of capital markets.


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Debt-funding dreams/nightmares and the SME sector

Contributed by: Meera Siva, CFA


Friday, August 4, 2017, Chennai

Credit growth fuels economic growth but lending is a sober business where the upside is capped and risks are uncertain. IAS Balamurugan, Managing Partner, Anicut Capital LLP, a SME-focused debt fund, introspectively looked at the issues in the credit business in India, based on his over two decades of banking experience at ICICI, UBS and Citibank. Bala is also the Co-founder of Metis Family Office Services, in Chennai and handles HNI investments.

Skip nostalgia

A banker’s problems in lending – to individuals and small companies – has changed for the better over the last two decades. Lending was an occupational hazard in the past as there was no concept of Know Your Customer. There were cases where the borrower will skip town and these skip cases made lending a nightmare for the banker in the 1990s.

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After the fall of the twin towers, the risks in lending – loss of capital – was considered manageable compared with the risk of letting a wrong person open an account – terrorism or money laundering. With strict KYC and now eKYC in place, people are more traceable and life is that much simpler for lenders.

Online lenders such as LendingKart (in which Anicut Capital has invested) complete the loan process online, thanks to online data and identity being established with Aadhar etc. There is a lot of efficiency and credit is available faster and at lower operational cost. But, it does not mean lending rates will go down. There may be a tendency to take more risks in lending to reach scale and this may push up defaults, and hence rates may go end up higher.

Hidden risks

Often credit risks seem obvious in hindsight but at the time of lending, the idea looks too safe and fail-proof. For example, SMEs that supply to foreign clients – Nike, Tesco – were considered good bets in lending as there was a pipeline of orders from these safe customers. But after 9/11, all orders were cancelled and suppliers were left without a recourse and the loans became non performing assets.

It would have been wise to diversify across sectors and geography but an event of that scale was not thought of in any model or analysis. And the reality is that rare events occur regularly. The take-away for lenders is that events are unavoidable and must be dealt with calmly. Bala takes it a step further and says that Anicut Capital bets on events – buyout of PE holding by promoter, equity fund raise, asset sale – to lend to smaller companies.

Many C’s of Credit

When deciding whether a SME is credit worthy, Bala advises looking at the character of the promoter first. Unlike a corporate, a SME is dependent on the founder and if the person is not rock solid, other positives do not matter. It is an art to assess character and reliance on online often kills this fine art of judging a person.

The second C to look at is the capability of the founder. This is to ascertain if the person has the capacity to grow the business and hence repay the loan. Here again, too much safety in judging may let you miss opportunities; that is still a smaller issue compared with taking a bad call and losing capital.

The other C’s are cashflow, collateral, credit rating and many more which are part of the detailed analysis that is done if the first two are met. When SMEs transfer asset to the next generation, there may be risks a lender should be aware of and assess. The style of operation of the inherited promoter and focus may differ from that of the earlier generation entrepreneur. The transitions call for re-evaluation of the two important C’s as they would have changed substantially. 

Other risks

Bala says that over-reliance on collateral by lenders is not a good thing as it is not easy to recover capital. Also, one must look at the financial asset and operational assets differently. An alarm clock making plant is not a good operational asset as it may not produce revenue or profit. But a good business in some financial trouble may be salvageable.

Often, the biggest risks to a business come from the government. The case in point is Nokia factory near Chennai. The factory asset could have been better transferred and jobs could have been saved. It also impacts smaller businesses in that area who rely on a larger manufacturer.

All said, high growth, high inflation country such as India is credit starved and lending is a good business that will do well. Bala advises that one can close their eyes and open an NBFC.

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In conversation with – Kenneth Andrade…

Contributed by: Shravan Kumar Sreenivasula, CFA, IAIP and Birla Sun Life AMC

Kenneth Andrade is known by the moniker “Midcap Moghul”. It is a very apt description of a fund manager who likes to be benchmark agnostic and aims to pick stocks that are wealth creators for his investors. He currently runs his own PMS by the name of Old Bridge Capital Management with a corpus of USD 150 mn. In a conversation with the very inquisitive Sonia Gandhi on a Friday evening in front of IAIP members, Kenneth covered from topics ranging from his role models, his market view, lucrative market opportunity he is sighting and his philosophy of investing. He always makes investing look simple and yet he picks up differentiated bets which run up to be multi-baggers.

