2020-01, Ambit Capital - When Accounting Predicted

STRATEGY
January 2020
We’re in good shape

Nobody understands our financial statement
When accounting predicted

Research Analysts:
Vinit Powle
[email protected]
Tel: +91 22 3043 3149
Nitin Bhasin
[email protected]
Tel: +91 22 3043 3241
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CONTENTS
When accounting predicted…………………………………………………………..5
Accounting quality shapes investment returns! ……………………………………6
Ambit’s ‘forensic’ model: Methodology …………………………………………..14
Signs of a potential deceit; learnings of last decade……………………………15
A few case studies from our model ……………………………………………….21
Link between accounting quality and investment returns ……………………..38
Accounting quality merits attention in a more normal market scenario …….42
How clients can use our forensic expertise ………………………………………44
Case study: Fooling by Pooling!……………………………………………………47
January 08, 2020 Ambit Capital Pvt. Ltd. Page 2

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THEMATIC ACCOUNTING January 08, 2020
When accounting predicted… 5 key improved companies over last 5

years
Ashok Leyland 3M India
Reverberations of IL&FS’ accounting shenanigans were felt by the Indian
economy throughout CY19. This coincided with the 10-year anniversary Godrej Consumers Balkrishna Ind
of Satyam scandal and also led to stringent regulations on auditors! In
this 10th edition of our accounting scorecard for nearly 1500 listed Jubilant Life Sciences
companies (ex BFSI), we reiterate that accounting quality is a pertinent Source: Ambit Capital research
first filter for stock selection. Of the key 16 accounting-related

company/stock crashes of the past decade, our accounting screens had 5 key deteriorated companies over last 5
highlighted more than 80%, sometimes very early. Most of these cases years
fared very poorly on capital intensity, related-party transactions and Zee Entertainment Take Solutions
working capital adjustments whilst raising pledges; a simple Glaxosmithkline
Sun Pharma Advanced
framework, voila! FF mcap of Zone of Darkness (ZOD) companies has Pharma
decreased from FY17 by 10%, yet it is still higher than its lowest (19% at Quess Corp
FY14); it’s not just the small-caps. Of the top 100 FF mcap companies, 29 Source: Ambit Capital research
are in ZOD. Ask us, have you avoided ZOD?
The simple variables when overlaid with
CY19: Many examples of accounting shenanigans exposed pledging predicted deceits awaiting
Over the past 15 months since IL&FS unraveled, DHFL, Yes Bank were amongst disclosure
the few whose questionable accounting/reporting practices were exposed,
leading to massive decline in investor wealth. Apart from this, there were a few
others (HDIL, CCD, Jain Irrigation, PC Jewelers) whose stock prices declined
massively on concerns over accounting practices. Our analysts, either on
bottom-up analysis or using our accounting screen, had been highlighting
concerns in most barring IL&FS.
Add pledging to our accounting analysis, save yourself from deceit

Out of key 16 companies which gained significant attention over the past
Source: Ambit Capital research
decade owing to alleged financial irregularities, 14 featured in bottom quality
deciles (D8-D10) either throughout the last 8-year period or at least once,
thereby making a good case for further analysis. In many cases, Red Flags were THIS NOTE CANNOT BE USED BY THE MEDIA
IN ANY SHAPE OR FORM WITHOUT PRIOR
raised 2-3 years before the concerns came to fore. Another unique thing CONSENT FROM AMBIT CAPITAL.
common in most of these was rise in percentage of pledged shares. Most of the
pledging was simultaneous to the rising capital intensity and related-party CASE STUDIES FEATURED IN THIS NOTE ARE
transactions. Some of the key examples were Manpasand Beverages and FOR ILLUSTRATIVE PURPOSES ONLY AND
MAY NOT NECESSARILY IMPLY ANY
Arshiya. ILL-INTENT ON THE PART OF THE COMPANY
IN QUESTION.
Fool-proofing and expanding our framework whilst regulator tightens
Over the past 2-3 years we not only added details of related-party transactions Research Analysts
and advances but also moved to 11 ratios using financials of 6-7 years.
Vinit Powle
Alongside, our analysts brought in an accounting-cum-business risk framework
+91 22 3043 3249
for banks and will soon release accounting screens for other BFSI segments. All
[email protected]
this whilst MCA, SEBI and RBI are expanding accounting disclosures (including
IND-AS), increasing liabilities on management and auditors, and increasing Nitin Bhasin
oversight on auditors (rotation, NFRA). Hopefully, next decade would be better! +91 22 3043 3241
[email protected]
Yes, in CY19 too ZOD/ZOP highlighted 12m back underperformed
Accounting quality is important in shaping investment returns. Poor quality
Reach out to us for…
accounting stocks (D8-10) continued to underperform by ~10% on a median
basis in CY19 compared to good quality accounting stocks (D1-D5). Needless to  Accessing our HAWK platform for gauging
accounting quality and capital allocation
say, the same applies to even long-term periods. On a five-year CAGR (Nov 14- history of non-BFSI firms. HAWK currently
19) basis, D10 (last decile) stocks delivered ~1% median CAGR returns. is updated with FY18 scores, FY19 scores
will be updated in next 30 days
 Heatmap for your portfolio companies
 Detailed bespoke for a company on both
accounting and corporate governance
 Training for your teams
Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may
have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.
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Accounting quality shapes investment

returns!
In CY19, India Inc. faced liquidity crisis post debacle of IL&FS. The liquidity
crisis also surfaced the bitter part of financial reporting norms in India with
regulators waking up to the call and making stringent decisions like setting
up of NFRA (National Financial Reporting Authority) or seeking ban on
faulty audit firms. The poor accounting quality stocks (D8-D10) continued to
underperform by ~13% on average basis in CY19 as compared to top quality
accounting companies (D1-D5). We, at Ambit, have always believed
accounting quality plays a very instrumental role in long-term wealth
creation and is a critical hygiene factor, lack of which is severely detrimental
to portfolio returns. This is also evident in long-term (six years) share price
outperformance of superior accounting quality deciles vis-à-vis poor quality
deciles irrespective of them being large-caps, mid-caps or small-caps. With
this note we launch our accounting model for CY19 extended to all companies
(ex BFSI) with market-cap greater than `1,000mn.
IL&FS – Accounting lapses were indicative of the brewing issues; now India
Inc. faces a liquidity crisis and set-up of NFRA
In CY18, IL & FS group entities reported inability to repay back certain loans to banks Poor quality accounting companies
and other lenders. During the same time, its founder Mr. Ravi Parthasarathy reported (D8-D10) underperformed by
his intent to leave the firm citing medical reasons. Whilst reasons for its debacle could ~13% (on average basis) between
be many, the investigations led by authorities like SFIO (Serious Fraud Investigation Dec-18 to Dec-19 as compared to
Office) very sharply brought out the ugly side of financial reporting practices in India. top quality accounting companies
SFIO probe revealed major lapses in the audit done by two globally renowned and (D1-D5)
well-respected auditing firms.
Needless to say, several large investors lost significant wealth. We at Ambit have
always believed poor accounting quality companies erode shareholders wealth over a
longer period of time. Our observation that high accounting quality means higher
investment returns over long term, while poor accounting quality means lower
investment returns over same time frame has always stood the test of time.
Exhibit 1: Zone of Darkness (D8-D10) companies continued to underperform at

several notches below Zone of Safety (D1-D5) companies
6.0
2.0
Average return (%)
(2.0) D1 D2 D3 D4 D5 D6 D7 D8 D9 D10
(6.0)
(10.0)
(14.0)
(18.0)
Source: Bloomberg, Ambit Capital research, Company. Universe for this company is BSE-500 companies (ex-BFSI)
with market cap of above `1bn at Nov’18. Share price performance is calculated over 21 Dec’18 to 02 Dec-19.
These are average returns of the deciles.
Investors could argue that average returns are not the right representative to gauge
impact of accounting quality as one stock with large negative returns could distort the
overall analysis. But the performance differential is equally evident using median
returns instead of average returns. On median basis, the bottom decile (D8-D10)
stocks declined by ~15% vs ~5% for the top five deciles (D1-D5) stocks.

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Exhibit 2: Even on a median basis, bottom quality accounting deciles have been
underperformers
8.0
4.0
Median return (%)
-
D1 D2 D3 D4 D5 D6 D7 D8 D9 D10
(4.0)
(8.0)
(12.0)
(16.0)
(20.0)
Source: Bloomberg, Ambit Capital research, Company. Universe for this company is BSE-500 companies (ex-BFSI)
with market cap of above `1bn at Nov’18. Share price performance is calculated over 21 Dec-18 to 02 Dec-19.
These are median returns of the deciles.
Accounting quality - A touchstone in defining long-term investment returns

Even an analysis over the previous six years (FY14 to FY19) suggests that accounting
quality does play an active role in shaping investment returns over the long run.
Superior accounting quality firms continue to outperform poor accounting quality
firms in the long run as is evident in performance differential for ‘Zone of Safety’ over
‘Zone of Darkness’ in the exhibit below:
Exhibit 3: Performance of accounting deciles over long periods of time
Median share price performance
Since… Decile 2014 2015 2016 2017 2018
5 yr. CAGR 4 yr. CAGR 3 yr. CAGR 2 yr CAGR 1 yr Abs
D1 6% 7% 5% -5% -5%
D2 10% 2% 11% -5% 11%
Zone of
D3 5% 11% 5% -3% -9%
Safety
D4 8% 1% -1% -15% -11%
D5 7% 6% 7% -14% -9%
Zone of D6 8% 3% 4% -14% -7%

Pain D7 6% 5% 3% -17% -8%
D8 1% 5% 3% -16% -9%
Zone of
D9 6% 0% 9% -20% -13%
Darkness
D10 1% 3% -7% -28% -19%
Source: Ambit Capital research, Company, Bloomberg, Ambit Capital research; Note: Accounting score is based
on annual financials over FY09-FY18. For deciles constructed using FY14 scores we have plotted the stock price
performance for five years i.e.27 November 2014 to 27 November 2019, for deciles constructed using FY15
scores we have plotted the stock price for four years i.e. from 27 November 2015 to 27 November 2019 and so
on.
Analysis of deciles constructed on the basis of accounting quality (quantified using Zone of Safety (D1 to D5) stocks
our model) brings out the following interesting observations: have delivered median ~7% CAGR
 Zone of Safety (D1 to D5): Over long periods, Zone of Safety has done returns in five years period, as
reasonably well. Deciles constructed on the basis of FY14 accounting scores against Zone of Darkness (D8 to
suggests that the Zone of Safety stocks have delivered median ~7% CAGR returns D10) have delivered median ~3%
in the 5-year period from Nov’14 to Nov’19. CAGR returns over same time
 Zone of Pain (D6 and D7): The next two deciles on accounting quality, i.e. D6 frame.
and D7, constructed using FY14 accounting scores have delivered median ~7%
CAGR returns in 5 years from November 2014 to November 2019, which is
almost equal to Zone of Safety stocks.

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 Zone of Darkness (D8-D10): The bottom three deciles. The worst quality stocks
on accounting quality based on FY13 accounting scores have been massive
underperformers with median ~3% CAGR returns from November 2014 to
November 2019. It is pertinent to note that D10 stocks have delivered ~1%
CAGR returns over same period.
This analysis clearly brings out the fact that accounting quality plays an important part
in generating investment returns over the long term.
Zone of Darkness means ‘lower returns over long period’ holds true across
large-caps, mid-cap or small-caps
In CY17, a year driven by excess liquidity, investors ignored accounting quality in
large-caps; but post CY17 the ZOD companies under large-cap have only
underperformed compared to ZOS and ZOP companies. Except CY17, Zone of Safety
mid-cap companies have clearly outperformed the ‘Zone of Pain’ or ‘Zone of
Darkness’ companies. Correction in poor accounting quality small-cap companies
was the sharpest.
Exhibit 4: Large-caps: >25% comprises of Zone of Darkness (ZOD) companies;
relative performance to Nifty of ZOD companies was higher in CY17 (driven by excess
liquidity); however fall was steeper in CY18
100% 15%
24% 17% 25%
33% 30%
80%
17% 5%
60% 15% 21%
26% 18%
-5%
40%
-15%
20%
50% 66% 48% 55% 54%
0% -25%
2014 2015 2016 2017 2018
Zone of Safety Zone of Pain
Zone of Darkness ZOS relative return (RHS)
ZOP relative return (RHS) ZOD Relative returns (RHS)
Source: Ambit Capital research, Company, Bloomberg. We have used Nifty-50 index to workout relative returns.
Accounting scores are based on annual financials over FY09-FY18. For instance ‘2014’ indicates 2014 deciles
and relative returns for same are average returns computed for next 1 year, i.e. Dec’14 to Dec-15 and so on.
Large-cap companies are companies with market cap of above `280bn for each year at Dec. Universe is BSE-500
companies (ex-BFSI)@ 31st Dec of each year.
Exhibit 5: Mid-caps: >25% comprises of Zone of Darkness (ZOD) companies; Zone of

Safety (ZOS) companies have only outperformed ZOD and ZOP companies post CY17
Mid-caps
100% 15%
24% 28% 22% 25% 28%
80% 10%
15% 16% 5%
60% 22% 21% 17%
0%
40%
61% 62% -5%
50% 54% 56%
20% -10%
0% -15%
2014 2015 2016 2017 2018
Zone of Safety Zone of Pain Zone of Darkness
ZOS relative return (RHS) ZOP relative return (RHS) ZOD Relative returns (RHS)
Source: Ambit Capital research, Company, Bloomberg. We have used NSE mid-cap index to workout relative
returns. Accounting scores are based on annual financials over FY09-FY18. For instance ‘2014’ indicates 2014
deciles and relative returns for same are average returns computed for next 1 year i.e. Dec’14 to Dec-15 and so
on. Mid-cap companies are companies with market cap of `85bn to `280bn for each year at Dec. Universe is
BSE-500 companies (ex-BFSI) @ 31st Dec of each year.

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Exhibit 6: Small-caps:>30% comprises of Zone of Darkness companies; investors

clearly ignored the accounting quality in CY17; correction in poor accounting quality
small-caps was the sharpest
Small-caps
100% 45%
80% 31% 33% 31% 32% 33% 35%

25%
60% 21% 18% 22% 20% 21%
15%
40%
5%
20% 48% 49% 46% 48% 46%
-5%
0% -15%
2014 2015 2016 2017 2018
Zone of Darkness ZOS relative return (RHS)
ZOP relative return (RHS) ZOD Relative returns (RHS)
Source: Ambit Capital research, Company, Bloomberg. We have used NSE small-cap index to workout relative
returns. Accounting scores are based on annual financials over FY09-FY18. For instance ‘2014’ indicates 2014
deciles and relative returns for same are average returns computed for next 1 year i.e. Dec’14 to Dec-15 and so
on. Mid-cap companies are companies with market cap below `85bn. Universe is BSE-500 companies (ex-BFSI)
@ 31st Dec of each year.
Considerable portion of large-cap companies is in ‘Zone of Darkness’

Basis FY15 financials, ~17% of total large-cap companies (lowest between FY14-19)
comprised Zone of Darkness companies. In the very next year, basis FY16 financials,
~33% of total large-cap companies consisted of ZOD companies. Needless to say, it
was during same period in which ZOD companies also gave highest returns. The
number of ZOD companies is again high at 33% at Dec’19. For mid-caps and small-
cap companies, the number of ZOD companies has always been around one-fourth
and one-third respectively (between FY14-FY19) of total number of companies
Exhibit 7: Basis FY19 financials, 33% of large-cap companies are ‘ZOD’ companies;
100% 227 250

31% 25%
80% 33% 200
22%
60% 21% 19% 150
40% 106 100

48% 75 54% 48%
20% 50
0% 0
Large caps Mid-caps Small-caps

Zone of Darkness total number of companies (RHS)
Source: Ambit Capital research, Company, Bloomberg. Note- Large-cap companies (market cap:
above `285bn), mid-cap companies (market cap: `85bn to `285bn and small-cap companies
(market cap: Less than `85bn). Universe is ex-BFSI @ 31st Dec of each year.
Relationship between voluntary resignations of auditors, independent

directors and ‘Zone of Darkness’ companies remains strong
CY19 was again characterized by a high number of auditor and independent director
resignations. Our analysis of resignations (between Apr’19 to Jul’19) of leading listed
companies suggests that over ~60% of companies with voluntary auditor resignation
feature in the ‘Zone of Darkness’ (constructed last year on our accounting model for
FY18-end financials). Meanwhile, ~50% of companies which faced ambiguous
independent director resignations feature in ‘Zone of Darkness’ and ‘Zone of Pain’.

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Exhibit 8: ~60% of auditor resignations have been in Exhibit 9: 47% of total ambiguous independent director
companies that feature in Zone of Darkness resignations relate to companies featuring in ‘Zone of
Darkness’ or ‘Zone of Pain’
Number of companies 4 Number of independent director

61 resignations (CY19)
2
30
24
1 1 1 1
0 0 0 0
D1 D2 D3 D4 D5 D6 D7 D8 D9 D10 Zone of Safety Zone of Pain Zone of Darkness
Source: Company, Ambit Capital research. We have considered auditor Source: Company, Ambit Capital research. Universe is BSE-500 companies
resignations from 01 April 2019 to 24 July 2019. Accounting scores are (ex-BFSI) with market cap of more than `1bn at Dec’18. Accounting scores
based on 2018 framework. Universe is ex-BFSI. based on FY13-FY18 financials. We have considered resignations from Jan’19
to Nov’19. Universe is ex-BFSI
Is accounting quality appropriately factored in valuations?

