Accounting Quality: Spotting the Naughty Lenders

The key questions the author seeks to answer in this chapter are:

• How can minority investors differentiate between companies with poor accounting quality and well-run financial services companies with high quality accounting?
• What is the relationship between share price returns and accounting quality, and what are the benefits of investing in companies with high quality accounting?
• Why is accounting quality central to investing in financial companies?

Why is Accounting Quality central to investing in Financial Companies?

For a lending business, capital is its raw material. A lender raises equity capital and then raises debt, which is as high as five to ten times the equity and lends it out.

The profits generated from this increase the bank's net worth, allowing it to raise more debt and increase the quantum of loans it can give out. For some exceptionally able Indian lenders, this dynamic has created a virtuous cycle and has generated extraordinary returns for their shareholders. However, poor accounting quality and dishonest promoters are an existential threat to a bank or NBFC.

Stage 1: When Investors do not know which companies have a poor quality of accounting

There is a strong correlation between accounting quality and shareholder returns, irrespective of whether the sub-par accounting practices of companies are common knowledge or not. Therefore, in this chapter, the author has given details of Marcellus's proprietary forensic accounting model to identify financial services companies whose accounting quality is poor.

This framework will help investors demarcate financial services companies with high-quality accounting from those with poor accounting.

Stage 2: When Investors know which companies have poor quality accounting but their accounting fraud is not public knowledge yet. 

In some cases, shareholders decide to invest in financial services companies despite being aware of their sub-par accounting quality. Such investors are of the view that either:

1. The fraud won't come to light.
2. They will be able to exit the stock before the fraud becomes public knowledge.
3. They will have enough time to exit the stock once the fraud is public knowledge.

None of these arguments holds. For instance, Yes Bank and DHFL saw a 40% crash in their share prices within a month of their accounting issues becoming public knowledge. Even their credit ratings saw accelerated downgrades once their accounting issues started emerging. For example, it took just six months for DHFL's AAA rating (in January 2019) to be downgraded to D, which is the default grade.

Stage 3: When accounting fraud is public knowledge 

Even after a fraud is  public knowledge, retail shareholders have a tendency to go bottom fishing, i.e., investing in fraudulent companies at low prices in the hope of witnessing a miraculous turnaround story. For example, the retail shareholding in Yes Bank and DHFL more than doubled once their frauds became public knowledge and share prices declined. Many investors fall prey to the anchoring bias—their attraction towards such companies is stoked because shares of these companies can be bought at a fraction of the price they had earlier traded at. However, turnaround stories in the case of financial services companies are rare, and even when such miracles happen, the minority shareholders get substantially diluted before the new management can achieve the turnaround.

Therefore, the most prudent approach for investors would be to not invest in companies with poor quality accounting, irrespective of whether such accounting malpractices are public knowledge.

How to identify naughty financial services companies? 

The author introduces us to the forensic accounting model used to identify fraudulent companies. 
Forensic accounting means the use of accounting skills to investigate potential fraud. A forensic accounting model uses a combination of financial analysis tools to flag off risks in the reported financial statements of banks and financial services companies. Marcellus has developed a model using a set of eleven accounting ratios specifically for conducting forensic checks on the numbers of financial services companies. These ratios, covering the balance sheet, profit and loss statement and cash flow statements, grade financial services companies based on the quality of their accounting. Some of the key ratios and their rationale are shown below.

The methodology evaluates eleven accounting ratios covering income statement (for revenue/earnings manipulation), balance sheet (for false representation of assets/liabilities), NPA recognition and audit-quality checks using at least six years of historical financial statements. The financial services companies are then ranked on each of these eleven ratios individually and slotted into ten deciles, from D1 to D10 (D1 being the best score and D10 the worst). These ranks are then cumulated across parameters to give a final pecking order on accounting quality. The author has termed the top three deciles as the ‘Zone of Quality’, the following three as the ‘Zone of Opacity’ and the bottom four as the ‘Zone of Thuggery’. 

There are several qualitative aspects of accounting and corporate governance which the forensic model may not be able to pick up due to a lack of data uniformity across companies or where there is subjective judgment involved. Such areas can only be evaluated through a deep dive into historical financial statements and primary data checks around management integrity. Some of the aspects that are checked to determine include loan sourcing strategies, underwriting processes, risk management practices, the quality of the board of directors, the nature and significance of related-party transactions and the governance culture within the bank/NBFC.