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Here are some of the key take-aways for me and hope it will be helpful for others who may have missed it.

  • On his view of the markets, he mentioned that the P/E ratio across the global markets is high. Investors have been looking for “E”. It is like looking for a corner in a room that has no corner. The reason why the P/E is high is due to lower bond yields and liquidity chasing assets that have atleast some yield. Infact, more liquidity is chasing equities as interest rates are increased by central banks leading to rise in bond yields (and hence capital losses)
  • On what could cause the most waited corrected, he warned that it is always an unknown and unexpected event which could bring down the valuations across the world. Today, it is difficult to point out which one
  • He cautioned that one has to take note that this decade has by far been the calmest in past many decades. There was the Global financial crisis in the previous decade, dot come crisis & Asian financial crisis in the previous one, junk bond crisis in the previous one and so on and so forth
  • He believes that the private capex is some time away as there seems to be no equity being put into companies which would typically lever it up to kick start the capex cycle. He has missed out on the recent financials rally and would be glad to be out of it going forward as well as he is wary of such high valuations for private banks and NBFCs
  • On his investment philosophy, he looks at companies which are distressed in an industry that is making money and pick those which are earning (ROCE) better than hurdle rate. He further mentioned that those companies that are garnering market share in the down cycle could be good investment bets as they are the ones to bounce back faster incase of up cycle. He has reiterated his guideline of liking companies that respect capital because equities is about buying efficient capital. He advised that most important point to note is to buy at right valuations
  • On an audience question as to how to evaluate corporate governance of a company, he mentioned that he would look how the four stake holders of the company are treated – Customer, Employee, Bond holders and Share holders. The customer through the kind of products offered and constant improvement of the same. The employee by way of compensation, opportunities and retention plan. The bond holders through the timely payment of coupons. The share holders through the efficient use of capital and payment of dividends. This should objectively measure the corporate governance of the company
  • He is most bullish on the entire value chain of the farmer. The focus of the government on rural (particularly farmer), increasing in MSP prices, soil health cards, crop insurance, direct fertilizer subsidies etc. augur well for the farmers. Government is paying 7:1 for crop insurance and farmer literally has downside protection incase of crop failure. The overall farm waiver could be 2.15 lakh crore rupees in three years which is 15% stimulus to the farmers. So, the entire farm value chain from seeds – fertilizers – mechanization etc. would get benefitted atleast for the next 2-3 years


  • SKS
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Demystifying Early Stage Startup Investing – The Opportunities & Challenges

By: Chetan G. Shah, CFA, Director, IAIP

The Indian Private Equity and Venture Capital industry has become sizeable over the last few years in terms of funds raised annually. Around 33 funds raised $4.9bn for investments in Indian start-ups in CY16 compared to 21 funds amounting to $4.5bn the previous calendar year as per Venture Intelligence. Compare this with around $7.0bn net inflows witnessed in the local mutual funds industry in CY16. Looking at the interests in this industry and the start-ups, IAIP organized a timely panel discussion on the opportunities and challenges faced by the industry. It invited Anil Joshi, Managing Partner, Unicorn India Ventures, Nikhil Vora, Founder & CEO, Sixth Sense Ventures Advisors and Vikram Gupta, Founder & Managing Partner at IvyCap Ventures Advisors. Akshay Mittal, CFA, an angel investor himself, moderated the session.

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Apart from sharing their experiences & journeys, hits & misses, the panelists provided interesting insights on valuations. With little to look at in the past in a start-up, one as to make assessment of its products or services, size of the opportunity, founders’ vision & track record, management team and potential value it can create for the investors over 3 to 4 years. Valuations can become murkier if the industry the investee company is catering to is suddenly in demand like e-commerce, or taxi aggregation or foodtech, each one of which was the flavor of the month. The greater fool’s theory is at work at such times. The investors too have different objectives with some capturing value as a strategic fit with their other businesses and others having clear mandate & exit timeline to manage. Hence valuation initially is sort of negotiation between the founders and private investors. Sometimes too much value is captured by the investors and sometimes by the founders. Neither is helpful in the long term.

As far as involvement in the operations of the investee companies are concerned they were frank that ultimately they are banking on the founders and their teams for executing the plans. However, they help management in getting customers, investors, provide insights on competing technologies or processes, and provide access to alumni network especially for B2B companies. Some of them have started and institutionalized mentorship programs. Overall the business works a lot on trust, relationships and alumni network.