Basis free float market cap, the contribution of ‘Zone of Darkness’ companies to total
free float market cap has reduced since CY17. We believe the drop in contribution of
ZOD companies is largely on account of significant correction in their stock prices
rather than improvement in their accounting scores as we observe accounting scores
have remained largely static since CY17.
Exhibit 10: Contribution of ‘Zone of Darkness’ companies to free float market cap has
reduced post CY17
Zone of Darkness Zone of Pain Zone of Safety
100%
90%
80%
70% 53% 55% 53% 56%
62% 60%
60%
50%
40% 14% 13%
28% 21% 16%
30% 18%
20% 34%
30% 24%
10% 19% 21% 23%
0%
2014 2015 2016 2017 2018 2019
Source: Company, Ambit Capital research, Bloomberg. Universe is BSE-500 (ex-BFSI). Market cap is considered
as at 31-Dec of each year except for 2019, where it is 13-Dec.
Satyam did trade at a valuation discount to Infosys and Wipro even before the
promoter owned up to aggressive accounting. That said, its share price crashed by
over 90% within two days of the fraud being made public. Thus, the market does not
already know and properly discount firms that have poor accounting quality.
More recently, 8K Miles Software lost more than 90% of its value since hitting all-time
high in Nov 2017. 8K Miles was trading at significant premium (on P/E multiples) to
its peers Accelya Kale, MPS Ltd and eClerx Services until a chain of questionable
(including resignation of auditors) events unfolded resulting in significant erosion in
value.

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To check if accounting quality is factored in stock valuations, we constructed four

sector-agnostic buckets. ‘Bucket A’ comprises the first quartile of each sector with
stock trading at most premium valuations; ’bucket B’ the second quartile of each
sector; ‘bucket C’ the third quartile of each sector; and ‘bucket D’ the last quartile of
each sector with stocks trading at most discounted valuations. Hence, every bucket
has an equal number of stocks from each sector, implying the buckets are sector-
agnostic.
Exhibit 11: 25%, 34% and 17% of total stocks featuring in D8, D9 and D10
respectively are trading at premium valuations; also significant numbers of ‘Zone of
Safety’ stocks are trading at cheap valuations.
Considerable percentages of three
Number of bottom decile (D10, D9 and D8)
Accounting Deciles Bucket A Bucket B Bucket C Bucket D stocks are trading at premium
stocks
D1 41 10% 27% 34% 24% valuations. Considering their poor
D2 41 34% 24% 27% 12% accounting scores, these stocks
D3 40 38% 18% 20% 20% should be carefully evaluated.
D4 42 24% 24% 17% 33%
D5 40 13% 30% 30% 23%
D6 41 17% 20% 29% 24%
D7 40 23% 25% 25% 20%
D8 40 25% 20% 20% 25%
D9 41 34% 22% 20% 20%
D10 41 17% 24% 10% 32%
Source: Bloomberg, Ambit Capital research. Note: Accounting score is based on annual financials over FY14-19;
we have considered 1-year trailing PE for our analysis purpose. Universe for this exhibit is the BSE-500 excluding
BFSI.
Considerable proportions of the bottom three decile stocks are trading at significant
premiums; so such stocks need to be diligently evaluated to ascertain investment
suitability.
Link between changes in accounting scores and investment returns for long
periods
We analysed the median share price returns of the portfolio of stocks based on a
combination of beginning period accounting quality (i.e. 2014) and accounting
quality based on the most recent year (i.e. 2019) over longer time periods; i.e. in this
case over Nov’14-Nov19. Results from our analysis have been summarized in the
exhibit below.
Exhibit 12: Median share price returns for a combination of stocks based on
beginning (2014) and ending period (2019) accounting scores
Ending period accounting quality (2019)
Zone of Zone of Zone of
Safety Pain Darkness
Zone of Safety 6.9% 8.5% 0.0%
Beginning period accounting
Zone of Pain 15.5% 9.7% 5.3%
quality (2014)
Zone of Darkness 14.5% 0.1% 1.2%
Source: Ambit Capital research, Company, Bloomberg
Following are the key takeaways from the above exhibit:

 Firms that moved from bottom three deciles (‘Zone of Darkness’) on accounting
quality in 2014 to Zone of Safety in 2019 delivered ~15% returns on a median
basis over Nov’14 to Nov19.
 Firms that continued to stay in ‘Zone of Darkness’ delivered 1.2% CAGR returns
(underperformance by 14% than firms which moved to ‘Zone of Safety’) on
median basis over Nov’14 to Nov19. Firms that continued to stay in ‘Zone of
Safety’ delivered ~7% CAGR on median basis over the same time.
 Firms that remained in Zone of Pain delivered CAGR returns at ~10%, i.e. higher
by 3% than firms that remained in Zone of Safety. however considering their
accounting scores, companies in Zone of Pain need to be evaluated carefully.

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Change in accounting scores over longer period of time: In the BSE-500

universe between FY14 and FY19, we observe around 50 companies switched either
from Zone of Darkness (2014) to Zone of Safety (2019) or vice versa. We believe
investors should be aware of sharp fluctuations in accounting scores in case of their
portfolio companies. We plot below a few examples whose accounting scores have
sharply deteriorated or improved between FY14 and FY19. Areas highlighted in pink
denote the areas of improvement or deterioration in FY19.
Exhibit 13: Top 2 ratios (highlighted in pink) of 5 key companies where scores improved in FY19
Rank-
Rank-CAGR Rank- Rank-
Rank- Rank- Misc Cum. Change in
Rank- Rank- in auditors Rank- PFD Advance
CWIP: chg in exps-% FCF/ Reserves
Company name CFO: Cont remn/CAGR Cash as a % to related
Gross depr of Total median (ex-Sec
EBITDA Liab in consol yield of Drs> parties /
Block rate revs revs Prem)/
revs 180 days CFO
(PAT-Div)
Ashok Leyland Ltd. 368 206 301 267 292 397 15 204 314 273 204
Jubilant Life Sciences Ltd. 248 150 146 107 337 299 22 204 335 273 305
3M India Ltd. 220 89 382 218 206 143 112 204 247 273 305
Godrej Consumer Products 291 147 352 368 359 135 141 204 299 273 204
Balkrishna Industries Ltd. 369 104 90 312 378 204 208 204 294 273 305
Source: Ambit Capital research, Company. Accounting scores are based on financial statements for the year FY14-FY19. Numbers in the boxes indicate accounting
scores relative to BSE-500 universe (ex-BFSI). Standalone financial statements are considered for Ashok Leyland.
Exhibit 14: Top 2 ratios (highlighted in pink) of 5 key companies where scores deteriorated in FY19
Rank-
Rank-CAGR Rank- Rank-
Rank- Rank- Misc Cum. Change in
Rank- Rank- in auditors Rank- PFD Advance
CWIP: chg in exps-% FCF/ Reserves
Company name CFO: Cont remn/CAGR Cash as a % to related
Gross depr of Total median (ex-Sec
EBITDA Liab in consol yield of Drs> parties /
Block rate revs revs Prem)/
revs 180 days CFO
(PAT-Div)
Zee Entertainment 53 79 144 115 372 295 50 102 344 134 204
Glaxosmithkline Pharma 296 88 3 262 179 31 241 204 375 273 305
Quess Corp Ltd. 39 354 384 28 312 376 28 204 54 1 305
Take Solutions Ltd. 32 335 326 7 257 390 65 102 34 273 204
Sun Pharma Advanced 8 42 344 139 145 101 349 204 5 273 305
Source: Ambit Capital research, Company. Accounting scores are based on financial statements for the year FY14-FY19. Numbers in the boxes indicate accounting
scores relative to BSE-500 universe (ex-BFSI).
Dispersion of accounting scores exists within a sector

Given the nature of framework, it is possible that a particular sector may get
penalised more as compared to others owing to its specific nature (e.g. E&C sectors
where CWIP/gross block ratio can be considerably high for years); however, the
dispersion of accounting scores within a sector highlight that there are differences in
accounting quality of companies within the sectors. For instance, in case of FMCG
sector within the BSE-500 universe (ex-BFSI), we observe that in the universe of 29
FMCG companies, the maximum and minimum accounting score is 297 and 132
respectively.

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Exhibit 15: Accounting scores of companies vary significantly within the sector;
Pharma has highest dispersion while auto anc has lowest in our analysis
340
290
240
190
140
90
Metals &
Light Engg.
IT
FMCG
E&C and Infra

Pharma
Chemicals
Oil & Gas
Auto Anc
Mining
Source: Ambit Capital research, Company. The chart plots the difference between the maximum and minimum
accounting score for each sector. We have excluded sectors with less than 15 companies. The figure within each
column indicates the number of stocks in the respective sector
Launching our proprietary accounting model for CY19

Given the powerful bearing that accounting quality has in shaping investment We launch our accounting model
returns, and with nearly all major listed companies having published their FY19 for FY19 for all companies (ex-
annual reports, in this note we bring to you this year’s edition of our annual BFSI) with market-cap greater than
accounting thematic extended to all companies with market-cap greater than `1bn
`1,000mn.
In the next section, we discuss the methodology used to rank the entire universe of
listed companies (excluding banks and financial services firms) with market-cap
greater than `1,000mn on the basis of their accounting quality. All our accounting
analysis is based on data sets taken from Ace Equity, Capitaline and Bloomberg. We
triangulate our data across three data sets to ensure that we minimise data-driven
errors in our analysis.

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Ambit’s ‘forensic’ model: Methodology

We use 11 objective, quantifiable ratios to rank the universe based on We use 11 quantifiable ratios
accounting quality in this year’s iteration. These ratios can be broadly across four categories of
categorised into four key areas of accounting checks as shown in the exhibit accounting checks
below.
Exhibit 16: Key categories of accounting checks - Universe (excluding Financials)
Category Ratios Rationale Variables used Basis for scoring
Cum. CFO/cum. EBITDA Check on a firm's revenue recognition CFO, adjusted EBITDA Express cumulated previous six years
policy; a low ratio may be indicative of CFO as a percentage of cumulated
aggressive revenue recognition adjusted EBITDA for previous six years
practices
Volatility in depreciation rate Penalise firms where volatility in Adjusted gross block of fixed Previous six year median of absolute
P&L mis-
depreciation rate is unusually high assets, depreciation charge depreciation rate changes
statement checks
Provisioning for doubtful debts Check on a firm's debtor provisioning Provision for doubtful debtors, Previous six year median of ratio
as a proportion of debtors policy; a low ratio raises concerns debtors outstanding for a
more than six months regarding earnings being boosted period of more than 180 days
through aggressive provisioning
practices
Cash yield A low cash yield may either imply Investment income, current Previous six year median of ratio
balance sheet misstatement or that the investments, cash and bank
cash is not being used in the best balance
Balance sheet interests of the firm
mis-statement Change in reserves (excluding A ratio of less than 1 may denote direct Profit after taxes, dividend Previous six year median of ratio
checks share premium) to net income knock-offs from equity amounts, reserves balances
excluding dividends
Contingent liability as a Indicative of the extent of off-balance- Contingent liabilities, net-worth Previous six year median of ratio
proportion of net worth sheet risk
Miscellaneous expenses as a Check on a firm's expenditure policy; a Miscellaneous expenses, CSR Previous six year median of ratio
proportion of total revenue high ratio raises concerns regarding expenses, revenues
the authenticity of such expenses
CWIP to Gross Block A high CWIP to gross block ratio could Capital work in progress, Previous six year median of ratio
either indicate unsubstantiated capex adjusted gross block of fixed
or delay in commissioning assets
Cumulative CFO plus CFI to Check on whether the firm has Cash flow from operations, Cumulate balances of previous six
median revenue historically been able to generate cash flow from investing years cash flow from operations and
Pilferage
positive cash flows after investing activities, revenues investing activities and express it as
checks
activities percentage of previous six years
median revenue
Related-party advances as a Penalise firms where advances to Long-term related party We use buckets of 3 +3 years e.g.
proportion of cumulative CFO related parties have been increasing advances, cash flow from cumulate CFO of FY14-FY16 and
operations express it as percentage of FY16
year-end advances and compare it
with cumulated CFO of FY17-19 to
FY19 advances ratio
CAGR in auditors remuneration Check on the audit quality; ideally Standalone audit remuneration, Difference in audit fee CAGR less
Audit quality to CAGR in consolidated growth in auditors remuneration revenues revenue CAGR for previous six years
checks revenue should be consistent with growth in is expressed as percentage of revenue
consolidated revenue CAGR for previous six years
Source: Bloomberg, Ambit Capital research. Note: *Depreciation accounting has undergone significant changes in FY15 (due to the requirements of the
Companies Act, 2013 that became applicable w.e.f. 01.04.2014). This has resulted in inherent volatility in the depreciation rate in FY15 across the universe.
However, given that we are looking at a 6-year median in our model, this change in depreciation accounting does not materially impact the scores for companies
in the universe.
A note on Ind-AS adoption

With effect from 01 April 2018, all listed Indian companies (excluding BFSI) have
become compliant with Ind-AS (substantially converged Global IFRS). We discussed
how Ind-AS is conceptually different from the erstwhile IGAAP extensively in our 20th
October 2015 thematic: “Are you ready for Ind-AS? (click here)
Ind-AS is adopted with the intention to achieve more transparency through increased
quality disclosures. In the subsequent section, we have provided a brief description of
these accounting ratios along with illustrative case studies. We have also detailed
how we tried to minimise the impact of Ind-AS adoption in our model.

Strategy
Signs of a potential deceit; learnings of

last decade
We, at Ambit, have believed in continuously developing our accounting
framework to make it robust in assessing accounting quality. Interestingly, if
we look at 16 cases which gained significant attention in the last decade
owing to alleged accounting irregularities, almost all of them got penalised
on our accounting framework at least once in previous 8 years. In the context
of Indian companies, the simple connotation of accounting fraud is either
siphoning of money or creating a rosy picture of business which is largely
understood to be done through irrational capex spends, high related-party
payments or working capital adjustments (three common parameters). Using
a sectoral heatmap analysis, we explain through these 16 cases how these
companies scored lowest on ratios relating to these three common
parameters. Lastly, we observe, even a rise in percentage of pledged shares
has some bearing on accounting fraud risk, with 50% of these 16 companies
showing increase in percentage of shares pledged.
Evolution of Ambit’s forensic framework

Analysis of more than 10 years of financial statements of Indian listed companies is
already with us. But we always believed in sharpening the existing framework plus
making it easy for investors to do a quick first level check on accounting quality of
their portfolio companies. Importance of accounting quality was never before been
understood so well. India Inc. has made significant strides in recent past to come at
par with other developed nations on accounting practices. The
government/regulators have been taking serious steps over the past decade. The
steps taken to enhance the quality of accounting practices in India can be broadly
divided into 5 phases over last decade: 1) Post Satyam, 2) Adoption of Companies
Act, 2013, 3) Adoption of Ind-AS (global IFRS), 4) Establishment of National Financial
Reporting Authority (NFRA), and 5) Other actions (e.g. SEBI’s ban on Satyam
auditors). Alongside, we also evolved on our ‘greatness’ framework to identify
companies with sound capital allocation practices.
Exhibit 17: Continuously developing our checks on accounting issues around Indian companies

Strategy
Accounting risk was present in almost all blow-ups

We look at accounting deciles of 16 companies across sectors which gained 14 out of these 16 companies
significant attention in last decade over alleged accounting irregularities. We consider either continued to remain in Zone
the accounting deciles from FY12 as we started classifying the companies into deciles of Darkness (i.e. D8-D10)
from that year. But, please note, even for FY12, we are looking at financial throughout these eight years
statements of previous six years to FY12 (till FY07) to determine the accounting (FY12-FY19) or they showcased
decile. Accordingly, we cover a fairly long period. One could argue that some blow- significant volatility in their
ups from these 16 cases happened in early years of last decade (say FY10) and hence accounting scores thereby shifting
the accounting scores in later years just highlight the continuing state of already poor sharply between the three quality
quality accounts. Hence, to reduce this ambiguity, we go till FY07. We believe zones.
featuring even once in Zone of Darkness in any of these eight years should have
warranted attention. Needless to say the stock returns of these companies were
either negative or significantly low than even risk free rates in India.
Exhibit 18: 14 out of 16 companies with alleged accounting irregularities featured in Zone of Darkness at least once; share
price performance of these companies was negative or below the risk free rate of return in India
Accounting Deciles over years* FY12-FY19
S.no Company name EBITDA
Revenue Share price
FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 growth
CAGR performance#
CAGR
1 Conglomerate #1 D10 D10 D10 D10 D10 D8 D8 D6 -4% -20% -43%
2 Realty#1 D10 D10 D10 D10 D10 D10 D10 D10 -7% -37% -32%
3 Healthcare Services#1 D10 D9 D6 D8 D6 D3 D4 D9 6% -8% 2%
4 Heavy Engineering#1 D9 D9 D9 D4 D9 D9 D10 D8 -19% -42% -28%
5 E&C and Infra#1 D10 D10 D10 D10 D9 D9 D10 N/A -8% -189% -39%
6 Media#1 D2 D2 D1 D4 D3 D8 D6 D9 15% 18% 4%
7 Heavy Engineering#2 N/A N/A D8 D9 D10 D10 D7 D6 -5% -13% -17%
8 Heavy Engineering#3 N/A N/A D8 D7 D9 D9 D10 D9 13% 3% -37%
9 Logistics#1 D10 D10 D9 D10 D10 D10 D10 D8 -17% -22% -25%
10 Auto Anc#1 D9 D9 D7 D7 D7 D9 D8 N/A -6% -24% -41%
11 Consumer Discretionary#1 N/A D8 D7 D8 D9 D8 D6 N/A 23% 48% -39%
12 Retail#1 N/A D2 D4 D5 D4 D5 D5 D3 16% 1% -15%
13 Aviation#1 D6 D6 D5 D4 D4 D4 D6 D6 6% 14% -34%
14 FMCG#1 N/A N/A N/A D7 D8 D9 D9 N/A 33% -230% -44%
15 IT#1 N/A N/A D10 D10 D10 D10 D10 D10 69% 66% 7%
16 Consumer Discretionary#2 D9 D9 D10 D10 D9 D8 D8 N/A -11% -6% -43%
Source: Ambit Capital research, Company. *Deciles are shown from the financial year they are available or FY12 whichever is earlier. This largely depends on
availability of financial information for previous six years. Revenue and EBITDA CAGR are calculated from FY12 to FY19 except for consumer discretionary#1,
Aviation#1 and consumer discretionary#2 where it is calculated till FY18. Share price performance is calculated from 31 Dec-12 to 31 Dec-19, except for Heavy
Engineering#3, Consumer discretionary#1 and FMCG#1 where it calculated from 08 Apr-15, 12 Apr-13 and 08 July-15 respectively to 31 Dec-19. Share price
performance of Auto anc#1 is calculated from 31 Dec’12 to 13 Aug-19
Watch out for capital intensity, related-party transactions and working

capital adjustments
In a very common parlance, accounting fraud is understood as siphoning of money
out of business by trusted senior personnel of corporations. Most understood ways of
doing that are: 1) unlawful loans, advances or payments to related parties and 2)
unwarranted capital expenditures. Secondly, investors have always been wary of
aggressive revenue recognition techniques. Volatility in working capital days (e.g.
bloating of debtor days) is one of the outcomes of aggressive revenue recognition
techniques.
Using sectoral heatmap analysis, we try to find peculiar characteristics of accounting
gimmicks that surfaced in these 16 Indian companies. Interestingly, we observe from
heatmap for previous three years (FY17, FY18 and FY19) that almost all of these 16
companies scored lowest on at least one of the accounting ratios that highlight high
capital intensity, high related party payments or working capital adjustments

