Learn some forensic accounting – an Indian Case Study

So, you are here because you want to learn some forensic accounting.
Maybe you have lost money in a stock which you later found out had some accounting frauds
and corporate governance issues. Now you are determined to make sure that you don’t lose
money in any other stock at least for issues related to fraudulent management.

This case study teaches you exactly how to do it.

But, before that, I want you to believe in these two things
1. You can detect accounting fraud just by reading the annual report
2. You don’t need any “insider information” or friends & connections at the “right places”

I know this sounds like a tall claim right now, but as you begin to read through this case study,
you will start getting the confidence that it is actually possible to detect accounting frauds by
reading the annual report.

There are several good books about accounting Shenanigans, the most popular amongst them
being “Financial Shenanigans by Howard Schilit”.

However, the problem is that all these books give a general idea about the subject and none
of them have Indian case studies.
So now, let us dive right into the case study.

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 (How investors could have avoided a 90% loss in VA Tech Wabag)

VA Tech Wabag is a very reputed name in the water treatment, sewage treatment, sea water
desalination fields. The company operates in 20+ countries. It has completed more than 6000
projects so far, has 3 R&D centres across the globe and has more than 100 patents to its name.

But, why has the stock crashed by 90% in the last 5 years?
The VA Tech Wabag stock was trading at a price of Rs 790 in Jul-15. On 29th May-20, it closed
at a price of Rs 91.

Rs 791 || Jul-15

VA Tech Wabag not only enjoys a pre-eminent position in the water treatment industry, it also
has some large institutional holding (as of 31st Mar-20)

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Mutual Funds like SBI, Sundaram hold shares in the company. Large institutional investors like
Sumitomo Corporation, MIT college endowment fund, Government Pension Fund Global (of
Norway) hold a significant position in the company.

The management of VA Tech Wabag has a good reputation. It is well poised to take advantage
of the Namami Gange (Clean Ganga) mission and the overall push towards river revival, sewage
treatment and clean drinking water all across the nation. More than 60% of the revenues of
the company come from projects executed outside India and the company’s order book has
been steadily increasing.

The order book stands at more than 3 times annual

revenues.

However, after falling from Rs 790 in Jul-15 to Rs 303 in Sep-19, the stock has fallen by another
70% in the last 8 months.
What went wrong?
Could the investor have predicted the decline in the stock price of VA Tech Wabag and got out
of the stock in time?

Let us investigate further.

The 2019 annual report of VA Tech Wabag was published on 19th Jul-19 on the BSE website and
one would have had a good 45 days to read it to decide by Sep-19 (when the price was Rs 303)
whether they want to hold the stock or sell it.
In this case study, I have used financials up to Mar-19 from the 2019 annual report.

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The first thing to check if everything is ok with the company is to check the operating cash flow
2012 2013 2014 2015 2016 2017 2018 2019 Cum Total
PAT 74 90 113 110 89 102 132 105 815
Operating
(79) 82 112 6 (217) 6 (216) (76) (382)
Cashflow

• VA Tech Wabag has reported a negative operating cashflow in 4 out of the last 8 years.
• The company has reported a cumulative PAT of Rs 815 Cr in the last 8 years.
• However, the cumulative operating cashflow is a negative (-382) Cr in the last 8 years.
• The company is not able to convert reported profits into cash.

What is the cause of the poor operating cashflow?

For an EPC (engineering procurement & construction) company it is usually the receivables
2012 2013 2014 2015 2016 2017 2018 2019
Sales 1,444 1,619 2,239 2,435 2,508 3,208 3,457 2,781
Receivables 1093 1109 1387 1481 1657 2124 2456* 2542*
Receivables / Sales 0.8 0.7 0.6 0.6 0.7 0.7 0.7 0.9
Receivable Days 277 251 227 223 242 242 260 335
* Due to change in Accounting Standard 115, certain receivables have been reclassified as
“Dues from customers for construction contracts” by the company. For our analysis purpose,
we will treat them as receivables since this money has not been received yet by the company.