  • CGS


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Investing vs Trading: An analogy with Cricket…

By: Sitaraman Iyer, CFA

I believe the world of sports and investments have a lot in common. Being an Indian, I will take theliberty of drawing comparisons between cricket and investments. Over the next few weeks,I will try to cover some themes that are common to these two professions.

Are you a Trader or an Investor?

For me, this is most important question one has to ask before indulging in any form of investing because if you are not certain, it could be detrimental. The ability to cut losses and not turn into an investor when you are a trader, or the ability to not cash out early and turn into a trader when you are an investor goes a long way in defining your success in the field of investment.

For me, the equivalent of short-term trading and long-term investing would be batting in T20 and test cricket, respectively. Both disciplines require completely different skills and mindsets.Very few people have been successful in juggling both the fields.



No matter how boring a player looks while playing test cricket, it is his ability to leave deliveries (avoid bad stocks and be patient), play risk-free cricket (stick to one’s core competencies),and adapt to different situations(identify optimistic/pessimistic market conditions) that stands him in good stead. Test cricket, like investing, is about planning, analysing, and utilising all information around before taking a decision.

In T20 cricket,you have to be restless, attack (quick churn), make impactful contributions (quick gains), and have the ability to ride your luck when the momentum (directional trading) is right. You also have to quickly assess a good score for a particular pitch to plan your innings (identify market pulse in order to time your exit). T20 cricket, like trading, is about predicting short-term flows and taking decisions without the luxury of having all the data points.

Definition of Success

Just as a T20 player scoring a quick-fire 30 will be as valuable as a player scoring a patient 150 in test cricket, gaining 3-4% in a day while trading would be as valuable as doubling your returns over 2-3 years while investing.

I have a confession to make: just as a novice gets attracted to T20 cricket because of the glitz and glamour associated with it, I too was attracted to the markets because of the stories that floated around during the famous bull run of 2003 and 2008.

However, my investment philosophies have evolved over time. I have realised that short-term investing/trading is not my cup of tea. With all due respect, the stalwarts of the markets, just like in cricket, are those who have done well over the long term.


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Feeling The Heat? – A view On Indian VC Industry

Contributed by: Meera Siva, CFA


June 2, 2017, Chennai

Is the start-up investment eco-system hot or feeling the heat? K A Srinivasan (KAS), Partner & CFO – Ventureast shared his views on the past and present state of VC investments, challenges in the Indian start-up ecosystem and the future, especially of tech ventures.

KAS focuses on Fintech and Food tech sectors and oversees fund administration, investor reporting, valuation and deal structuring besides helping portfolio companies in designing their internal controls and monitoring processes. He has over 25 years of experience in finance & accounting and operations across multiple verticals – Manufacturing, Processing and Services. Prior to Ventureast, he ran his own Finance and Accounting Outsourcing (FAO) business, and sold it to Aditya Birla group. Earlier, he was the Global Finance Controller for Sutherland Global Services and had held several senior positions in A V Thomas group and managed their agro operation. KAS is a Chartered and Cost Accountant.

Return expectations

Start-ups typically start bootstrapped operations with funds from family and friends, followed by angel funding and/or seed funding. The first institutional level fund raising from Venture Capital firms starts from Series A or sometimes from Pre Series A. VC firm will participate at least two more rounds and post that PE will enter.

Investing in early stages means there are higher risks as there is not much data/numbers available. One needs to understand the operations, segment to place a bet. About 25% of investments give good returns 8-10x. About a fourth give 1-2x return. Another fourth may give 0.5-1x return and the rest is written off. So, for the portfolio, a return of 3x is a decent expectation. Ventureast’s first fund gave a 6x return, in mid 2000s.

On individual investments, VCs look for 10x return (to make up for the many that may fail). The return expectation for PE is 3x as failures are lower. At angel stage, risks are higher and return expectation is 20-30x. More and more later stage investors are moving to earlier stage to catch start-ups young and at lower valuations (with hopes of higher returns).

E-commerce story

There was a valuation boom and now gloom in the e-commerce segment. But the fact is that e-commerce has great potential and much of the pain is self-inflicted. Back-end technologies – such as helping to reduce return rates in shoes, clothing – as well as personalization options without adding to inventory, will aid e-commerce penetration. India lags China big time and as internet and mobile penetration increases, there is huge potential. In segments such as grocery, the likes of BigBasket are making good inroads. Convenience, which is leading to adoption by the newer generation will help its growth to become a billion-dollar company.