Strategy
Exhibit 19: 3 key variables coupled with continuous increase in percentage of shares
pledged can indicate amiss
Related party
advances
Continuous increase
in % of
shares pledged
Accounting fraud
Capital Working capital

intensity adjustments
Source: Ambit Capital research, Company
High capital intensity was prominent versus peers

A simple sectoral level heatmap shows several companies out of these 16 companies
got penalised on low CFO+CFI/median revenue ratio or high CWIP to gross block
ratio as compared to their peers. A low CFO+CFI/median indicate inability of a
company to generate sufficient cash after investing activities. A high CWIP to gross
block ratio could indicate unsubstantiated, delayed or unauthorized capex.
High related-party payments and outstanding balances over longer period
Simple check through our ratio ‘Related-party advances as a proportion of cumulative
CFO’ reveals several companies carried significant amount of related-party advances
year on year as compared to peers. The purpose and recoverability of these advances
always seemed to be an issue.
Working capital adjustments were very noticeable
Volatility in working capital days is a common outcome of aggressive revenue
recognition practices adopted by companies. Our framework captures red flags
around revenue recognition techniques using these ratios: 1) low or volatile
CFO/EBITDA ratio, 2) low provisioning of debtors outstanding for a period of more
than 180 days, and 3) cash yield. For rationales explained in exhibit 14, all three
ratios have direct links in identifying aggressive revenue recognition practices.
NOTE: How to read a heatmap shown below. For BSE-500 companies, the Ask us for sectoral level heatmap
ranking is done at sector level. For instance, say healthcare sector has 25 companies. for your portfolio companies
Rank 1 on ratio ‘cumulative CFO/cumulative EBITDA’ for a particular company
denotes lowest score on the said ratio while rank 25 denotes the highest score.
Hence, the lower the rank, the poorer it is. For sub-BSE 500 companies, ranking is
done at the entire sub-BSE 500 level. There are 900-1000 companies in sub-BSE 500
segment for all three years FY17/FY18/FY19.

Strategy
Exhibit 20: FY2019 - For any company barring 1, the first 2-3 lowest scores are on either or all of ratios, which highlight their tendency of high capital intensity, high related-
party advances or working capital issues
Ranking-Common ratios
Total companies Change in

CAGR in
within sector PFD-% of Cum. Adv. to reserves
Company name BSE500/ cum. CWIP: auditor's Misc.
or sub- Cont Liab- Change in Cash Debtors FCF/ related (ex Sec-
Sub- CFO/cum. Gross remn/ exps-% of
BSE500 % of NW depr rate yield more than median parties / prem)/
BSE500 EBITDA Block CAGR in total revs
universe six months revs CFO (PAT ex
consol revs
dividend)
Healthcare Services#1 8 BSE500 8 2 4 4 1 6 7 6 5 1 1
Media#1 11 BSE500 1 4 2 8 10 9 2 3 7 2 6
Heavy Engineering#2 11 BSE500 10 10 11 7 3 2 4 6 2 1 8
Heavy Engineering#3 11 BSE500 2 11 2 4 4 11 10 6 1 1 8
Retail#1 12 BSE500 1 11 11 3 12 12 3 6 7 1 9
Realty#1 918 Sub-BSE500 307 148 459 72 911 87 200 459 21 303 1
Logistics#1 918 Sub-BSE500 7 1 597 617 290 347 256 230 863 615 689
Aviation#1 918 Sub-BSE500 833 1 389 394 800 149 498 689 778 615 1
IT#1 918 Sub-BSE500 274 825 88 4 445 874 28 1 63 615 689

Source: Ambit Capital research, Company. Financials considered for above heatmap are from FY14-FY19. Above exhibit does not include other 9 companies out of total 16 companies considered in our analysis because either their
market cap was below `1bn or unavailability of financial statements or the accounting irregularities were discovered very early in last decade and hence ignored for FY19 heatmap

Strategy
Rise in percentage of shares pledged? Time to run a quick first-level check

on accounting quality
Increase in percentage of shares pledged cannot be considered a blanket negative;
however in case of 16 companies under our analysis, we observe that for ~50% of
cases the percentage of shares pledged significantly increased between FY10 and
FY19. Also, they remained at significantly higher level. Rise in percentage of shares
pledged along with Red Flags on accounting can be a reason to worry for investors.
We believe investors should run a quick first-level check on accounting quality using
HAWK wherever there is constant increase in percentage of share pledged.
Exhibit 21: In 50% of cases, there was significant rise in % of shares pledged between FY10 and Sep-19
% of shares pledged
Company name
FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 Sep-19
Heavy Engineering#2 6 4 5 62 57 66 84 100 100 100 -
Logistics#1 13 29 59 20 67 84 100 100 100 100 100
Media#1 30 25 35 35 42 38 42 39 53 66 96
Aviation#1 - - - - - - - - - - DNA
Heavy Engineering#1 70 63 89 100 100 99 96 99 99 76 76
Conglomerate #1 0 0 0 0 1 1 20 20 20 20 20
Auto Anc#1 - - - - - - 5 5 - - -
Healthcare Services#1 68 45 71 64 70 75 78 86 17 0 -
Realty#1 37 66 64 81 81 85 78 70 72 62 69
Consumer Discretionary#2 - - - - - - - 12 37 75 75
IT#1 - - 89 54 54 - - 9 11 14 14
Retail#1 - - - - - - - - - - -
Consumer Discretionary#1 - - - - - - - 3 11 - -
Heavy Engineering#3 - - - - - - - - - - -
FMCG#1 - - - - - - - - - - 100
E&C and Infra#1 - - - - 50 - - - - - -
Source: Ambit Capital research, Company. Before Sep-19, percentage of pledged shares is noted at Mar-31 of each financial year presented in the table
Lessons from Satyam debacle are still not taken seriously by investors
We present one case study from FMCG where we compare two companies within
these sector; a company with a good accounting quality versus a company with
weaker accounting quality. In both the cases, we observe that stock market was not
concerned about relatively poor accounting quality as long as the company was
posting good headline and operating financials parameters. However, to a discerning
investor, the signs of weak business model were visible through detailed accounting
checks or even through some basic analysis. Until some event led to cash flow
concerns and auditor resignations, the stock of the weaker accounting quality
company held up and then suddenly plummeted. The two case studies also highlight
prominence of high capital intensity in the financial statements of companies with
alleged accounting irregularities.
Case Study: A tale of two FMCG companies

In this case study FMCG#1 is a relatively smaller but fast growing company, while
FMCG#2 is fairly large and well established company. Over FY14-FY18, FMCG#1’s
revenue grew at 34%CAGR (17X the pace of FMCG#2) with lower but stable EBITDA
margin. Lead by strong improvement in headline financials, FMCG#1 always traded
at premium to FMCG#2. What investors missed but could have been picked by
discerning ones was drastically reducing fixed asset turnover (from 2.8X in FY14 to
1.3X in FY18), on other hand making continuously negative free cash flow
(cumulative `10bn over FY14-19). All throughout the high growth phase, FMCG#1
fared very poorly on FCF and fixed asset turnover. Amid, FCF concerns becoming
more evident followed by auditor resignation citing ‘lack of information’, valuation of
FMCG#1 significantly plummeted post Mar-18.

Strategy
Exhibit 22: FMCG#1 was growing ahead of FMCG#2 and also posting lower but
stable margins, before suddenly deteriorating in FY19
FMCG#1 revenue growth FMCG#2 revenue growth

FMCG#1 EBITDA margin (RHS) FMCG#2 EBITDA margin (RHS)
60% 25%
40% 20%
20% 15%
0% 10%
FY14 FY15 FY16 FY17 FY18 FY19
-20% 5%
-40% 0%
Exhibit 23: In spite of lower and decreasing gross block Exhibit 24: …..FMCG#1’s free cash flow has been negative
turnover of FMCG#1 vs FMCG#2….. Cum. CFO plus
Cum CFO Median
Net sales/gross block CFI to median
plus CFI revenues
revenues
FY14 FY15 FY16 FY17 FY18 FY19 ` mn FY14-19 FY14-19 FY14-FY19
FMCG#1 2.8 2.8 2.3 1.5 1.3 0.7 FMCG#1 (10,547) 5,785 (1.8)
FMCG#2 3.1 3.2 3.0 2.5 2.4 2.5 FMCG#2 50,082 76,677 0.6
Source: Ambit Capital research, Company Source: Ambit Capital research, Company
Exhibit 25: FMCG#1 traded at premium to FMCG#2 until investors finally realized the
issues in Mar’18. It sharply corrected post auditor resignations citing lack of
information as reason for resignation
60 FMCG#1 FMCG#2
50
40
30
20
10
Mar-16
May-16
Sep-16
Nov-16
Mar-17
May-17
Sep-17
Nov-17
Mar-18
May-18
Jan-16
Jul-16
Jan-17
Jul-17
Jan-18

Strategy
A few case studies from our model

We discuss 11 case studies on how various leading listed Indian companies We discuss 11 case studies on how
get penalised on our framework discussed above. These case studies are for leading Indian listed companies get
illustrative purposes only. The objective is to demonstrate the working of our penalised on our framework
framework and not to imply any ill-intent on the part of any company in
question.
I - P&L mis-statement checks
Companies can easily manage accounting profits or EBITDA while it is more difficult
to manipulate actual cash flows. Companies can manipulate the accounting profit (or
EBITDA) by resorting to 1) Aggressive revenue recognition policies; 2) Deferring
booking of certain expenditures; or 3) Capitalising revenue expenditure etc. In other
words, accounting profit or EBITDA could be subject to various accounting gimmicks.
Hence it is imperative for investors to evaluate true cash generating abilities of a
company.
Thus we seek to penalise such firms in our model using the following ratios:
1 Cumulative CFO to cumulative EBITDA
This ratio is a check a company’s ability to convert EBITDA into operating cash
flows.
A company’s accounting profits should ideally translate into cash flows. A low
ratio (i.e. CFO/EBITDA that is significantly less than one) should raise concerns
about the practices followed by company; these could include: 1) Adopting
aggressive revenue recognition techniques like channel stuffing, booking revenue
in advance (i.e. even before goods are actually delivered to customers) and 2)
high credit period to customers in anticipation of booking higher revenues etc.
To arrive at the scores for the universe on this measure, we first cumulate CFO
and EBITDA over the last six years. We then sort companies on this ratio and
penalise firms where this ratio is abysmally low.
Ind-AS adjustment: For companies which adopted Ind-AS in FY17, we use
FY14-15 cash flow from operations, EBITDA as per IGAAP and FY16-19 cash flow
from operations and EBITDA as per Ind-AS. For companies which adopted Ind-AS
in FY18, we use FY14-16 cash flow from operations, EBITDA as per IGAAP and
FY17-19 cash flow from operations and EBITDA as per Ind-AS.
Case study: ZEE Entertainment (ZEEL IN, US$ 3.6bn, Not Rated)
Whilst Zee’s EBITDA increased, there was reduction in cash flow led by build-up
of inventory, advances, receivables and deposits, the pre-tax CFO to EBITDA ratio
declined sharply. ZEEL began showing issues with CFO/EBITDA ratio since FY17.
Exhibit 26: Sharp reduction of pre-tax CFO to EBITDA
` mn Pre-tax CFO EBITDA Pre tax CFO/EBITDA(RHS)

30,000 100%
25,000 90%
80%
20,000
70%
15,000
60%
10,000
50%
5,000 40%
- 30%
FY13 FY14 FY15 FY16 FY17 FY18 FY19

Strategy
Given the large chunk of loans/advances/deposits given, we take that data into
receivables for all periods presented for ZEEL. This data is not taken for other
companies. ZEEL’s receivable days have continued to increase and are back to FY14
levels. Whilst peers like Sun TV have been able to reduce receivable days in the last
year, ZEEL’s have remained flat
Exhibit 27: Receivable days have increased sharply
FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19
Zee 240 227 204 230 197 215 170 203
Sun TV 93 104 100 106 113 107 117 109
TV18 104 104 88 81 161 98 180 90
Star 102 90 96 92 99 95 90 NA
Sony 181 138 186 64 56 61 68 NA
Peer Median 104 104 100 92 113 98 117 109
Source: Ambit Capital research, Company.
Interestingly, receivables from related parties (Dish and Siti) also increased
significantly. There has been a sharp spike in receivables from Dish in FY19 (68% of
the subscription revenue recognized in FY19 is receivable). Receivables from Siti are
167% of the subscription income recognized in FY19. This implies that revenue
recognized from Siti in FY18 is also still not realized in cash. We believe that this
would be a key metric to be tracked.
Exhibit 28: Receivables from Dish have shot up Exhibit 29: The same for Siti are beyond FY19 revenues
Dish SI* Dish TR* TR as a % of SI(RHS) Siti SI* Siti TR* TR as a % of SI(RHS)
` mn
` mn 1,800 180%
6,000 80% 1,600 160%
70% 1,400 140%
5,000
60% 1,200 120%
4,000
50% 1,000 100%
3,000 40% 800 80%
30% 600 60%
2,000
20% 400 40%
1,000
10% 200 20%
- 0% - 0%
Given continuing investments in content, inventory has risen nearly three-fold from
FY16 to FY19. This has led to a sharp jump in inventory days; now it is nearly half a
year of sales. Any stress in the inventory book or less than expected realization from
the marquee properties lying in the inventory could be a material event for ZEEL. We
believe inventory days would be a key metric going forward.
Exhibit 30: Inventory days have increased by over 2X from FY16 for ZEEL
Zee 80 86 97 89 83 96 143 177
SunTV 325 331 293 229 219 230 211 166
TV18 100 179 168 139 415 NM NM NM
Star 194 142 112 62 77 131 140 NA
Sony NA NA NA 238 282 203 146 NA
Peer Median 147 160 140 139 219 167 145 247
Source: Ambit Capital research, Company, Ace-Equity

Strategy
Exhibit 31: ….and inventory as a % of pre-tax CFO continues to rise
` mn Pre-Tax CFO Inventory Inventory/Pre tax CFO(RHS)
50,000 400%
350%
40,000
300%
30,000 250%
200%
20,000 150%
100%
10,000
50%
- 0%
Above challenges gets effectively captured on our framework and hence ZEEL gets
penalised on our framework.
2 Volatility in depreciation rate
Companies Act 2013 prescribes rate of depreciation for different categories of Our model penalises high volatility
assets but companies can differ from these prescribed rates on the basis of their in depreciation rate
own technical evaluations about the life of the asset. This leaves room for the
companies to manipulate the amount of depreciation charge every year. So we
believe undue volatility in the depreciation rate warrants further investigation.
We first calculate the depreciation rate for each of the past seven years (FY13-
FY19). We then calculate the change in depreciation rate for each year (giving a
set of six observations). We then calculate the median of absolute changes and
then sort the companies on this ratio so that the company with the smallest
change in depreciation rate receives the best score. The rationale is to penalise
companies that have high volatility in their depreciation rate on a YoY basis.
Note: Depreciation accounting has undergone significant changes in FY15 owing
to the requirements of the Companies Act, 2013 that became applicable with
effect from 01 April 2014. This resulted in inherent volatility in the depreciation
rate in FY15 across the universe.
However, for the purpose of our analysis, we use a six-year median of volatility in
depreciation rate. So this change in depreciation accounting does not materially
impact the accounting scores of companies covered in our forensic universe.
Ind-AS adjustment: For companies which adopted Ind-AS in FY17, we have
calculated the depreciation rates for FY14-15 as per IGAAP. For FY16-19, we
calculate the depreciation rate as per Ind-AS. Here we use depreciation expense
as per FY16-FY19 accounts; for gross block we use FY16 gross block as per
IGAAP and then make adjustments for changes in gross block in FY17- FY19. We
then take a median of volatility in depreciation rate, using FY14-15 depreciation
rate as per IGAAP and FY16-19 depreciation rate as per Ind-AS.
For companies which adopted Ind-AS in FY18, we calculate volatility in
depreciation rate over FY14-16 as per IGAAP but for FY18-19 we calculate the
depreciation rate as per Ind-AS (wherein we use the depreciation expense as per
FY17-FY19 accounts; for gross block we use FY17 gross block as per IGAAP and
then make suitable adjustments for changes in gross block in FY18 and FY19)
Case study: Vakrangee Ltd. (VAKRANGEE IN, US$ 0.8bn, Not Rated)
Vakrangee’s depreciation rate has historically been volatile vis-à-vis peers (see
exhibit below):

