Beware of companies in low tax sectors-these may bite you

While reading about failure patterns of listed Indian companies, some themes caught my eye. One of them is that certain sectors had a high share of corporate mishaps. Whether it is the plantation investments Ponzi schemes of the 1990s, real estate boom of the early 2000s, some things never change. The below post tries to analyze and explain why

1. Agriculture-Tax free income hence cannot correlate tax payments to reported income. Also, there is usually indirect tax exemption as well, so possibility to raise 'accommodation bills without any other offsetting check/VAT chain'. Forensic audits ordered/pending for Kaveri Seeds and Camson Biotech, and the near insolvency of India's largest rose grower Karuturi networks, illustrate the point, that accounting issues in these sectors do exist. Other examples like Transgene Biotech also exist. 
2. Education-Like how Chinese shell companies were incorporated abroad (with local operating partnerships) to circumvent Chinese FDI restrictions, Indian companies resorted to agreements with trusts etc to make money from the traditionally non profit education sector. This did not end well for Educomp and Everonn, both of whom are facing distress..
3. Scrap Sales-This sector again operates on cash, hence for companies whose raw material/finished product uses scrap/recyling, there is a risk of siphoning out. While companies like Ganesha Ecosphere have thankfully not reported frauds so far, this risk exists.
4. Real Estate-Nearly all the players experience high leverage and low profits despite ever mounting prices. It seems promoters become rich(eg DLF) with outside interests(eg land) disguised via land ownerships/shell companies, while shareholders face negative returns
5. Jewellery-This industry is notorious for trust based/cash transactions. There were pan India strikes when PAN was introduced for high value transactions, and when excise was proposed-even at a much higher exemption threshold. Examples of frauds in this sector include Winsome Diamonds, while financial distressed firms include Gitanjali Gems

Bottomline-Triangulation of data is always useful and being subject to direct/indirect taxes(and the resultant audits/returns/investigation) helps outside investors to detect red flags, or exit somewhat in time. Of course, as I outlined in an earlier post, this exit may be premature http://specialsituationsindia.blogspot.in/2016/04/should-you-buy-on-dips-after-news-of.html but one is informed atleast

Company auditors doubts its ability to stay in business? Read this before selling

Recently, there were going concern qualifications expressed by auditors, for airlines like Kingfisher/SpiceJet, and investors pressed the panic button. Going concern just means 'business as usual' and when the auditor feels that this is not tenable(without restructuring/bankruptcy), then they are dutybound to caution others of the same. But before investors panic, they should atleast understand the rationale behind this, as well as the conditions/limitations of this. It is contained in SA-570(Going Concern)[http://220.227.161.86/15401Link36_SA570-final_standard.pdf] which auditors need to follow. Some highlights of this standard relevant to investors are

1. Financial Statements are prepared on cost basis , unless management either intends to liquidate
   the entity or to cease operations, or has no realistic alternative but to do so. Under the Companies Act 1956, directors are dutybound to certify in their 'Directors Responsibility Statement' that they have prepared the accounts on going concern basis! Hence, to accept any other basis is tantamount to violating the law unless they file for liquidation. However, auditors go by the economic substance and not the legal form, and while they cannot second guess management intent, they can certainly opine on the compulsions which will leave management with  no realistic alternative, but to cease operations/liquidate etc. 
2. For helping the auditor arrive at the conclusion that going concern cost basis is justified, the management is expected to(as per para16, ibid) make its own assessment, and then the auditor is expected to evaluate the feasibility of those plans, reasonableness of assumptions, reliability of underlying data used in forecasts, consider additional facts in his knowledge. Also, auditor would look into whether company can realistically fill its unfilled orders, get committed funding/support.
3. If there is a material uncertainty(like CDR negotiations on/major lawsuit pending), then the auditor is expected to highlight that uncertainty in adequate detail for investors to decide for themselves. But that itself does not mean an adverse comment.
4. Some interesting red flags suggested for the auditor and which I feel investors are advised to consider are(I do not consider routine redflags like financial ratios etc)
1. delay in approval of financial statements could be related to events or conditions relating
   to the going concern assessment. For example, GTL Ltd/GTL Infra delayed their financials.
2. Fixed-term borrowings approaching maturity without realistic prospects of renewal or repayment. Since Indian companies do not usually reveal/tabulate their debt maturity schedule, getting this information will need some digging in. 
3. Substantial operating losses or significant deterioration in the value of assets
   used to generate cash flows:-Since segment reporting is not adequate to get this data, investors must rely on the MD&A for this or else track the company metrics over time
4. Inability to comply with the terms of loan agreements:-This would not be public data usually, but annually, the CARO 2003 order mandates auditors to mention such defaults..
5. Change from credit to cash-on-delivery transactions with suppliers:-This would show in the reduction of the creditors days, which is an alarming signal as creditors would usually have a better sense of the business than even investors
6. Inability to obtain financing for essential new product development or other
   essential investments:-Often, companies hit the equity market with FPO/rights issue for quite small amounts, which does indicate that other financiers are shunning them..
7. Pending legal or regulatory proceedings against the entity that may, if successful, result in claims that the entity is unlikely to be able to satisfy:- While tax disputes usually do not become that big, cases like the sugar mills SAP price dispute fall under this category
8. Changes in law or regulation or government policy expected to adversely affect the entity:-The Andhra Pradesh ordinance(later on made into an Act) on microfinance which changed the fortunes of SKS Microfinance, is a classic example. 
5. Do note however, that auditor would have access to the risk mitigation strategies of the company which are not usually in the public domain. So the auditor's not considering any major risk factor may mean that the company MIGHT have a robust mitigation plan in place 
6. Also, remember the auditor is not passing his business judgement here. His role is just to check whether there is a significant dark cloud, and if so whether the financials explain it in sufficient depth. Remember, the risk-return tradeoff is not examined. Just ask those persons who purchased Satyam below Rs 10, and made 10x returns once it jumped back to normal.

So in short, before selling your shares/shorting the stock, do read the audit opinion/para in its entirety, and even for 2-3yrs before, and try evaluating against the above criteria and the audit standard, with what you already know. After all, barring black swans, no major problem rises overnight, so it would be interesting to know what prompted a sudden change in auditor assessment, or(like in case of airlines), the media just hyped something which was anyway there.