Cash on delivery (CoD) is a big issue for e-commerce, as return rates are over 60% in this segment. Moving to digital payment methods will help etailers. Also adding charges for delivery if the goods are not accepted may be needed to reduce losses.

There is less investment seen in brick and mortar businesses, except for hospitals. Others such as retail, food, infra and energy are not seeing much interest. In food, though overall sector CAGR is 10-15% growth, the same store sales growth for restaurants are not good and there is a lot of churn due to changing user tastes.

Promising tech story

Technology – artificial intelligence, big data analysis – hold a lot of promise and many firms are getting funded. AI based service industry is gaining traction. One example is Docsapp where initial data gathering is done through machines, saving doctors time.

Fintech is a space which is not a winner-take-all model (unlike marketplaces such as Amazon or cab aggregation such as Uber).  Technology plays a major role in loan origination, credit appraisal, Disbursement and collection. Algorithm based credit appraisal and risk analysis are gaining momentum. Aadhar makes eKYC faster and social network crawling, CIBIIL score, bank statement through Perfios makes the credit appraisal quicker and reduce the Turn Around Time. Fintech companies are focusing on getting primary data of the borrowers through POS or WEBPOS which makes the credit appraisal more robust. SMS crawling, contact filtering makes the collection better.   

Issues to sort out

While the outlook is good, there are issues to sort out. One is the scale up challenge, Two, there is still challenge in finding good talent, for example, a suitable co-founder.

Three, there are high expectations from founders on valuations at Series A level. If series B is not able to live up to Series A valuation, it becomes tough to raise money at Series B since new investors will be reluctant to come in at the down round. It is advisable to have a convertible structure at Series A with more management incentive if the promoters able to raise the value. that will be more sustainable.

Four, founders should be numbers savvy. They should understand the business metrics very well. Else, they should rope in a good financial expert from the start.


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By Gaurang S. Trivedi, CFA

The Art in Fundamental Analysis

Financial statement analysis, which represents the art in the fundamental approach to valuation of equities, enables creditors and investors to make better economic decisions. Statutory statements prepared for reporting purposes are a combination of accounting rules formulated to characterize the accrual process, management estimates based on past experience applied to projected events, and managerial judgment that is subject to cost-benefit rationale. An interested reader has to just glance through a corporate press release of a quarterly earnings announcement to assimilate what the aforementioned signifies. The net earnings per share number, which in the ultimate analysis increases shareholders’ equity, is mostly neglected in management discussions and analysis. A majority of the managerial analysis is concentrated on alternative numbers arrived at by massaging the earnings information. The current use of pro-forma (read alternate) numbers to represent true operating earnings stems from the very real need for corporate managements to meet earnings estimates and support stock prices for companies that have meager, if any, positive net earnings to report. The ensuing treatise is an endeavor to reconnect the economic implications of the accounting for depreciation, goodwill amortization/impairment charges (universally assumed to be non-cash charges), as well as other one-time charges, that are being neglected by most investors when analyzing manipulated pro-forma earnings reports from corporate managements.

Case for Pro-Forma Adjustments

The theoretical support for pro-forma earnings stems from the perception that they depict the real economics of a business. Accounting earnings, though universally accepted to be the uniform language of business, are not considered representative of true economic income. To substantiate this premise let me first walk through the accounting treatment of depreciation and goodwill amortization/impairment in the corporate books.

Depreciation may be defined as a fall in an asset’s value and a reduction in the future benefits to be derived from its ownership due to normal business usage. Since depreciation is a charged expense, it is accounted as a reduction in earnings. However, as no corresponding cash outflow takes place, there is justification to add to earnings for arriving at economic (cash) income or in computing cash flow from operations.

Table A – Depreciation Accounting

·         When an asset is purchased Asset = (Cash) (a)
·         When depreciation is recorded Depreciation = Asset – Depreciated Asset (b)
·         Substituting (1) in (2) Depreciation = (Cash) – Depreciated Asset (c)
·         From (3), always (Cash) > Depreciated Asset (d)
·         From (3) and (4) Depreciation = (Cash) (e)
·         Or, (Depreciation) = Cash (f)

Parentheses represent a negative number or outflow

Goodwill is created as a result of a merger or an acquisition when the purchase price (transaction value) exceeds the fair value of net assets acquired. Irrespective of the exchanged currency (cash, stock, or some combination of both), the goodwill amount recorded as a result of the transaction will be the same. It thus represents expected future benefits (intangible) to the acquiring entity as a result of integrating the target entity’s operations. Since amortization/impairment of goodwill symbolizes a reduction in the future benefits to be derived from ownership of the net assets acquired, it is charged as an expense to current income. However as no corresponding cash outflow occurs, there is a reasonable basis to add to earnings for arriving at economic (read cash) income or in computing cash flow from operations.