Strategy
Exhibit 32: Vakrangee has volatile depreciation rate as compared to its closest possible peers
YoY change in depreciation rate
Depreciation rate
Company/metric (in bps)
FY14 FY15 FY16 FY17 FY18 FY19 FY15 FY16 FY17 FY18 FY19
Vakrangee Ltd 20.1% 16.2% 15.6% 13.1% 4.5% 5.6% 391 55 250 859 104
Firstsource Solutions 10.2% 9.2% 7.2% 6.1% 6.7% 8.2% 102 202 103 61 147
Hinduja Global Solutions 10.0% 10.6% 12.1% 11.2% 10.4% 12.9% 55 155 92 75 248
Source: Company, Ambit Capital research
One plausible reason for such volatility in depreciation rate could be the continuous
changes to its gross block.
Exhibit 33: Vakrangee’s gross block breakup; company made significant sale of
assets in FY19 largely of computer hardware
Composition
Gross block
Land Improvement 0.0% 0.0% 0.0% 0.0% 0.0% 8.4% 7.1%
Buildings / Premises 1.2% 1.0% 1.0% 1.0% 24.5% 15.7% 10.7%
Plant& Machinery 0.9% 0.8% 1.0% 1.3% 29.4% 22.9% 44.1%
Furniture & Fixtures & Office
8.7% 7.0% 6.7% 6.6% 9.5% 8.7% 6.2%
Appliances
Vehicles 0.1% 0.1% 0.1% 0.1% 2.5% 1.2% 0.8%
Leasehold Land 0.0% 0.0% 0.0% 0.0% 0.0% 25.0% 17.0%
Computer Hardware 89.1% 91.2% 91.3% 91.1% 34.1% 18.2% 14.2%
Other Fixed Assets 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Source: Company filings, Ambit Capital research
Sharp fluctuation in depreciation rate in FY18 compelled us to do a further analysis of

block of assets. We observed Vakrangee made a significant sale of assets in FY17 of
which a significant portion of gross block sold (~98%) consisted of computers.
Accordingly, it was obvious for depreciation rate to come down, as the depreciation
rate for computers is quite high as compared to other assets.
However, we need more information on how company managed to increase the
revenues without any replacement (new additions) of computers. One possible
reason could be change in the nature of business activities. In FY18, company’s e-
governance project contributed mere 8%, while revenue from Vakrangee Kendra
contributed 92% as against 36% and 64% in FY17 respectively. Nonetheless,
reduction in computers gross block was as high as ~98% and hence more
information is required on the same. Also, there was no corresponding increase in
any item of other expenses like computer lease etc. which could have meant
company started using computers through rent.
Exhibit 34: Company made significant sale of computers in FY17 without any major
replacement in coming years…..
Gross block (` mn) FY15 FY16 FY17 FY18 FY19
Land Improvement - - - 105 132
Buildings / Premises 104 103 142 197 200
Plant& Machinery 100 134 170 288 828
Furniture & Fixtures & Office Appliances 696 697 55 110 116
Vehicles 5 6 15 15 15
Leasehold Land - - - 315 319
Computer Hardware 9,489 9,666 197 229 266
Other Fixed Assets - - - - 0.55
Total 10,394 10,605 580 1,260 1,878

Strategy
Exhibit 35: …however revenues only increased in FY17 and FY18; composition of
revenue shifted more towards Vakrangee Kendras
e-governance projects Vakrangee kendra Revenues(Rs. bn)
100% 70
64
60
80% 43%
54% 50
64%
60% 40 40
92%
100%
40% 32 30
28
57% 20
20% 46% 15
36% 10
0% 8% -
FY15 FY16 FY17 FY18 FY19
Whilst Vakrangee fares well on our other accounting ratios, it gets penalised on
volatility in depreciation metric.
3 Provision for doubtful debt as a proportion of debtors more than six Low provisioning raises the spectre
months of earnings being boosted through
aggressive provisioning practices
This ratio is a check on conservativeness of a company’s provisioning policy.
Debtors more than six months have a greater probability of defaulting and,
hence, best practices would require higher provisioning for such debtors.
A low ratio, on the other hand, raises the spectre of earnings being boosted
through aggressive provisioning practices. We use a six-year median for this
measure and penalise firms where this ratio is abysmally low.
Note: We agree that in case of several companies, given the nature of their
business operations, debtors more than six months are not material (vis-à-vis the
size of the business). Thus, in such cases, we assign an average score to the firm
on this parameter to avoid unduly penalising firms where debtors more than six
months are a small fraction of the consolidated revenue (our threshold for this is
0.2% of consolidated revenue).
Ind-AS adjustment: For companies which adopted Ind-AS in FY17, in some
cases we have calculated the scores on this parameter by using provisioning for
old debtors over FY11-16 (as per IGAAP) given data pertaining to debtors
outstanding for more than six months is not available under Ind-AS accounts. For
companies which adopted Ind-AS in FY18, we have calculated the scores by using
provisioning for old debtors over FY12-17 as per IGAAP.
Case study: VA-Tech Wabag (WABAG IN, US$ 0.2bn, Not Rated)
Receivable days for VA-Tech have been continuously increasing, particularly if we
include all the receivable balances (trade receivables, retention money and due
from customers). Due from customers are essentially ‘unbilled revenues’.
However, in spite of the higher share of debtors more than six months,
provisioning for old debtors (i.e. provisioning for debtors as a percentage of
debtors more than six months) is still far from 100% (see exhibit below). There is
no separate provision on due from customers.
Exhibit 36: Provisioning for old debtors – VA-Tech’s provision for doubtful debt have picked up significantly each year, but
still far from 100%
PFD as a % of Debtors more than Debtors more than six months
Company/metric six months as a % of Gross Debtors
FY15 FY16 FY17 FY18 FY19 FY15 FY16 FY17 FY18 FY19
VA Tech Wabag 12% 39% 26% 40% 60% 22% 14% 15% 22% 19%
Source: Company filings, Ambit Capital research.

Strategy
Provision for doubtful debts as % of debtors more than 6 months have grown almost
3X since FY17, sharp change in provisions at every balance sheet data indicates
company has been aggressive in making provisions in earlier years only to realise
later that higher provisions were required.
On considering all the receivables balances together, we observe the situation is
more serious. We observe the data for receivables for FY17-19 from the FY19 annual
report. Total receivable days at FY19 stand at 381 days.
Exhibit 37: Total receivable days have crossed 350-day mark and have been
increasing since FY17
Trade receivables (Rs.bn) Customer retention(Rs.bn)

unbilled revenue(Rs.bn) Receivable days
30 303 381 400
286 350
12 300
10 12
20
250
5 5 200
4
150
10
100
12 12 13
50
- -
FY17 FY18 FY19
Source: Ambit Capital research, Company. Total receivable days include trade receivables, unbilled revenue and
customer retention money. Receivable days are calculated on closing balances
So VA-tech Wabag gets penalised on this metric on our framework.
II - Balance sheet mis-statement checks

Direct write-offs from equity without routing it through the P&L account, high levels of
off-balance-sheet risks, low investment income (as a percentage of cash and
marketable investments) etc. are some of the key areas that need to be scrutinised to
assess the sanctity of a company’s balance sheet.
In that context, these are the ratios that we use to penalise such firms:
4 Cash yield
Cash yield denotes the yield that is being earned on cash and marketable
investments.
A low cash yield may either imply balance sheet mis-statement or cash not being
used for the firm’s best interests
With the risk free rate in India being 6-7%, one would expect idle cash and
marketable investments to generate at least 5-6% returns. A low cash yield could
thus be a cause for concern as it could mean that either the balance sheet has
been mis-stated or cash is not being used in the best interests of the firm.
We calculate the cash yield for each of the last six years. We then sort the firms
on this ratio using the last six-year median such that companies with relatively
high cash yields get a high score while companies with lower cash yields get
penalised the most.
used FY14-15 investment income and cash and marketable investments (to
compute the cash yield) as per IGAAP, while FY16-19 investment income and
cash and marketable investments are as per Ind-AS. For companies which
adopted Ind-AS in FY18, we have used FY14-16 investment income and cash and
marketable investments as per IGAAP and FY17-19 investment income and cash
and marketable investments as per Ind-AS.

Strategy
Case study: Eveready Industries (EVEREADY IN, US$ 0.05bn, Not Rated)
Eveready Industries caught attention in Jun’19 as its auditor resigned citing no
proper reasons.
Low cash yield numbers basis our working draw our attention to make further
analysis. Interest is earned on two assets: 1) bank balances in the form of
deposits and 2) loans and advances made to others.
Exhibit 38: Eveready’s cash yield has been very volatile over the years
Investment income yield
Company/metric
FY15 FY16 FY17 FY18 FY19 Average
Interest income/average cash and bank
6% 3% 2% 3% 2% 3%
balances
Interest income / average loans given balances 72% 31% 35% 26% 18% 36%
Source: Company, Ambit Capital Research. We have considered average cash & bank, loans given balances.
Lower interest income on cash and bank balances is primarily on account of

higher balance (~90%) lying in current accounts at every balance sheet date.
However, interest earned on loans given balances looks very high. Simple
calculation of interest income to closing or closing average loans and advances
balances gives a very high ratio of interest earned. We observe that significant
amount of loans is also given and recovered during the year and hence simple
interest income to closing loans balances will not give right answer to interest
rate earned.
Exhibit 39: Interest income on cash and bank balance is low as a significant portion of
cash is held in current accounts
Cash in current account (%) 91% 89% 86% 87% 91%
Other bank balances (%) 9% 11% 14% 13% 9%
Total cash and bank balance(Rs.mn) 71 72 56 56 72
Interest income 2 2 1 2 1
Source: Ambit Capital research, company
While interest is charged on loans given, interest received as a percentage of interest

income booked has been decreasing.
Exhibit 40: Several transactions of financial nature are taken Exhibit 41: Interest income received as % of interest
during the year income booked has been decreasing
FY15 FY16 FY17 FY18 FY19 Interest earned on loans
Interest earned from others Interest received as % of interest earned
19 64 84 126 286
(` mn) 350 140%
Closing loans given balances 27 381 90 893 2,308 286
300 120% 120%
Loans given to others (` mn) (430) (500) (650) (1,580) (4,625)
Loans realised from others 250 100%
430 150 1,000 820 3,407 92%
(` Mn)
200 80%
Source: Ambit Capital research, Company. Cash flow statement 69%
150 60%
126
100 84 40%
64 32% 30%
50 19 20%
0 0%
We urge investors to ask for more information on the purpose of such transactions of
financial nature.

Strategy
5 Change in reserves (excluding share premium) to net income excluding

dividends: Under IGAAP and in some specific situations under the current A ratio of less than one on change
regime of Ind-AS (substantially converged global IFRS), certain provisions are in reserves, ex-share premium to
allowed directly through write-offs to equity without reflecting these adjustments net income, ex-dividends, may
in the P&L. Further, through various court approvals, several companies have denote direct write-offs through the
taken direct write-offs from reserves without routing it through the P&L. balance sheet
In order to penalise firms that have historically taken direct knock-offs from
equity, we calculate the change in reserves (excluding share premium) on a YoY
basis and divide it by that year’s PAT excluding dividends. We then take a six-year
median of this ratio. A ratio of less than one indicates direct write-offs to equity
without routing these through the profit & loss (P&L) account and may indicate
aggressive accounting policies.
Ind-AS adjustment: For companies which adopted Ind-AS in FY17, the data
related to reserves and net income from FY16 to FY19 is basis the Ind-AS
financials. For companies which adopted Ind-AS in FY18, the data related to
reserves and net income from FY17 to FY19 is basis the Ind-AS financials.
Case study: India Cements (ICEM IN, US$ 0.3bn, Not Rated)
We plot two instances in the consolidated financial statements of India Cements
for FY15 and FY17 wherein the company took a direct hit to the reserves without
routing it through the profit and loss statement.
 After the Companies Act, 2013 became applicable, several companies were
required to adjust the depreciation rates (basis the new schedule of depreciation
rates) from the beginning of the life of asset and pass the impact from such
change through the reserves as at 01 April 2015. India Cements charged the
reserves and surplus balance on 01 Apr 2015 by `2.3bn with additional
depreciation charge which meant India Cements has technically reduced the life
of assets or increased the depreciation rates. While there is no issue with the said
adjustment, we believe more information is required on why the depreciation
rates were increased in FY15 only as increase in depreciation rate was even
allowed under previous law (Companies Act, 1956)
 Secondly, on adoption of Ind-AS in FY17, India Cements booked
provisions/losses to the tune of `5.2bn (including deferred tax of `1.1bn) directly
through reserves. The buffer created from fair valuation gain of ` 28.6bn from
revaluation of certain fixed assets was used to absorb this provision. We believe,
more information will be required on why these provisions were not made in
IGAAP regime basis the principle of conservatism and prudence.
Exhibit 42: Several provisions and losses were booked on adoption of Ind-AS; fair
valuation gain on certain fixed assets acted as buffer to absorb these losses (numbers
are in lacs)

Strategy
6 Contingent liabilities as a proportion of net worth

A significant contingent liability (‘off balance sheet risk’) is a potential liability
which could lead to a significant cash outflow. A high ratio raises concerns
regarding the strength of the company’s balance sheet in the event that these
contingent liabilities materialise. Also, significant amount of contingent liabilities
over years could highlight that the company is being very aggressive, thereby
avoiding making provisions for these liabilities with intent to show higher profits.
Given that contingent liabilities also include genuine items such as letters of A very high proportion of
credit, bill discounting and capital commitments, we seek to eliminate as many of contingent liabilities to net worth
these items whilst computing the figure for contingent liabilities. We use a six- indicate disproportionately high
year median for this measure and penalise firms with a very high proportion of off-balance sheet risk
contingent liabilities.
used FY14-15 contingent liabilities and net worth as per IGAAP while FY16-19
contingent liabilities and net worth are as per Ind-AS. For companies which
adopted Ind-AS in FY18, we use FY14-16 contingent liabilities and net worth as
per IGAAP while FY17-19 contingent liabilities and net worth as per Ind-AS.
Case study: Gayatri Projects (GAYAPROJ IN, US$ 0.2bn, Not Rated)
Gayatri’s contingent liabilities to net-worth ratio stood as high as 412% at FY19
year-end. Six-year median (FY14-FY19) for the same ratio is 828%. Contingent
liabilities drastically reduced to `43bn in FY16 from `93bn in FY15 and then rose
to `48bn in FY19. The sharp reduction in contingent liabilities followed by the rise
again was largely led by corporate guarantees given by the company to
banks/financial institution for loans availed by them.
Exhibit 43: Break-up of contingent liabilities; corporate guarantees given for loans Gayatri’s contingent liabilities
availed by group companies is on rise stand at ~412% of FY19 net
As per annual report (Rs.bn) FY15 FY16 FY17 FY18 FY19 worth…
Claims against the company * * - - -
Guarantees given by the banks towards performance
8 12 13 13 15
and contractual commitments
Corporate guarantees given to group companies 84 30 31 36 33
Disputed liability of income tax, sales tax, service tax
1 1 1 1 0
etc
Total contingent liabilities 93 43 45 49 48
Net-worth 7 5 5 10 12
Contingent liabilities/net-worth 1272% 783% 872% 487% 412%

Strategy
We delve into corporate guarantees given to group companies. We believe, since the
group company wise (name of entities) break-up for corporate guarantees given by
the company is not disclosed in the related-party disclosure, it is difficult to select any
group company for determining its financial solvency position through other details
available in the financial statements. But the ‘Emphasis of matter’ paragraph in the
auditor’s report highlights some liquidity issue with one of the associate company.
Exhibit 44: ‘Emphasis of matter’ para in FY19 audit report highlights subsidiary of an
associate to which corporate guarantee is given has defaulted in loan repayment
Source: Company filings, Ambit Capital research. Audit report on consolidated financial statements
Note no.31.17 of the consolidated financial statement suggests the company has
given an irrevocable and unconditional guarantee of `18bn to the lenders of above
subsidiary of an associate, yet the management believes no provision is required to
be made in respect of the same.
Exhibit 45: Note no 31.17 of financial statement highlights Exhibit 46: …(note no 31.17 continued) but management
not all is well at subsidiary… continues to believe all is well
We believe investors should remain skeptical of rising contingent liabilities of Gayatri

Projects and ask for more information wherever required

Strategy
III - Cash pilferage checks

Cash pilferage is the third category of checks that we analyse. High miscellaneous
expenditure (for which no further disclosures are available), unsubstantiated capex,
negative free cash flows over long periods of time, and advances given to related
parties are some of the key categories of checks that should raise eyebrows and,
hence, need to be scrutinised.
We use the following ratios:
7 Miscellaneous expenses as a proportion of total revenue
A high proportion of miscellaneous
This ratio is a check on a company’s expenditure policy. Miscellaneous expenses,
by their very nature, do not require any further disclosure. A high ratio thus raises expenses raise concerns regarding
the genuineness of such expenses
concerns regarding the authenticity of such expenses.
Thus, in order to penalise firms with high miscellaneous expenses, we calculate
miscellaneous expenses as a proportion of total revenue for the last six years and
then use a six-year median for this measure.
used FY14-15 miscellaneous expenses and total revenue as per IGAAP while
FY16-19 miscellaneous expenses and total revenue are as per Ind-AS. For
companies which adopted Ind-AS in FY18, we have used FY14-17 miscellaneous
expenses and total revenue as per IGAAP while FY18-19 miscellaneous expenses
and total revenue are as per Ind-AS.
Case study: DB Realty (DBRL IN, US$ 0.04bn, Not Rated)
An analysis of DB’s miscellaneous expenses (as a percentage of net sales)
suggests miscellaneous expenses have been significantly higher than those of
peers (see exhibit 21 below). Miscellaneous expenses is generally a residual head
of expense; i.e. when a particular expense cannot get clubbed in specific head of
expense owing to its nature, it is clubbed with miscellaneous expense. In an ideal
case, where the number of specific heads of expenses is more, miscellaneous
expense should be low. But despite having a higher number of heads for specific
nature, the miscellaneous expenses are high for DB.
Exhibit 47: DB Realty’s miscellaneous expenditure as % of Exhibit 48: ….despite having more specific expense heads
revenue has always been higher than its peers… under ‘other expenses’ schedule
Miscellaneous expenditure as % of net
Company/metric sales Specific expense heads
32
DB Realty 1% 1% 3% 8% 1% 25
Prestige Estates 0% 0% 0% 0% 1% 22
Godrej Properties 0% 0% 0% 0% 0%
DB Realty Sobha Prestige Estate Godrej

Properties
Note that not only has this ratio been higher than that of peers, in FY18, the
miscellaneous expenditure rose to as high as 8% of revenues. Also, miscellaneous
expenses as % of revenue look very volatile.