Table B: Goodwill Accounting

Assuming goodwill is created by a cash acquisition
·         When a company is acquired Net Assets Acquired + Goodwill = (Cash) (g)
·         By rearranging (1) Goodwill = (Cash) – Net Assets Acquired (h)
·         From (2), always (Cash) > Net Assets Acquired (i)
·         From (2) and (3) Goodwill = (Cash) (j)
·         When goodwill is written off (Goodwill) = Cash (k)


Building a Case against Pro-Forma Adjustments

Observe that both depreciation and goodwill amortization/impairment charges do reduce reported earnings and as a pass through effect via retained earnings result in a diminished equity accumulation. Therefore, in order to examine the validity of the premise of depreciation and goodwill amortization/impairment adjustments for reconciling accounting earnings to economic income (EBITDA and/or cash flow analysis), I have presented my ensuing arguments in economic terms. The espoused rationales are an attempt to shed new light in the controversy surrounding pro-forma earnings and its brethren cash earnings. Exhibit 1 summarizes the framework used in the presentation of different relationships that develop as a result of corporate activity to support my inferences.

Exhibit 1: Framework for Illustrating Corporate Activity Relationships

  • Asset accounts affected by the purchase of an asset or purchase method acquisition


Net Assets Acquired

  • Equity accounts affected by a purchase method acquisition

Shareholders’ Equity comprising Equity Share Capital, Share Premium (APIC) and Retained Earnings

  • Nominal account depicting a diminution in future benefits from a purchased asset


  • Nominal Account representing a diminution in future benefits from acquired net assets


Logic Gap

The above summarization of depreciation and goodwill treatment for cash flow computation involves converting accounting earnings to economic income. This conversion process, however, is a result of cognitive dissonance, which simply put, is lack of consistency in knowledge and belief. Economic theory is a decision enabling mechanism for rational allocation of scarce resources (cash for this research purpose) among alternative uses. Thus in economic analysis, investments in any tangible or intangible assets are just another form of holding cash. After all, the net worth of a corporate entity holding $1 million in cash, or immovable/intangible property of equivalent value, is the same. Excluding initiated bankruptcy protection proceedings, a corporate entity is theoretically expected to exist in perpetuity. Hence, asset liquidity is generally not regarded as a predominant issue when conducting a valuation exercise. Consequently, the corporate entity is indifferent between the nature of its assets as long as their ownership satisfies the shareholder objective of maximizing wealth. Also, recall that the purchase of any movable, immovable, or intangible property for cash affects only the asset side of the balance sheet. The individual asset values may change, but the total asset value remains the same. Now, with this knowledge, visualize the whole process from an economic perspective, absent the accounting language for business transactions and see how that translates in the economic (cash) income model and free cash flow computations.

Exhibit 2 Simplified Accounting Statements

Balance Sheet as at the beginning of a given financial year
Equity Capital 200 Cash 100
Retained Earnings 100 Fixed Assets 200
Total 300 Total 300
Income Statement for the given financial year
Sales 500
Costs 300
Depreciation 100
Net Income 100
Cash Flow from Operations for the given financial year based on above:
Net Income 100
Depreciation 100
Total 200
Balance Sheet as at the end of the given financial year
Equity Capital 200 Cash 300
Retained Earnings 200 Fixed Assets 100
Total 400 Total 400


Exhibit 2 enumerates the basic accounting statements used for reporting purposes in any given year. The accounts are simplified for purposes of enabling easier comprehension of the concepts to be discussed. The cash flow from operations is arrived at by adding back depreciation charges to net income. Exhibit 3 mathematically illustrates the enumerated income statement.