Strategy
8 CWIP as a proportion of gross block

The idea here is to penalise firms that show consistently high CWIP relative to the A high CWIP relative to gross block
gross block as this may either indicate unsubstantiated capital expenditure or a may either indicate
delay in commissioning (which may in turn be motivated by a delay in the unsubstantiated capex or delay in
recognition of the related depreciation expense). We calculate the proportion of commissioning
capital work in progress to gross block for each of the last six years and then take
a simple six-year median.
used FY14-15 CWIP and gross block as per the previous IGAAP while FY16-19
CWIP is as per Ind-AS. FY17-FY19 gross block is calculated using FY16 gross
block as per IGAAP and then making suitable adjustments for changes in gross
block in FY17/FY18/FY19. For companies that adopted Ind-AS in FY18, we used
FY14-16 CWIP and gross block as per IGAAP while FY17-19 CWIP is as per Ind-
AS. FY18 gross block is calculated by using FY17 gross block as per IGAAP and
then making suitable adjustments for changes in gross block in FY18 and FY19.
Case study: Coffee Day Enterprises (CCD IN, US$0.1bn, Not Rated), Sical
Logistics (SICAL IN, US$ 0.01bn, Not Rated)
Group entities Coffee Day Enterprises, Sical Logistics (subsidiary of Coffee Day
Enterprises) lost significant market value since the promoter of Coffee Day
committed suicide in CY19 essentially citing business/liquidity related issues. Both
Sical and Coffee Day Enterprises get penalised on our framework and feature in
lower accounting quality deciles over years.
CWIP/gross block was one ratio were Coffee Day Enterprises got penalised.
Whilst rising CWIP balance could genuinely be on account of business operations
or decisions; we believe investors need to keep a thorough check on this. Rising
CWIP balance on one hand while deteriorating debt-equity ratio on other hand
raised a Red Flag a long time back. CWIP was largely held on account of Sical(
subsidiary)
Exhibit 49: Simultaneous rise in CWIP/gross block and debt-equity ratio
CWIP/Gross block Debt-Equity
Coffee Day Enterprises Ltd. 28% 30% 28% 35% 40% 1.7 2.0 2.1 2.0 1.8
Source: Ambit Capital research, Company. Note: *CWIP includes capital advances and intangible assets under development.
9 Cumulative CFO plus CFI to median revenue Our model penalises firms that
have not generated positive free
We calculate the cumulative CFO (cash flow from operations) plus cumulative CFI
cash flows even on a six-year basis
(cash flow from investing activities) over the last six years. Next, we divide this by
the last six-year median revenue for the company to normalise it for the size of
the company. The higher the ratio, the better our perception of the company’s
accounts
The idea is to penalise firms which over such long periods have been unable to
either generate positive cash flows from operations or alternatively where cash
flow from investments have consistently eaten away cash generated from
operations.
Ind-AS adjustment: For companies which adopted Ind-AS in FY17, we used
FY14-15 CFO, CFI and revenue as per IGAAP while FY16-19 CFO, CFI and
revenue are as per Ind-AS. For companies which adopted Ind-AS in FY18, we
used FY14-16 CFO, CFI and revenue as per IGAAP while FY17-19 CFO, CFI and
revenue are as per Ind-AS.

Strategy
Case study: Den Networks (DEN IN, US$ 0.04bn, Not Rated), 8K miles
(KMSS IN, US$ 0.01bn, Not Rated)and Take solutions (TAKE IN, US$
0.2bn, Not Rated)
We select 3 companies out of all companies which gets penalised on our Despite lower asset turns
network. An analysis of Den Networks, 8K Miles, and Take Solutions asset turns (suggesting operating
suggests the gross block turnover has been decreasing YoY. In spite of the lower inefficiencies), Den’s, 8K Miles’s
gross block turnover (suggesting inefficiencies in sweating the assets), all three and Take Solutions’s free cash
companies’ cumulative CFI over the last five years has consistently eaten cash flows have historically been
generated from operations, raising questions regarding the wisdom of capex (see negative
exhibits below).
Exhibit 50: In spite of the low asset turnover vs its Exhibit 51: …all 3 companies’ free cash flows have been
peers… negative (` mn)
Gross block Asset Turnover Cum. CFO plus
Company/metric Cum. CFO Median
CFI to median
FY17 FY18 FY19 Company/metric plus CFI revenues
revenues
Den Networks 0.7 0.7 0.7 (FY14-FY19) (FY14-FY19) (FY16-FY18)
8K Miles 2.8 2.9 1.5 Den Networks. (26,338) 11,435 (2.3)
8K Miles (2,613) 4,001 (0.7)
Take Solutions 1.8 2.2 1.8
Take Solutions (5,550) 11,873 (0.5)
Source: Company, Ambit Capital research. Source: Company, Ambit Capital research.
Given negative free cash flows on a cumulative basis over the past few years,
Den Network, 8K Miles and Take Solutions get a low score on free cash flows to
median revenues on our model. All 3 companies have lost significant share value
in recent years.

Strategy
10 Related-party advances as a proportion of cumulative CFO We also penalise firms where

We calculate the cumulative CFO (cash flow from operations) over the last three related-party advances have been
years and the three years before that and compare it with the related-party increasing
advances (as at FY19-end and FY16-end). Next, we compute the ratio of related-
party advances as a proportion of cumulative CFO over the preceding three years
for both FY16 and FY19. We penalise companies where this ratio is increasing
while rewarding companies where this ratio has been declining. Firms with no
related-party advances get the highest possible score.
The idea is to penalise firms where related-party advances are consistently eating
away into cash generated from operations.
Ind-AS adjustment: For companies which adopted Ind-AS in FY17, we use
FY14-15 cash flow from operations, related party advances (RPAs) as per IGAAP
and FY16-19 cash flow from operations, RPA’s as per Ind-AS. For companies
which adopted Ind-AS in FY18, we use FY14-16 cash flow from operations, RPA’s
as per IGAAP and FY17-19 cash flow from operations, RPA’s as per Ind-AS.
Case study: Eros International Media (EROSMEDIA IN, US$ 0.02bn, Not
Rated)
Problems for Eros’s shareholders typically begin in June’19 as rating agency CARE
cut its ratings from BBB- to default citing delays or likely default in servicing debt
availed from banks. One of the reasons, Eros gets penalised on our framework is
owing to high related-party advances.
Exhibit 52: Related-party advances – Eros International Media
Particulars Amount (` mn)
FY19 Related-party advances (RPA) 4,285
Cumulative CFO over FY17-19 8,724
FY19 RPA as a % of cum. CFO over FY17-19 ~49%
FY16 Related-party advances (RPA) 6
Cumulative CFO over FY14-16 29,755
FY14 RPA as a % of cum. CFO over FY14-16 0%
Source: Company filings, Ambit Capital research
A glance at consolidated financial statements of Eros International Media for

FY17/FY18/FY19 highlights certain dubious transactions entered between the group
companies. Nature, purpose and business reasons of these transactions are not easily
understood through disclosures in the financial statements alone. We look at
transactions entered by the company with fellow subsidiaries and immediate holding
company. These are typically also the material ones within all the related-party
transactions at the consolidated level taken together.
There are several transactions (loans given/taken) of financial nature between the
company and its holding company/fellow subsidiaries. FY16 to FY19 consolidated
financial statements indicate giving and receiving of loans/advances over the years.
We observe transaction with 3 related parties and found no disclosure on interest
cost. Whilst it can be assumed that these are advances given as advances for content
or business purpose, but it is difficult to comprehend purpose for these transactions
given their ‘give and take’ nature.
Exhibit 53: Eros Worldwide FZ LLC (holding company) - transactions related to
financing nature taken during the previous years; no interest element is involved
Transactions (` mn) FY16 FY17 FY18 FY19
advance/ loan given - - 1,012 3,531
Recovery of advance/loan Transactions during - - - 391
advance/loan taken the year 4,115 1,461 326 1,060
Repayment of advances/loans 4,859 5,401 1,842 -
Trade balances due from 758 784 660 1,170
Trade balances due to Closing balance 1,437 1,348 1,330 934
Advance/loan due to at balance sheet date 6,049 1,830 345 1,405
Advance/loan due from - - 1,012 4,298
Source: Ambit Capital research, Company. Related party disclosures

Strategy
Exhibit 54: Eros International Limited (fellow subsidiary): transactions of financial

nature were squared off during the year; but no interest element is involved
Transactions (` mn) FY17 FY18 FY19
Content advance given 761 1,118 -
Refund of content advance 269 1,871 -
Transactions during
Recovery of advance loan/given - - 28
the year
Advance/loan taken 1,264 35 111
Repayment of advances/loans 1,256 35 110
Trade balances due from 9 9 -
Trade balances due to 8 10 11
Closing balance at
Content advance given to (balance sheet) - 33 -
balance sheet date
Advances loans due to - - 1
Advance/loan due from - 33 5
Exhibit 55: Eros Films Limited - Isle of Man (fellow subsidiary); transactions of
financial nature squared off during the year; however no interest element is involved
Transactions (` mn) FY17 FY18 FY19
Advance/loan given - - 1,394
Transactions during the year
Recovery of advance/loan given - - 1,394
Considering high related-party advances as at FY19 year-end, Eros gets penalised on
our framework.
IV - Audit quality checks

Having looked at the reported financial statements, the auditor and the auditor’s
report are the next most important sections of the annual report that need attention.
Independence of the auditors is of utmost importance in ensuring the fairness of
financial statements. Unreasonably high fees paid to the auditors may impair the
auditors’ independence to some extent, so a disproportionate increase in audit fees
versus the increase in top-line calls for caution as well.
We use the following ratio to evaluate the quality of the audit and the auditors:
11 CAGR in auditor’s remuneration to CAGR in consolidated revenue We penalise firms where growth in
We calculate the CAGR in standalone auditor’s remuneration and the CAGR in auditor’s remuneration has been
consolidated revenue over FY14-19. A lower ratio of CAGR in auditor’s exorbitantly high vis-à-vis growth
remuneration relative to CAGR in consolidated revenue receives a high score. in the firm’s revenue
The rationale is to penalise companies where growth in auditor’s remuneration
exceeds growth in revenue.
Ind-AS adjustment: For all companies, we have used FY14 auditor’s
remuneration and consolidated revenue as per IGAAP while FY19 auditor’s
remuneration and consolidated revenue are as per Ind-AS.
Case study: A listed company (‘XYZ’)
XYZ lost ~75% of its share value in the past one year. Real problems for the
shareholders started in Aug’19 as the company filed a letter with the stock
exchange intimating certain accounting irregularities.
XYZ’s revenue is not directly comparable YoY as it was subject to several
restatements between FY15-19 owing to revenues from discontinued operations,
adoption of Ind-AS, Ind-AS 115 (new revenue recognition standard).
Nonetheless, on an ‘as is’ comparison it only reflects that revenue fell over years;
but on the other hand the auditor remuneration has only increased.

Strategy
Exhibit 56: Total audit remuneration has grown sharply in Exhibit 57: Core audit fees for XYZ has continuously grown
FY15, FY17 and FY19 despite continuous fall in revenue as compared to Nifty 50 companies
Growth in total auditor's remuneration(YoY) Growth in core audit fee - XYZ

Growth in Consolidated revenues(YoY) Growth in core audit fee - Nifty 50
60% 46%
42%
50%
23% 20%
20%
15%
12% 6% 7%
3%
-4% -2%
FY15 FY16-16% FY17 FY18 FY19 FY15 FY16 FY17 FY18 FY19
-7%
-19% -21% -19%
-23%
Source: Ambit Capital research, Company Source: Ambit Capital research, Company. Nifty 50 companies are ex-BFSI
Break-up of total auditor remuneration for XYZ vs Nifty 50 companies suggests

non-core audit fees of XYZ contributed a significantly higher share to total auditor
remuneration as compared to Nifty 50 companies. We believe high amount of
other charges paid to the auditors could jeopardize the auditor’s independence.
Exhibit 58: Non-core audit fees of XYZ contributed major Exhibit 59: For Nifty 50 companies , non-core audit fees
portion till FY17 (more than 50-60%) contributed around 35% between FY15-19
Core audit Fees Other fees Core audit Fees Other fees
Total fees (Rs. mn)-RHS Total fees (Rs. bn)-RHS
100% 40 100% 2.0
35
32% 34
80% 61% 80% 38% 37% 37% 34% 34% 1.9
53% 46% 30 1.9
57% 28 1.9
60% 25
22 60% 1.8
1.8 1.8
20 20
40% 17
15 40% 1.7
68%
62% 63% 63% 66% 66%
47% 54% 10
20% 43% 39% 20% 1.6
5
1.5
0% 0 0% 1.5
Source: Ambit Capital research, Company. We have considered limited Source: Ambit Capital research, Company
review fees as part of other fees
A sharp rise in audit fees in case of XYZ could also be attributed to financial
statements being audited by joint auditors (i.e. more than one auditor) during
FY17-19; however we believe still it is difficult to explain such sharp rise in total
auditor remuneration. Also, it is pertinent to note that one of the auditors
resigned within less than 2 years from the audit engagement. The company
referred to same as ‘casual vacancy’ in FY19 annual report.
Cumulating scores: We first assign scores to all the firms in the universe on each of
the 11 parameters discussed above. Next, we add the scores across the 11
parameters to arrive at the final blended accounting score for each firm.
Unlike last year when the entire universe was divided into Ind-AS and non Ind-AS,
this year all the listed companies have adopted Ind-AS so we have divided the entire
universe into BSE 500 and sub-BSE 500.
Based on these parameters, we rank 407 firms in the BSE 500 universe and 917 firms
in the non-Ind-AS universe on accounting quality in this year’s exercise. Given most
of the measures discussed above are not applicable to a bank or an NBFC, from the
entire universe we have excluded banks and financial services firms. For investors
interested in our forensic work on banks, please note:

Strategy
35 firms have been included based on their financials over FY13-18 as their FY19 Table 1: Firms included based on
annual reports had not been published at the time of running this exercise (see Table FY13-FY18 financials
1 at right). Further, 13 firms have been included based on their standalone financials Capitaline name Ticker Year End
as their consolidated financials would include the results of their financial arm and, Borosil Glass BRSL IN Mar.
hence, would not have been comparable with the rest of the universe (see Table 2 on CG Power & Indu. CGPOWER IN Mar.
the right below table 1). Prakash Inds. PKI IN Mar.
Siemens SIEM IN Sep.
Like last year, we have extended this year’s forensic accounting exercise to Ruchi Soya Inds. RSI IN Mar.
include all firms with market-cap above `1,000mn. The exhibits and Khoday India KHOD IN Mar.
discussion in the subsequent sections, however, are only for the Ind-AS Uttam Value Ste. UVSL IN Mar.
universe (excluding financial services). Unitech UT IN Mar.
Data sources: We have used Ace Equity and Capitaline as data sources for the PS IT Infra PSHI IN Mar.
underlying financial data whilst stock price data has been sourced from Bloomberg. ITI ITI IN Mar.
We had to use Ace Equity for some data items and Capitaline for some others in Jaybharat Text JTRE IN Mar.
order to minimise data errors. Unfortunately, neither of these databases (nor any Guj. Borosil GBS IN Mar.
other database in India) is entirely reliable by itself. Ashapura Minech. ASMN IN Mar.
Please note, however, that several adjustments need to be made to each of the Alok Inds. ALOK IN Mar.
individual variables which we have not detailed here. For further details on these Sanwaria Consum. SANWCL IN Mar.
adjustments, kindly email the authors of this note. Indsil Hydro IHPM IN Mar.
Jet Airways JETIN IN Mar.
Excel Crop Care EXCC IN Mar.
Vardhman Acrylic VAL IN Mar.
3i Infotech III IN Mar.
Moschip Tech. MOSCHIP IN Mar.
Hi-Tech Pipes HITECH IN Mar.
8K Miles KMSS IN Mar.
Florence Invest. FIL IN Mar.
Shahlon Silk SHAHLON IN Mar.
Pennar Engg.Bld. PEBS IN Mar.
Nagarjuna Fert. NAGARFER IN Mar.
Essar Shipping ESL IN Mar.
Eco Friendly EFFL IN Mar.
Esteem Bio Org. EBPL IN Mar.
HPC Biosci. HPBL IN Mar.
Channel Nine CNEL IN Mar.
Coffee Day Enter CCD IN Mar.
Bharat Road BRNL IN Mar.
Diksat Transwor. DIKSAT IN Mar.
Table 2: Firms included based on

standalone financials
Capitaline name Ticker
Maruti Suzuki MSIL IN
Larsen & Toubro LT IN
Bajaj Auto BJAUT IN
M&M MM IN
GAIL (India) GAIL IN
Hero Motocorp HMCL IN
Grasim Inds GRASIM IN
Ambuja Cem. ACEM IN
Info Edg.(India) INFOE IN
Ashok Leyland AL IN
Exide Inds. EXID IN
Prism Johnson PRSMJ IN
PTC India PTCIN IN