Exhibit 3 Mathematical Representation of Income Statement

S – C – D = N (01)
S = Sales
C = Costs excluding depreciation
D = Depreciation
N = Net Income
Also (01) can be rewritten as:
S – C = N + D (02)

A close look at the reformulation in equation (02) reveals that the right hand side of the equation is nothing but the cash flow from operations computation using the indirect method. However in reality, the cash flow of 200 in our illustration, is generated by the corporate activities represented on the left-hand side of the equation i.e. Sales minus Costs excluding depreciation. This can be confirmed by observing the difference in the values for cash on the balance sheets at the beginning and at the end of the year. However depreciation charges have resulted in reducing the net value of fixed assets by the booked amount i.e. 100. More importantly, the total asset and equity amounts have increased only by 100, an amount corresponding to net income for the period. This negates the notion that depreciation is a non-cash expense in the economic sense as currently perceived and previously described. Exhibit 4 and the supporting analysis that follows will further evince the above observations.


Exhibit 4 Depreciation in an Economic Framework

Assuming purchase of an asset is just another form of holding cash
·         When an asset is purchased Asset = Cash (03)
·         When depreciation is recorded Depreciation = Asset – Depreciated Asset (04)
·         Substituting (03) in (04) Depreciation = Cash – Depreciated Asset (05)
·         From (03), (04) and (05) Cash > Depreciated Asset (06)
·         Let Change in Cash (CC) denote CC = Cash – Depreciated Asset (07)
·         From (05), (06), and (07) Depreciation = CC (08)
·         From (08) when charged to income (Depreciation) = (CC) (09)
  • Parentheses represent a negative number or outflow


In the economic framework as presented in Exhibit 4, depreciation represents a reduction in cash. Consequently, the net effect of a depreciation charge is a cash outflow, and hence there is no justification to add to earnings for arriving at economic (or cash) income. A base case scenario of a subsequent disposal of an asset for book value (original cost less accumulated depreciation) will enable a better understanding of this analysis. Instrumental in this explication is the fact that the purchase of an asset has no bearing on the income statement i.e. the purchase is not recorded on the income statement as an expense. In the above referenced scenario, upon the disposal of an asset, the company will receive an amount that is less than the original cost. The difference in original cost and realized price represented by depreciation is thus a real cash reduction, and hence should be treated as a cash outflow. This analysis may generate a counter argument of incorporating the time value of money, which would necessitate that such treatment should be considered only when the actual event of disposal takes place i.e. when reduction in value is realized. As a resolution to this counter proposition, we need to recognize that theoretically, corporate managements are expected to act as fiduciaries of corporate assets and maximize shareholder value. Thus, any estimate of value erosion represented by depreciation should be considered as realized, accounted for, and analyzed in that context. Moreover, current cash based earnings valuation techniques do not reverse the positive adjustments to earnings from depreciation when assets are disposed or written off completely, thereby creating and maintaining a systematic upward bias in both income and valuation.


Exhibit 5 Goodwill as a Result of Merger or Acquisition in an Economic Framework

·         In case of acquisition for cash Net Assets Acquired + Goodwill = Cash -10
·         By rearranging (10) Goodwill = Cash – Net Assets Acquired -11
·         From (10) and (11) Cash > Net Assets Acquired -12
·         Let Change in Cash (CC) denote CC = Cash – Net Assets Acquired -13
·         From (10), (11), (12) and (13) Goodwill = CC -14
·         From (14) and when written off (Goodwill) = (CC) -15
·         In case of acquisition for equity Net Assets Acquired + Goodwill = Equity -16
·         By rearranging (16) Goodwill = Equity – Net Assets Acquired -17
·         From (16) and (17) Equity > Net Assets Acquired -18
·         Let Change in Equity (CQ) denote CQ = Equity – Net Assets Acquired -19
·         From (16), (17), (18) and (19) Goodwill = CQ -20
·         From (20) when written off (GI) = (CQ) -21
·         From (15) and (21) for all charges (CC) = (CQ) -22


As depicted in Exhibit 5, the entire process of goodwill creation and its attendant amortization/impairment charge can be economically modeled in the context of changing the form of holding cash (acquisition for cash), or new issue of equity for cash and the subsequent acquisition of net assets at a premium represented by goodwill with that cash (acquisition for equity). An acquisition using a combination of cash and equity can be analyzed similarly. As such, there is no justification to add the amortization/impairment charge to earnings for arriving at economic (cash) income. In materiality, equation (22) reveals that all charges appearing on the income statement can be modeled in the economic framework to represent a reduction in cash and therefore do not merit an upward adjustment in free cash flow computations. Implicit in this interpretation is the fact that cumulative past earnings and operating cash flows are virtually identical. The variance in operating cash flows and reported earnings associated with charges in one time period results from the difference in the timing of the flows, not the actual nature and value of the flows. Restructuring charges and other assorted non-recurring expenses (one-time charges) do matter to the equity holder as they reduce the accrual of profits (economic rent) to their ownership stakes and should therefore be incorporated in the valuation process when they’re recorded and not when they’re paid out, to negate any potential earnings management motivations.