Strategy
Link between accounting quality and

investment returns
In this section, we seek to answer the following question: ‘Does accounting We explore the link between
quality, as measured by our model, have any link with stock market accounting quality and stock
performance?’ To answer this, we assess the link between the blended returns
accounting score for the BSE-500 universe, derived using the methodology
discussed above (i.e. using six years of consolidated financials), and the
share price performance over the last six years (i.e. Nov 2013 to Nov 2019).
We note the following key takeaways from our analysis:

 Decile-level analysis points to a strong link between accounting quality and
investment returns;
 There is a strong link between accounting quality and investment performance
even after controlling for sector effects; and
 Large-cap firms have better accounting quality vis-à-vis mid/small-cap firms.
At the universe level there is no significant relationship between accounting

quality and investment returns
At the universe level (i.e. all leading listed Indian companies that have adopted Ind-
AS), we do not find any significant relationship between accounting quality and share
price performance. This could partly be explained by the fact that at the stock level,
several other factors influence share price returns (such as underlying fundamental
performance, company-specific and industry-specific factors).
Exhibit 60: Scatter plot does not show any significant relationship between accounting
scores and share price performance for leading listed Indian companies
145% R² = 2% Stock-level noise leads to a weak

relationship between accounting
Share price performance
115% scores and stock returns at the

(Nov '13 to Nov '19)
85% universe level …
55%
25%
-5%
75 125 175 225 275
-35%
-65%
Accounting score
Source: Bloomberg, Ace Equity, Capitaline, Ambit Capital research. Note: Accounting score is based on annual
financials over FY14-FY19; stock price performance is from November 2013 to November 2019 on a CAGR
basis. Universe for this exhibit BSE-500 (ex-BFSI).
Decile level suggests accounting quality is a significant driver of stock returns

To control the noise around individual stocks, we now construct deciles on the basis
of accounting scores for the companies. A decile-level analysis is revealing and
demonstrates the power of accounting quality in shaping investment returns.
An R-squared of ~64% suggests that accounting quality is a significant driver of stock
returns. D9 and D10 have performed the lowest in the long run; the stocks under
these deciles should be carefully evaluated as these stocks have fared poorly in
comparison to top 5 deciles on either of the 11 accounting ratios under our
framework.

Strategy
Exhibit 61: Decile-level analysis reveals a strong link between accounting quality and
share price performance
25% R² = 64% …however, deciles constructed on
23% D5 accounting scores demonstrate the
performance (Nov '13 to
21% power of accounting quality in

Median share price
19% D4 shaping stock returns

D8 D7 D1
17% D3 D2
Nov '19)
15%
13% D6
11% D9
9%
7% D10
5%
140 170 200 230 260
Accounting score based deciles (FY12-FY18)

financials over FY13-FY18; stock price performance is from November 2013 to November 2019 on a CAGR
basis. Universe for this exhibit is BSE-500(ex-BFSI).
If we look at the R-Squared evolution over last 6 years (2014-19), we note that the R-
Squared has in fact declined from 77% in FY13 to 64% in FY19. We believe that the
key reason for this is because ‘Zone of Pain’ stocks have done reasonably well.
In terms of individual decile performances, the first decile (D1) delivered stock price
return of median 18% CAGR since November 2013. In contrast, the last decile (D10)
delivered returns of median 7%% CAGR, implying 12% CAGR outperformance for D1
vs D10. The performance differential across deciles becomes more evident in the
exhibit below; but stocks under D6-D7 should be carefully evaluated as they have
fared relatively poor on accounting parameters in comparison to the top 5 deciles.
Exhibit 62: Whilst D9 and D10 have clearly underperformed, D8 stocks need careful
evaluation
Top accounting decile outperforms
25%
the bottom decile by 7% on a
'Zone of 'Zone of
'Zone of Safety'
Pain' Darkness'
CAGR basis
20%
Median share price
15%
Nov '19)
10%
5%
0%
D1 D2 D3 D4 D5 D6 D7 D8 D9 D10
Accounting score based deciles
Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accouting score is based on annual
financials over FY14-19; stock price performance is from November 2013 to November 2019. Shaded areas
denote the three zones on accounting quality. Universe for this exhibit is BSE 500 (Ex BFSI)
The most crucial takeaway from the above exhibit is that the market can be divided
into three different ‘Zones’ on accounting quality on the basis of investment
performance – the ‘Zone of Safety’, the ‘Zone of Pain’ and the ‘Zone of Darkness’.
The top 5 deciles on accounting do not seem to be materially different from each
other on investment performance and we label it the ‘Zone of Safety’. The
outperformance in the next two deciles (D6 and D7) suggests that such stocks need to
be scrutinised carefully to deliver investment performance. At D9 and D10, however,
the performance slumps significantly, suggesting that this is the ‘Zone of Darkness’,
one to be avoided at all costs. D6 has performed almost in par with Zone of Safety
deciles, but given their poor accounting scores they need to be further evaluated.
Exhibit 60, therefore, suggests that thinking about accounting quality as just one of
the many factors affecting investment returns isn’t appropriate. It is, in fact, a critical
hygiene factor, the lack of which can be seriously detrimental to portfolio returns.

Strategy
Sector-agnostic buckets continue to demonstrate need to avoid the bottom

decile on accounting
One may argue that in the decile construction above, sector effects have not been
nullified and some sectors may do better than others on our accounting model by
virtue of the nature of their businesses. The decile performances thus might reflect
serendipitous sector effects. To control the sector effects, we now construct four
sector-agnostic buckets such that ‘bucket A’ comprises the first quartile of each sector
on accounting scores, ’bucket B’ comprises the second quartile of each sector, ‘bucket
C’ comprises the third quartile of each sector and ‘bucket D’ comprises the last
quartile of each sector. Hence, every bucket has an equal number of stocks from
each sector, implying that the buckets are sector-agnostic.
Each bucket in this case will have similar sectoral compositions and, hence, a
performance assessment of these buckets should enable one to assess the impact of
accounting quality on stock price performance in a sector-agnostic manner. Exhibit
below displays these four buckets with their respective stock price performances.
Clearly, the performance differential points to a strong link between accounting
quality and stock price performances even after controlling for sector effects.
Exhibit 63: Strong link between accounting quality and stock performance even after
factoring sector effects
Sector-agnostic buckets constructed
21%
with homogenous sectoral make
20% 220, 19.0% and differentiated only on

Median share price
19%
249, 17.5% accounting quality show
18% accounting quality drives
199, 16.7%
Nov '19)
17% investment performance even after

16% controlling for sector effects
15%
14% 172, 13.1%
13%
12%
Bucket A Bucket B Bucket C Bucket D
Sector-agnostic accounting buckets
financials over FY14-19; stock price performance is from November 2013 to November 2019 on a CAGR basis.
Universe for this exhibit is the Ind-AS universe. The first entry is the accounting score over FY14-FY19; the second
entry is the median CAGR stock returns in that bucket from November 2013 to November 2019.
The above exhibit again highlights the importance of avoiding the lowest quality firms
on accounting quality regardless of how cheap they are.
Size buckets – large-caps have better accounting quality than small-caps
To address the size dimension, we split our universe of stocks into four sizes of
buckets as shown below. Bucket 1 comprises the largest 100 stocks in terms of Accounting quality is better for
market-cap, Bucket 2 the next 100, Bucket 3 the next 100 and Bucket 4 the lowest larger caps on an average
112 stocks in terms of market-cap (thus, taking the total to 408 firms).
Exhibit 64: Larger capitalisation firms have better accounting scores on average
Average Average % stocks in '
Number of firms
Bucket Market cap range (` bn) Market cap range (USD bn) accounting share price Zone of
in the bucket
score performance darkness'
top 100 Bucket 1 ` 206bn- ` 9,238bn US$ 2.9bn-US$130bn 212 18.4% 29.0%
next 100 Bucket 2 ` 71.1bn- ` 199bn US$ 1.0bn-US$2.8bn 213 22.6% 25.0%
next 100 Bucket 3 ` 34.7bn- ` 73.6bn US$ 0.49bn-US$1.0bn 212 20.8% 25.3%
bottom 107 Bucket 4 ` 1.8bn- ` 34.5bn US$ 0.02bn-US$0.48bn 202 9.1% 39.8%
Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY14-19; stock price performance is
from November 2013 to November 2019 (on a CAGR basis). Universe for this exhibit is BSE-500 companies (ex-BFSI)

Strategy
As one would expect, we find that the average accounting score as well as the stock
price performance vary directly with market cap; i.e. the larger market-cap buckets
(i.e. Buckets 1 and 2) have better accounting scores as well as better stock price
performance whilst the smallest market-cap bucket has the worst accounting score as
well as the worst stock price performance.
Further, the proportion of stocks in the ‘Zone of Darkness’ (i.e. stocks that fall in D8,
D9 and D10) too varies with market cap. Whilst 29% of firms belonging to the largest
market cap bucket fall in the ‘Zone of Darkness’, ~40% of the firms belonging to the
smallest market cap bucket fall in this zone.
Delving further into the stocks that are in Bucket 4 of market cap, we note that ~34%
of these names also fall in Bucket ‘D’, i.e. the bottom quartile stocks from each
sector. This suggests that a significant proportion of firms from Bucket 4 on market
cap also fall in the bottom quartile on accounting quality in their respective sectors.
Exhibit 65: Distribution of the smallest market-cap firms across the four accounting
quality buckets
Number As a % of total number of firms in Bucket '4'
Accounting quality bucket
of firms (i.e. the smallest 284 firms in the BSE500)
Bucket A (best quality) 19 18%
Bucket B 28 26%
Bucket C 24 22%
Bucket D (worst quality) 36 34%
Total 108 100%
Source: Company, Ambit Capital research. Universe for this exhibit is BSE500 (ex-financials).

Strategy
Accounting quality merits attention in a

more normal market scenario
The bottom decile stocks have been massive underperformers in CY19. A Bottom deciles (D8-D10) on
situation like this might create even more performance pressure on accounting quality has declined by
promoters or management, which may in turn resort to certain accounting ~16% average returns over the
manipulation practices. So investors need to be more vigilant. Our forensic past one year versus 3% decline for
model should help investors in this regard. the top decile companies (D1-D5)
Stocks with poor accounting quality have corrected the most
Analysis of share price performance over the past year of deciles on accounting
quality constructed last year suggests the bottom deciles (i.e. the worst quintile stocks
on accounting quality on our model) declined by ~16% on average versus ~3%
correction for top decile companies.
Exhibit 66: Poor quality stocks have declined the most in the past year
6.0
Average return (%)
2.0
(2.0)
(6.0)
(10.0)
(14.0)
(18.0)
D1 D2 D3 D4 D5 D6 D7 D8 D9 D10
Source: Bloomberg, Ambit Capital research. Note: Universe for this exhibit is the BSE500 ex financials universe.
Performance has been calculated over 21 Dec’18 to 02’Dec’19. These are average returns for the deciles.
Should investors shun accounting quality and invest in lower quality firms? While investors might feel the urge
to go down the quality spectrum,
Needless to say, given the massive correction of poor quality firms in the ensuing
we believe investors need to be
correction phase, investors should stay away from low quality companies at all times.
much more vigilant
However, whilst markets can remain irrational for long and test even the sanest of
investment philosophies, at Ambit, we have always believed that for long-term wealth
creation accounting quality plays a very instrumental role and is a critical hygiene
factor, lack of which is severely detrimental to portfolio returns (see our discussion in
the preceding session).
Global Trust Bank (2004), Satyam (2009), Arshiya (2013), Amtek Auto (2015) and,
more recently, Ricoh India (2016) are only some of the biggest accounting frauds (in
Amtek, the company failed to honour debt obligations) that have shaken the Indian
markets. In all these cases, while the companies had a stellar past (in terms of share
price performance), these stocks tanked significantly once the accounting
irregularities got exposed.

Strategy
Exhibit 67: GTB’s share price performance before and after Exhibit 68: Satyam’s share price performance before and
discovery of under-provisioning by the bank after confession of manipulation of books of accounts
350.0 700.0
300.0 600.0
250.0 500.0
200.0 400.0
150.0 300.0
100.0 200.0
50.0
100.0
-
-
Dec-98
Jun-99
Sep-99
Dec-99
Mar-00
Jun-00
Sep-00
Dec-00
Feb-01
Aug-01
Nov-01
Feb-02
Aug-02
Nov-02
Feb-03
Jan-04
Oct-03
Jul-03
Jul-04
Apr-99
May-01
May-02
May-03
Apr-04
Dec-03
Jul-04
Feb-05
Sep-05
Jul-11
Nov-06
Jun-07
Jan-08
Feb-12
Apr-06
Aug-08
Mar-09
Sep-12
Oct-09
Dec-10
Apr-13
May-03
May-10
Global Trust Bank Sensex Satyam Computers Sensex
Source: Bloomberg, Ambit Capital research. Note: Shaded area denotes share Source: Bloomberg, Ambit Capital research. Note: Shaded area denotes
price reaction resulting from the event. share price reaction resulting from the event.
Exhibit 69: Arshiya’s share price performance before and Exhibit 70: Amtek Auto’s share price performance before
after allegations made by its employees and after default of debt obligations
450.0 400.0
400.0 350.0
350.0
300.0
300.0
250.0
250.0
200.0
200.0
150.0 150.0
100.0 100.0
50.0 50.0
- -
Nov-13
Aug-14
Nov-14
Aug-15
Nov-15
Aug-16
Nov-16
Aug-17
Nov-17
Dec-08
Jun-09
Dec-09
Jun-10
Dec-10
Jun-11
Dec-11
Jun-12
Dec-12
Jun-13
Dec-13
Jun-14
Dec-14
Jun-15
Dec-15
Jun-16
Dec-16
Jun-17
Feb-14
Feb-15
Feb-16
Feb-17
May-14
May-15
May-16
May-17
Arshiya Sensex Amtek Auto Sensex
Source: Bloomberg, Ambit Capital research. Note: Shaded area denotes share Source: Bloomberg, Ambit Capital research. Note: Shaded area denotes
price reaction resulting from the event. share price reaction resulting from the event.
Whilst we agree that it requires a lot of time for these accounting issues to
materialise, when they do, they tend to be a binary event for the stock price.

Strategy
How clients can use our forensic expertise

We discuss four distinct ways in which clients can use our forensic expertise.
Given change in accounting quality has a powerful bearing on investment
returns, clients can use our forensic model to identify firms/sectors that are
witnessing improvement/deterioration in accounting quality. To access our
model, clients can use our HAWK platform to screen the entire listed universe
(~1500 firms in the latest iteration) on the basis of their accounting quality.
For clients interested in their portfolio heatmaps, we can also provide an
accounting heatmap of their portfolio within five working days of receiving it
if the constituent stocks are in our accounting model. For a more detailed
analysis, we also conduct extensive bottom-up company-specific bespoke
research for clients. Finally, for interested clients, we would also be more
than happy to do a session on forensic accounting with your entire team.
Using our model to identify firms witnessing improvement/deterioration in

accounting scores
While our discussion above suggests accounting quality has a powerful bearing on Extreme swings in accounting
investment returns, our work on change in accounting quality suggests even a change quality has historically created
in accounting quality has a meaningful bearing on investment returns. large alpha over next 1-2 years
For instance, analysis of accounting quality of BSE500 firms in 2014 and 2018
suggests poor/(superior) accounting firms in 2014 with improvement in accounting
scores by 2019 significantly outperform at ~14% in CAGR terms against accounting
firms with no improvement in scores (see exhibit below):
Exhibit 71: Portfolio returns for a combination of stocks based on beginning (2014)
and ending (2019) period accounting scores
Ending period accounting quality (2019)
Zone of Zone of Zone of
Safety Pain Darkness
Zone of Safety 6.9% 8.5% 0.0%
Beginning period
Zone of Pain 15.5% 9.7% 5.3%
accounting quality (2014)
Zone of Darkness 14.5% 0.1% 1.2%
Source: Bloomberg, Ambit Capital research. Note: Performance has been calculated over Nov ’14 – Nov ’19. This
is median returns for the portfolio. This exhibit has been reproduced without any changes from our 22 June 2017
report: “Track extreme swings in quality”.
Thus, given out/(under)performance of firms witnessing improvement/(deterioration)

in accounting scores, we believe it is not just the absolute accounting quality but also
the change and, more importantly, extreme swings that are more relevant.
For the entire list of stocks that are witnessing improvement/deterioration in
accounting quality, kindly contact the authors of the note.

Strategy
Access our HAWK platform

In the wake of several clients requesting access to both our ‘forensic’ and ‘greatness’ Clients can access our HAWK
models, in July last year, we launched our HAWK platform giving clients access to platform to screen ~1,400 firms on
Ambit’s proprietary ‘forensic’ and ‘greatness’ models in an easy to use and intuitive their accounting quality
format (click here for the User Guide).
Our HAWK platform allows clients to screen the entire universe ex-financials (~1,500
listed Indian companies ex-BFSI) on the basis of their accounting quality (quantified
using our ‘forensic’ model) and capital allocation track record (quantified using our
‘greatness’ framework’) over the last ten years. Whilst the platform currently has the
accounting scores for all the companies updated until FY17, in a few weeks from
now, we will refresh our platform to incorporate FY18 financials as well.
As an example, the following exhibit illustrates how clients can use our HAWK
platform to identify the more conservative or the more aggressive sectors – both on
capital allocation as well as the quality of financial reporting.
Exhibit 72: Sector-level heatmap analysis using HAWK
Source: Ambit HAWK, Ambit Capital research. Note: Each block represents a sector – block size represents either free float or market cap, block color represents
either forensic score or greatness score. Clients can use the toggle buttons to switch the representations. Click on any sector to see the constituent stocks – this also
changes current selection to all stocks in that sector. The other charts update automatically. Data for the above exhibit pertains to FY12-17.
Please contact your relevant sales representatives at Ambit if you have not yet
received the login credentials for HAWK or if you would like a demo on how to use
the product.
Portfolio heatmaps
We can give interested clients an accounting heatmap of their portfolios within five We can give interested clients
working days of receiving them if the constituent stocks are in our accounting model. accounting heatmaps for their
This will enable clients to identify if any of their holdings are in the ‘Zone of portfolio
Darkness’. A sample screenshot of what such a diagnostic looks like is presented
below.

Strategy
Exhibit 73: Indicative portfolio heatmap

Scores
Misc.
Ambit Cont Rel. party CAGR in PFD (% of Change in
Companies Change exps Cum. FCF/
sector CFO- |Liab advances auditor’s fees Cash debtors reserves/ Overall
in dep. (% of median
EBITDA (% (as a % of to CAGR in yield more than (PAT ex- Score
rate total revenue
of NW) cum. CFO) cons. revenue six months) dividend)
rev.)
ABC Industrials 11 12 13 8 2 13 6 13 11 3 9.2
XYZ Utilities 13 8 12 9 5 12 2 7 7 3 7.8
PPP Utilities 1 5 8 10 8 8 11 11 6 3 7.1
RRR IT 3 2 10 12 7 10 8 10 5 3 7.0
DEF Metals 12 10 4 5 6 3 3 6 13 3 6.5
GHI Metals 10 6 7 6 1 2 12 5 12 3 6.4
TTT Oil & Gas 6 11 5 4 4 7 1 1 10 2 5.1
PQR Oil & Gas 7 13 3 2 3 1 4 1 2 3 3.9
Note: ORANGE denotes sub-par accounting quality relative to the sector average on a particular parameter as well as overall; RED denotes that the stock falls in
the ‘Zone of Darkness’
In-depth bespoke analysis

From our discussions above, we note that our accounting model uses 11 objective, Finally, for a more detailed
quantifiable parameters to assess the overall quality of a firm’s accounts. That said, it research on a particular stock, we
has certain limitations too. For example, as we will see in the next section of the note, also conduct in-depth bespoke
certain subjective assessments on governance standards cannot be quantified and research
can only be made after going through the annual reports. Our bottom-up analysis,
therefore, plays a vital role in helping our clients identify these parameters.
Thus, for clients interested in a more detailed analysis, we also conduct extensive
bottom-up company-specific bespoke research.

Strategy
Case study: Fooling by Pooling!

AR 09-18 analysis reveals Capital IT Technologies benefitted from loopholes The identities of company and the
in Pooling of Interests method by overpaying for acquisitions (~88% goodwill related senior management personnel
in investments over FY10-14) and subsequently writing down against are kept anonymous. Further, since the
reserves. Some payments on acquisitions (e.g. Target 1) were ~41% higher company went into significant
than the disclosed amounts. Target 1, Target 2, Target 3, Target 4 and Target restructuring in FY19, the case study
5 are the amalgamations that resulted in 3-17% of Capital IT Technologies’ includes financial numbers updated
net-worth erosion, in multiple instances! Aggregate book tax was ~20% only till FY18 since FY18 and FY19
lower than cash taxes paid, indicating overstatement of PAT over FY09-18. number are not directly comparable.
Low cash yields (2-4%) were a function of a shocking share of cash and kind
parked in current accounts (38-75% vs normative of ~20%). Taking cues from
Satyam’s case, investors should be concerned about the actual cash
presence! Board is of questionable independence with 4/5 independent
directors remaining too long (some since FY05!). Auditor fees for ‘other
services’ grew 71% CAGR over FY14-18!
Long-term book tax – cash tax divergence is a fault

line
We notice that the provisions for income tax made by the company in its P&L
statement and the cash taxes paid (as reported in its cash flow statement) over the
long term (FY09-18) differ by a meaningful extent (~20%).
These items need not necessarily match in the short term given temporary differences
arising out of differential treatment in items like depreciation and amortization. For
instance, adopting accelerated depreciation for tax purposes and straight line
depreciation for reporting purposes.
However, we expect such differences to normalize over the long term, driving
convergence of book provision for taxation and actual taxes paid. Material divergence
in the case of Capital IT Technologies (20% vs 12% for Peer 1 and 0%-1% in case of
Peer 2 and Peer 3), a level which is not observed in the case of its competitors, raises
red flags about the potential overstatement of historical book profits.
Exhibit 74: Alarming level of divergence between book taxes and cash taxes over the
long term
Aggregate divergence b/w book taxes and cash taxes over FY09-18
20%
12%
1%
0%
Capital IT Peer 1 Peer 2 Peer 3

Technologies
As we deep dive into this aspect, we understand a significant part of this long-term
divergence was arising out of the difference reported in FY15. While the reported ETR
during that year was ~4.6%, it is surprising to note that the tax rate based on cash
taxes paid was as high as 31.3% (vs ~18% then MAT rate in India).
AR15 of Capital IT Technologies vaguely narrates the reasons for the lower reported
ETR. While the company indicates that it filed for revised tax returns of earlier years in
US jurisdiction after completion of “extensive revised documentation”, it does not
divulge any further details or disclosures on what prompted the revised tax returns to
tax authorities.

Strategy
Exhibit 75: Long-term book tax – cash tax reconciliation exposes fault lines in the company’s accounting and disclosures
FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 Total (FY09-18)
P&L provision for tax (X) 120 169 155 437 766 941 115 830 606 698 4,835
Current tax (Y) 126 233 206 472 859 1,159 280 941 638 623 5,538
Cash tax expense (Z) 141 213 249 268 998 1,291 777 816 669 586 6,009
Difference (X-Z) 18% 26% 61% -39% 30% 37% 577% -2% 10% -16% -20%
Besides, the company also states that amalgamation of Target 1 India (also known as
Capital IT Technologies global solutions, then 100%-owned subsidiary) with Capital IT
Technologies had an impact on lower provision for book taxes during the year. It
adds that amortization of goodwill on amalgamation was recognized as a tax
deductible expense for FY14 and FY15, resulting in a provision reversal.
The modus operandi of goodwill!

Goodwill accounting leads us to a more important RED FLAG in the way Capital IT
Technologies recognized goodwill on consolidation in some of its major acquisitions,
the movement and their subsequent adjustment directly against the reserves without
passing through P&L. Going by the data from annual reports, Bloomberg and media
articles, we understand that the company has done four major and three minor
acquisitions over FY10-15. On a whole, we estimate the company to have spent not
more than Rs6bn (not adjusted for time value) over this period.
We believe more information is required on the movement of goodwill on
consolidation over FY09 (EOP) to FY15. The peak change (vs base, FY09 EOP) in
reported goodwill over this horizon is ~Rs5.7bn, representing ~88% of the purchase
consideration paid out by Capital IT Technologies towards investment in subsidiaries
over FY10-14, as per its cash flow statement! This indicates that the company has
significantly and consistently overpaid for its acquisitions over this horizon.
Exhibit 76: ~88% of the incremental investments were recorded as goodwill over this
period
Rs mn FY10 FY11 FY12 FY13 FY14 FY15
Increase in goodwill YoY 665 350 2,323 801 1,571 (906)
Cash outflows towards investment in
668 463 2,366 1,255 1,732 1,182
subsidiaries
% of cash outflow being recorded as goodwill 100% 76% 98% 64% 91% -77%
Capital IT Technologies had repeatedly marked down the carrying value of goodwill
on consolidation, adjusting it directly against the reserves (rather than charging it to
P&L). To conclude, we notice a pattern of repeated overpayments towards
acquisitions – corroborated by (1) high share of goodwill in purchase considerations
and the (2) subsequent mediocre growth of the company indicating the absence of
any synergies – followed by a systematic reduction of reserves and surplus at a
consolidated level.
Exhibit 77: For instance, amalgamation of Target 2 and Target 3 in FY13 reduced
~3% of then net worth

Strategy
Target 1 amalgamation is a questionable transaction!

While these transactions may not appear very big, the company repeated the pattern
in amalgamation of Capital IT Technologies global solutions (originally Target 1) in
FY15. Target 1 global is an entity acquired by Capital IT Technologies in FY12 that is
into the sale of certain software and its implementation, consultancy, maintenance
and support services.
By end of FY12, Capital IT Technologies acquired ~58% stake in Target 1 with a plan
to increase its stake to 100% subsequently by paying a maximum of ~Rs1.4bn (fixed
consideration of Rs405mn and maximum performance based consideration of
Rs959mn) to acquire the balance ~42% stake. However, subsequently the company
acquired balance ~42% stake in Target 1, paying almost ~Rs1.8bn (~41% higher
than the originally earmarked and disclosed amount as per AR12). This material
increase in consideration was understood by analyzing the “Non-current investments”
account in the standalone section of the subsequent annual reports). We believe
more information should have been disclosed for change in consideration.
Interestingly, Capital IT Technologies amalgamated Target 1 (renamed as Capital IT
Technologies Global by then) with itself, resulting in a material reduction in the
outstanding goodwill on consolidation. Again, Capital IT Technologies adjusted it
(~Rs 2.2bn, ~17% of FY15 net-worth) directly against reserves.
Exhibit 78: Net of pre-amalgamation reserves, debit to consolidated reserves is
Rs2.2bn
Exhibit 79: Adjustments related to Target 1 amalgamation in general reserve in FY15
Exhibit 80: Adjustments against surplus in statement of Profit & Loss

Strategy
And it does not stop with Target 1

Capital IT Technologies repeated this pattern of amalgamations with Target 4 and
Target 5 in FY16. ~US$27mn was adjusted against the reserves directly without
passing it through P&L. Since these entities were then step-down subsidiaries of
Capital IT Technologies (subsidiaries of Capital IT Technologies Info systems), debit to
reserves was visible only in consolidated financials. Adjustment to the tune of
~Rs1.5bn (~11% of FY16 net-worth) was made to the surplus in statement of P&L.
Acquisition failures – Coincidence or deliberate?

In the aftermath of consolidating the above acquired entities, Capital IT Technologies
has massively underperformed other mid-caps on revenue growth (US$). This
disappointing post-amalgamation performance defeats the argument that these
acquisitions are highly synergistic and accordingly deserves premium considerations.
What is more ironic is the fact despite the dismal performance post integration,
consideration paid out to some entities (e.g. Target 1) in the subsequent years (some
of which is also performance based) ended way higher (by ~41%) than what was
initially agreed upon and disclosed to investors!
Exhibit 81: Capital IT Technologies lagged most other mid-caps on revenue growth
(US$) during FY13-18
14.2%
12.5% 12.0%
11.4%
6.7%
Peer 1 Peer 2 Peer 3 Peer 4 Capitalist

Technologies
Management attributed most of the acquisition failures to some or the other reasons.
However, looking at the modus operandi – (1) overpaying for acquisitions, (2)
structuring payments / stake purchase in tranches over time, (3) finally amalgamating
the entities using pooling of interests method, (4) adjusting goodwill against reserves
and (5) providing insufficient disclosures throughout – we are of the view these
acquisition failures look dubious.

Strategy
Is the cash on books real?

Cash yields of Capital IT Technologies over FY14-18 (2-3%) remained
consistently and alarmingly lower than most peers (6%-8%) and the normal
cash yields in India. This is due to the shocking share of cash and short-term
investments (CSI, 38-75%) parked in non-interest bearing current accounts.
Learning from Satyam’s accounting fraud suggests such disproportionately
high share of CSI stashed in current accounts at the cost of lower yields is a
Red Flag. Peer analysis suggests a meager ~20% of CSI in current accounts
should suffice to run normal business operations despite IT/ER&D companies
operating in different geographies through multiple subsidiaries. Given its
business model, Capital IT Technologies generates decent cash flows every
quarter, though cash conversion is more volatile than peers. Also, dividends
paid never exceeded 9-14% of EOP current account balances. This backdrop
raises concerns about the actual presence of cash being reported in the
balance sheet. Our concerns are aggravated by instances of Capital IT
Technologies resorting to more expensive debt (e.g. to fund capex in FY17),
keeping current accounts untouched!
What’s the reason for low cash yields?

Yields of Capital IT Technologies on cash and short-term investments over the last
five years were extremely low in the range of 2-3% vs 6-8% for most competitors. It
should be noted forex gains/losses are not counted towards calculating cash yield.
Exhibit 82: Capital IT Technologies has alarmingly low cash yields
4%
3%
4%
3% 3%
3% 2%
2% 2%
2%
2%
1%
1%
0%
Source: Company, Ambit Capital research. Note: Above yields are calculated using the average balances of cash
and short-term investments at the beginning and at the close of the year
A deeper examination of Capital IT Technologies portfolio of cash and short-term

investments indicate shockingly high allocation towards current accounts which do
not pay any interest!

Strategy
Exhibit 83: Share of funds parked in current accounts by Exhibit 84: … than those of a pro-forma IT/ER&D firm
Capital IT Technologies is significantly higher…
Loans , 2% Cash &

Other Bank
cheques , Loans , 0%
balances ,
4%
Other Bank 15%
Cash &
balances ,
ST cheques ,
16%
Investment, 0%
Current
19% account ,
14%
ST
Current Investment,
account , 71%
64%
Source: Company, Ambit Capital research. Note: Share of cash and short Source: Company, Ambit Capital research. Note: Share of cash and short
term investments term investments
The share of funds invested in current accounts (as % of overall cash and short-term
investments) moved in the range of 38-75% over the last five years while it peaked at
30-40% for peers. Based on our learnings from the case study of Satyam’s accounting
fraud, we view such disproportionately high share of funds in current accounts at the
cost of lower cash yields as a Red Flag.
Exhibit 85: Shockingly high amount cash & short-term investments parked in current
accounts
Cash & short-term investments invested in current accounts

80% 75%
75%
70%
64%
65%
60% 56%
55% 51%
50%
45%
38%
40%
35%
30%
Is there a genuine need to park cash in current

accounts?
To run the operations
In FY17-18, for instance, almost 64-75% of the company’s cash and short-term
investments were stashed in current accounts while the peer median was as low as
~20%. Similar to Capital IT Technologies, it should be noted even peers are
operating through multiple subsidiaries within different geographies.
This indicates that the company is parking a significantly higher share of funds in
current accounts than what is needed to run normal business operations in the short
term. In addition, like any other IT/ER&D business, Capital IT Technologies is a decent
cash generating company (though cash conversion is more volatile than peers).

Strategy
Exhibit 86: Decent cash generation despite higher volatility of cash conversion
Pre-tax CFO/EBITDA FY14 FY15 FY16 FY17 FY18
Capital IT Technologies 55% 113% 114% 66% 123%
Peer 1 88% 105% 85% 84% 116%
Peer 2 74% 106% 75% 116% 98%
Peer 3 80% 117% 85% 100% 114%
Peer 4 -58% 83% 134% 93% 101%
Median 77% 106% 85% 96% 108%
In the context of the company generating decent cash flows quarter after quarter, we
do not see a real need for parking such an alarming level of cash in current accounts,
which impacts overall cash yield.
To pay dividends or for acquisitions
Cash dividends paid out by the company (including DDT) over FY14-18 accounted for
not more than 9-14% of the EOP balances only in current accounts. This translates
into 4-11% of EOP balances of overall cash and short-term investments. Our
concerns get aggravated by the fact that dividend payout of Capital IT Technologies
has never been material w.r.t its overall current account balances.
Exhibit 87: Dividend payouts have never been Exhibit 88: …w.r.t. cash balances of the company
meaningful…
Dvidend as % of EOP current account Dividend as % of EOP cash & short term
16% balance investments
14% 12%
11%
14% 12%
12% 10%
12% 11%
8%
10% 9% 8%
6%
8% 6% 5%
4%
6%
4%
4%
2%
2%
0% 0%
Source: Company, Ambit Capital research Source: Company, Ambit Capital research
The acquisition intensity of the company came down meaningfully over the last three
years. Even otherwise, acquisitions in case of companies like Capital IT Technologies
(unlike companies which engage in more periodical investments) are one-off events
which do not necessitate parking of funds in current accounts forever at the cost of
diluting the overall shareholder returns!
Why borrow when (if) you have cash?!