Application for Investment Management

Concomitant with the foregoing economic rationale and the financial implications of the accounting of corporate activities, the computation of free cash flow supports the upward adjustment in earnings for depreciation because it considers the effect of capital expenditures (asset purchases) at the outset as a cash outflow. Recognize also, that it still does not require upward adjustments for goodwill impairment charges or other charges deemed non-cash (e.g. restructuring charges) in computing free cash flow. Although there are a number of predications for mergers and acquisitions such as taking advantage of tax loss carry-forwards of the target, increasing liquidity or to bring a better balance to the capital structure of the acquiring firm, etc., most of them are short term in nature. The fundamental economic premise underlying a majority of mergers and acquisitions is usually adding to current capacity (growth through increased market share) or expanding the product line (growth through diversification) and the associated cost savings from leveraging economies of scale. This is logically the same as incurring capital expenditures for expansion plans, albeit with the economic advantage of synergies and time savings realizable in bringing added capacity online and marketing the expanded product offering. Thus in analyzing the impact of mergers and acquisitions, subsequent goodwill amortization/impairment charge should be added back to earnings for free cash flow computation only after an initial cash outflow is recognized at the time of a merger or acquisition, i.e. the merger or acquisition is treated as a capital expenditure. A common justification against this interpretation in the case of mergers and acquisitions where equity is exchanged is that the initial cash outflow implication is considered by the increase in the number of shares outstanding. This assertion however is mired in fallacy. It takes into consideration only one effect of the transaction, i.e. an increase in equity. Ordinarily, when equity capital is raised, the ownership of shares is exchanged for cash. In the case of mergers and acquisitions involving exchange of equity, this cash is assumed to be expended on the purchase of net assets and goodwill (if any) i.e. a treatment akin to capital expenditure. Thus, currently practiced free cash flow based valuation techniques allow the acquiring company to have the cake and eat it too. Not only is the initial cash outflow not recognized, but also, goodwill amortization/impairment is added back in free cash flow computation as a bonus. The process systematically creates and maintains an upward bias in current and future free cash flows thereby manifesting into higher stock price of the acquiring company. It favors the growth through acquisition strategy over organic growth strategy. This treatment is analogous to viewing one ton of steel as heavier than one ton of cotton. The proposed methodology of computing free cash flow is thus strategy neutral, i.e. it treats companies that grow through internally generated funds equally with companies that grow through acquisitions thereby facilitating equitable comparisons for investment purposes.

Final Thoughts

Like a golfer who struggles with the putter, an investor lacking full cognizance of the interaction of accounting, finance, and economics makes decisions with a major handicap. The purpose of this research is to generate a healthy debate amongst accounting, finance, and other professionals who are consumers of company information to evaluate the efficacy of reported financial statements, management discussion and analysis that accompanies them, and current valuation methodologies practiced. Contrary to popular notions, if cognitive biases are removed, one may find that accounting earnings do mirror economic reality. The preceding analysis and proposed free cash flow computation methodology showcases the fallacy of pro-forma earnings presentation and the doctoring of earnings by corporate managements and analysts to meet estimates and justify high stock prices. It could well explain the observed frenzy in using bloated stock prices as a currency for a majority of unsuccessful mergers and acquisitions. It also brings to light ethical issues that managements face when preparing and reporting financial information. It is also an attempt to help streamline the analysis of corporate information; conforming it to a principles based approach to render it more objective and unbiased. All types of equity pricing methods are susceptible to manipulations in the short run. In the long run however, equity prices always reflect the underlying fundamentals and will adjust for any innovative accounting. Equities investment begins with computing expected returns and concludes with comparison and analysis of actual returns with the expected returns. Since earnings comprise an integral part of expected returns, a sound knowledge of accounting theory and concepts is essential for conducting insightful financial analysis. In conclusion, users of financial statements will be better served if they take cue from their animal friends and sniff before they consume anything given to them.

– GT

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