Despite sitting on such high current account balances (where yield is 0%), we noticed
instances of Capital IT Technologies resorting to short-term borrowings (paying short-
term rates). For instance, the capex intensity of the company increased in FY17 (to
Rs1.9bn, ~6% of revenue). This was driven by setting up of a new facility with an
investment of Rs1.1bn. However, during the year as short term borrowings on the
balance sheet increased, management attributed that to capex!!
We believe more information is required on why the cash sitting on balance sheet
(FY16 EOP: overall cash & short-term investments = Rs4.6bn and funds in current
account alone = Rs2.4bn) was not used, why would the company fund capex through
debt (being a net interest payer) rather than utilize cash in current accounts or even
other accounts.

Strategy
Incomplete disclosures
Historically, we believe Capital IT Technologies’ disclosures on key aspects
like (1) auditor’s remuneration and (2) goodwill remained insufficient. Over
FY14-18, fees paid to auditors for ‘other services’ increased ~7x and now
accounts for ~38% of auditor’s remuneration. Prima facie while this indicates
a potential for conflict of interest, Capital IT Technologies has not provided
any further disclosures on the nature of these services. Despite the high
share of goodwill on the balance sheet (25% of average net-worth, FY18),
Capital IT Technologies’s disclosure quality on this aspect is sub-standard
with no details about allocation to different CGUs or even the assumptions
used in goodwill impairment test and calculation of recoverable amount.
‘Other services’ from auditors?!

Auditor’s remuneration witnessed a strong increase of ~13% over (FY14-18) ahead
of the company’s revenue growth (US$: 6% and INR: 8%). Within the auditor’s
remuneration, while audit fee remained more or less stable (at ~Rs9mn over the
observation horizon), we are surprised to note ~7x jump in fee to auditors for other
services. This item now comprises ~38% of auditor’s remuneration, way above the
~7% it used to contribute in FY14.
Exhibit 89: Auditor’s remuneration has grown ahead of Exhibit 90: Fee for other services now comprise ~38% of
revenue auditor’s remuneration
80% 71%
CAGR (%, FY14-18) Reimbursem
70% ents
60% 5%
50%
40%
30% Fee for
20% 13% other
8% Audit fee
6% services
10% 50%
38%
0%
Revenue - INR
Revenue - US$
Fee for other

remuneration
services
Auditor
Limited
review of
quarterly
results
7%
Source: Company, Ambit Capital research Source: Company, Ambit Capital research
Insufficient disclosures on goodwill

AR18 and even the previous annual reports provide insufficient disclosures about
goodwill despite this accounting for ~25% of average net-worth in FY18. We believe
these disclosures make an otherwise complex goodwill trajectory even more difficult
to comprehend. While Ind-AS itself calls for more disclosures around goodwill (e.g.
reconciliation between YoY changes), firms with a material share of goodwill on their
balance sheets are now providing even greater number of proactive disclosures.
However, Capital IT Technologies continues to provide a bare minimum number of
disclosures.

Strategy
Exhibit 91: Share of goodwill on the balance sheet remains high
Goodwill / Net Worth

50% 47%
45%
39%
40%
35%
30% 28% 26%
24%
25%
20%
15%
10%
5%
0%
Source: Company, Ambit Capital research. Note: EOP data considered in the above chart
Capital IT Technologies does not even provide disclosures related to the number of
Cash Generating Units (CGU) recognized by the company and the share of goodwill
on the balance sheet apportioned to each of those CGUs. Historically, the company
made acquisitions in both IT services and engineering services areas. Accordingly, the
current goodwill on the balance sheet is arising out of two diverse business streams.
Exhibit 92: The company’s goodwill contributors are in different segments
Acquisition Segment
Target 6 consulting IT services
TARGET 4 Solutions IT services
Target 3 Gmbh Engineering services
Target 1 IT services
Target 5 holding Engineering services
Automotive company Engineering services
Engineering company Engineering services
Source: Company, Ambit Capital research.
Given the nature of these two businesses is different with dissimilar growth, margin
and risk profiles, we would assume there are at least two CGUs in the company.
Other companies provide proactive disclosures in terms of the share of goodwill
allocated to each CGU and the assumptions used in goodwill impairments test and
calculation of recoverable amounts.
Such disclosures help analysts and investors in getting a basic understanding if the
carrying value of goodwill on the balance sheet is justifiable or vulnerable to
impairments in the near future. However, Capital IT Technologies is currently not
providing these assumptions in the annual reports. Accordingly, it is difficult to arrive
at a conclusion regarding the justifiability of the current goodwill on the balance
sheet.
Exhibit 93: Companies with high share of goodwill (e.g. leading business services
company) provide its detailed allocation to various CGUs of the company

Strategy
Exhibit 94: In addition, ARs (e.g. a leading business services company) also provide
detailed disclosures on assumptions used in goodwill impairment test and calculation
of recoverable amount

Strategy
Mediocre corporate governance

Of the five independent directors (IDs) on the board, four have remained for
too long (some of them since FY05!) without any rotation. One of those was a
KMP/nominee of ex-significant shareholder (a company). While Capital IT
Technologies designated him as an ID when he was representing ex-
significant shareholder, it is more surprising to note that he was re-
appointed as an ID even after he ceased to be a representative of ex-
significant shareholder. In addition, we noticed that some of the IDs currently
have equity stakes in the company. The historical attendance track record of
IDs in board meetings is mediocre. While the proportion of IDs in key
committees like that of audit, nominations and remuneration is just as per
legal requirement, we contest the independence of four of the five IDs. While
audit fee was stagnant over FY14-18, fees to auditors for ‘other services’
increased ~7x, resulting in auditor’s remuneration outgrowing the
company’s revenue.
Board independence compromised?

About 50% of the directors on the board currently are designated as IDs. The share of
IDs over the last five years was in the range of 50-55%. Chairman of the board is not
an ID. While the attendance of IDs in the board meetings held during FY18 was
~85%, the track record was poor in the previous years (56-73% over FY14-17).
Reported attendance also includes attendance through tele-conferencing!
Exhibit 95: Share of independent directors on the board Exhibit 96: …their attendance track record indicate that
and… the board is not independent
55% 55% 90% 85%
54% 80% 72% 73%

67%
70%
53%
60% 56%
52%
50%
51%
50% 50% 50% 50% 40%
50% 30%
49% 20%
48% 10%
0%
47%
Source: Company, Ambit Capital research Source: Company, Ambit Capital research. Note: Above chart indicates the
attendance track record of independent directors on the board.
In addition, we doubt the independence of some of the IDs as they (1) remained on
the board for too long and (2) have equity stakes in the company. In the absence of
robust rotation process (once in at least 5 years), we believe the independence of the
board will get compromised.
We contest the independence of four of the five board members who are currently
designated as IDs for the following reasons.
Mr. ID#1
Has been on the board since FY05, initially designated as “Non-executive /
independent director”. Mr. ID#1 was the Chairman and Managing Director of the ex-
shareholders group in India from Mar-04 to Oct-17.
He was an ex-shareholders’ nominee on the board till Oct-14. It should be
remembered that ex-shareholder had a partnership with Capital IT Technologies
during 2002-13 and a significant equity stake (initially ~13% which was divested
subsequently). Despite his representing ex-shareholder, we wonder how he could be
designated as an ID over FY05-15.

Strategy
In Oct-14, when Mr. ID#1 ceased to be an ex-shareholders’ nominee, Capital IT

Technologies re-appointed him as an additional director. He continues to be ID of
Capital IT Technologies till date despite his association with ex-shareholder and very
long stint (~14 years already) as an ID. We contest his basic eligibility to be an ID on
the grounds that (1) he was closely related to ex-shareholder and (2) he had already
spent a long stint as ID of Capital IT Technologies .
In FY18, Capital IT Technologies re-appointed him as an additional and independent
director of the company for a period of 5 more years’ w.e.f. Oct-17.
Ms. ID#2
Ms. ID#2 has been an independent director since FY09 and currently owns 0.07% of
equity stake in Capital IT Technologies. Besides the length of her stint as an ID (nearly
10 years), her ownership of shares of the company raises corporate governance
questions.
In the AGM of Aug-17, the company reappointed Ms. ID#2 as an independent
director for an additional term of 5 years starting April-17.
Mr. ID#3
Mr. ID#3 has been an ID on the board since FY14 (5 years already). In the AGM held
in Aug-17, the company reappointed him as an ID for a term of five years from April-
17. Good corporate governance practices suggest rotation of independent directors
once in at least 5 years, and so we view his re-appointment as a bad corporate
governance practice.
Mr. ID#4
Mr. ID#4 has been an independent director on the board since FY13 (6 years
already). In the AGM held in Aug-17, the company reappointed Mr. ID#4 as an
independent director for a term of five years starting April-17.
Are the key committees independent?

Historically, independence of key committees like audit committee, nominations and
remunerations committee has just satisfied the legal requirements (which is 67% for
audit committee and 50% for nominations and remunerations committee).
While the representation of independent directors on the audit committee in FY18
was ~100%, historically it remained in the range of 67-80%. Representation of
independent directors in the nominations and remunerations committee was 50% in
the recent years, just meeting the legal requirement.
With the independence of four out of five independent directors being in question, we
are of the view that the key committees of the board are not ‘truly’ independent.
Exhibit 97: Historically, independence of the audit Exhibit 98: Independence of nomination and
committee just satisfied the legal requirement remunerations committee just satisfies the legal
requirement
120% 62%
60%
100% 60%
100% 58%
80%
80% 56%
67% 67% 67%
54%
60%
52%
50% 50% 50% 50%
40% 50%
48%
20%
46%
0% 44%
Source: Company, Ambit Capital research. Note: Above data pertains to Source: Company, Ambit Capital research. Note: Above data pertains to
percentage of the audit committee represented by independent directors percentage of the nominations and remunerations committee represented by
independent directors.

Strategy
Strong increase in salaries of KMPs

The combined salary of Mr. Chairman & Group CEO and Mr. CEO & Managing
Director witnessed a strong ~42% CAGR over FY15-18. It should be noted that both
are also co-founders of the company. Revenue CAGR of Capital IT Technologies over
the same period was 5% (US$) and 7% (INR). White collar wage inflation in India over
the period was in high single digits.
Exhibit 99: Combined salary of promoters saw disproportionate growth over FY15-18
As % of PBT
2.5%
2.1%
2.0%
2.0%
1.5%
0.9%
1.0%
0.7%
0.5%
0.0%
FY15 FY16 FY17 FY18

Strategy
Institutional Equities Team

Research Analysts
Name Industry Sectors Desk-Phone E-mail
Nitin Bhasin - Head of Research E&C / Infra / Cement / Home Building / Aviation (022) 66233241 [email protected]
Ajit Kumar, CFA, FRM Banking / Financial Services (022) 66233252 [email protected]
Amandeep Singh Grover Small-Caps (022) 66233082 [email protected]
Ashish Kanodia, CFA Consumer Discretionary (022) 66233264 [email protected]
Ashwin Mehta, CFA Technology (022) 6623 3295 [email protected]
Basudeb Banerjee Automobiles / Auto Ancillaries (022) 66233141 [email protected]
Darshan Mehta E&C / Infrastructure / Aviation (022) 66233174 [email protected]
Deep Shah Media / Telecom / Oil & Gas (022) 66233064 [email protected]
Dhruv Jain Mid-Caps (022) 66233177 [email protected]
Karan Khanna, CFA Small-Caps / Strategy (022) 66233251 [email protected]
Karan Kokane Automobiles / Auto Ancillaries (022) 66233028 [email protected]
Kushagra Bhattar Healthcare (022) 66233062 [email protected]
Nikhil Mathur, CFA Healthcare (022) 66233220 [email protected]
Pankaj Agarwal, CFA Banking / Financial Services (022) 66233206 [email protected]
Prateek Maheshwari Cement (022) 66233234 [email protected]
Ritesh Gupta, CFA Consumer Discretionary / Agri & Chemicals (022) 66233242 [email protected]
Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 66233175 [email protected]
Satyadeep Jain, CFA Metals & Mining (022) 66233246 [email protected]
Shreya Khandelwal Banking / Financial Services (022) 6623 3292 [email protected]
Sumit Shekhar Economy / Strategy (022) 66233229 [email protected]
Udit Kariwala, CFA Banking / Financial Services (022) 66233197 [email protected]
Varun Ginodia, CFA E&C / Infrastructure / Aviation (022) 66233174 [email protected]
Vinit Powle Strategy / Forensic Accounting (022) 66233149 [email protected]
Vivekanand Subbaraman, CFA Media / Telecom / Oil & Gas (022) 66233261 [email protected]
Sales
Name Regions Desk-Phone E-mail
Dhiraj Agarwal - MD & Head of Sales India (022) 66233253 [email protected]
Bhavin Shah India (022) 66233186 [email protected]
Dharmen Shah India / Asia (022) 66233289 [email protected]
Abhishek Raichura UK & Europe (022) 66233287 [email protected]
Pranav Verma Asia (022) 66233214 [email protected]
USA / Canada
Hitakshi Mehra Americas +1(646) 793 6751 [email protected]
Achint Bhagat, CFA Americas +1(646) 793 6752 [email protected]
Singapore
Srinivas Radhakrishnan Singapore +65 6536 0481 [email protected]
Sundeep Parate Singapore +65 6536 1918 [email protected]
Production
Sajid Merchant Production (022) 66233247 [email protected]
Sharoz G Hussain Production (022) 66233183 [email protected]
Jestin George Editor (022) 66233272 [email protected]
Richard Mugutmal Editor (022) 66233273 [email protected]
Nikhil Pillai Database (022) 66233265 [email protected]
Babyson John Database (022) 66233209 [email protected]

Strategy
Explanation of Investment Rating

Investment Rating Expected return (over 12-month)
BUY >10%
SELL <10%
NO STANCE We have forward looking estimates for the stock but we refrain from assigning valuation and recommendation
UNDER REVIEW We will revisit our recommendation, valuation and estimates on the stock following recent events
NOT RATED We do not have any forward looking estimates, valuation or recommendation for the stock
POSITIVE We have a positive view on the sector and most of stocks under our coverage in the sector are BUYs
NEGATIVE We have a negative view on the sector and most of stocks under our coverage in the sector are SELLs
* In case the recommendation given by the Research Analyst becomes inconsistent with the rating legend, the Research Analyst shall within 28 days of the inconsistency, take appropriate measures (like
change in stance/estimates) to make the recommendation consistent with the rating legend.
Disclaimer
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2020-01, Ambit Capital - When Accounting Predicted

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STRATEGY

We’re in good shape

When accounting predicted

When accounting predicted…………………………………………………………..5

Accounting quality shapes investment returns! ……………………………………6

Ambit’s ‘forensic’ model: Methodology …………………………………………..14

Signs of a potential deceit; learnings of last decade……………………………15

A few case studies from our model ……………………………………………….21

Link between accounting quality and investment returns ……………………..38

Accounting quality merits attention in a more normal market scenario …….42

How clients can use our forensic expertise ………………………………………44

Case study: Fooling by Pooling!……………………………………………………47

January 08, 2020 Ambit Capital Pvt. Ltd. Page 2

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THEMATIC ACCOUNTING January 08, 2020

When accounting predicted… 5 key improved companies over last 5

first filter for stock selection. Of the key 16 accounting-related

Add pledging to our accounting analysis, save yourself from deceit

Accounting quality shapes investment

Exhibit 1: Zone of Darkness (D8-D10) companies continued to underperform at

January 08, 2020 Ambit Capital Pvt. Ltd. Page 6

Accounting quality - A touchstone in defining long-term investment returns

Zone of D6 8% 3% 4% -14% -7%

January 08, 2020 Ambit Capital Pvt. Ltd. Page 7

Exhibit 5: Mid-caps: >25% comprises of Zone of Darkness (ZOD) companies; Zone of

January 08, 2020 Ambit Capital Pvt. Ltd. Page 8

Exhibit 6: Small-caps:>30% comprises of Zone of Darkness companies; investors

80% 31% 33% 31% 32% 33% 35%

Considerable portion of large-cap companies is in ‘Zone of Darkness’

100% 227 250

40% 106 100

Zone of Safety Zone of Pain

Relationship between voluntary resignations of auditors, independent

January 08, 2020 Ambit Capital Pvt. Ltd. Page 9

Number of companies 4 Number of independent director

D1 D2 D3 D4 D5 D6 D7 D8 D9 D10 Zone of Safety Zone of Pain Zone of Darkness

Is accounting quality appropriately factored in valuations?

Zone of Darkness Zone of Pain Zone of Safety

January 08, 2020 Ambit Capital Pvt. Ltd. Page 10

To check if accounting quality is factored in stock valuations, we constructed four

Following are the key takeaways from the above exhibit:

January 08, 2020 Ambit Capital Pvt. Ltd. Page 11

Change in accounting scores over longer period of time: In the BSE-500

Dispersion of accounting scores exists within a sector

January 08, 2020 Ambit Capital Pvt. Ltd. Page 12

E&C and Infra

Oil & Gas

Launching our proprietary accounting model for CY19

January 08, 2020 Ambit Capital Pvt. Ltd. Page 13

Ambit’s ‘forensic’ model: Methodology

A note on Ind-AS adoption

January 08, 2020 Ambit Capital Pvt. Ltd. Page 14

Signs of a potential deceit; learnings of

Evolution of Ambit’s forensic framework

Source: Ambit Capital research

January 08, 2020 Ambit Capital Pvt. Ltd. Page 15

Accounting risk was present in almost all blow-ups

Watch out for capital intensity, related-party transactions and working