Receivable days has been very high for the last 8 years. VA Tech Wabag takes 300+ days (10
months) to collect money from its customers after it has completed the works.

Consequently, the borrowings have also increased over the years.

2012 2013 2014 2015 2016 2017 2018 2019
Sales 1,444 1,619 2,239 2,435 2,508 3,208 3,457 2,781
Borrowings 125 82 158 181 388 314 482 613
Debt / Equity 0.2 0.1 0.2 0.2 0.4 0.3 0.4 0.6

Debt to Equity ratio has deteriorated from 0.2 in 2012 to 0.6 in 2019 – however it has not
reached alarming levels yet.
Total Debt (Rs 613 Cr) is much lower than the receivables (Rs 2542 Cr).

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How is the company funding its working capital requirements (receivables) if not by
borrowings?
2012 2013 2014 2015 2016 2017 2018 2019
Sales 1,444 1,619 2,239 2,435 2,508 3,208 3,457 2,781
Trade Payables 676 754 993 1,015 1,190 1,400 1,617 1,686
Payable Days 171 170 162 152 173 159 171 221

It is evident that VA Tech Wabag is funding its long receivables cycle by delaying payment to
its own vendors. A vendor (sub-contractor) looking to take up a new job with VA Tech Wabag
in 2019, can expect to receive his payments with a delay of 7 months (221 days) after he has
completed his job and raised the bill. A vendor/sub-contractor who does decide to take up the
job will be either desperate for business or will do so at a much higher cost after accounting
for the financial costs of the delayed payment.

Let us try and probe a little more about the trade receivables.
From note 7 to the consolidated financial statement, what do we observe?

Typically trade receivables are due within 30/60/90 days of presenting the customer with the
bill. However, a significant amount of Rs 127 Cr is mentioned under the head non-current
receivables. To begin with, the company expects this money to be realized after 12 months.

Let me also draw your attention to note 12 of the consolidated financial statements

A massive amount of Rs 1192 Cr is “Due from Customers” as of Mar-2019.

What is this “Dues from Customers”?

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“Dues from customers” in unbilled revenue – the company has completed the work, but has
not yet presented the bill to the customer. This looks preposterous.
In fact, the “Dues from customer” asset also includes the revenues and profits that have
already been recognized in the P&L statement even before the bill has been presented to the
customer.

Extract from note 3.4 to the consolidated financial statements

“Unbilled Revenue” is not a very uncommon thing for EPC companies, however such high levels
of both trade receivables and unbilled receivables looks a little problematic.

Let us dig even deeper – check out note 12 to the consolidated financial statements
Direct Adjustment with retained earnings

Extract from the note 34 of the consolidated financial statements.

The contract balances stand at Rs 1192 Cr as on 31st Mar-19. This is the “Dues from customers”
we saw above in note 12 to the consolidated financial statements. During the year FY19, Rs
369 Cr of the Contract Balances were billed and moved to “Trade Receivables”. However, Rs
163 Cr were written off as allowance for expected credit losses. This was even before any bill
was raised to the customer. Also, let us check what were the bad debts written-off in the profit
and loss statement.

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Extract from note 31 to the consolidated financial statements.

We observe that the bad debts written-off in the profit and loss statement in the entire year
were only Rs 92.5 Cr. Thus, the expected credit losses under “Dues from customers” which were
Rs 161 Cr have not passed through the P&L statement.
Profit before Tax in FY19 was Rs 110 Cr. If this Rs 161 Cr was charged to the P&L statement, the
company would have had to report losses.

Apparently, this direct adjustment to retained earnings without mentioning this write-off in
the P&L statement has been going on for some time now. VA Tech Wabag wrote-off Rs 172 Cr,
Rs 121 Cr, Rs 138 Cr, Rs 131 Cr in the year 2018, 2017, 2016, 2015.

Let us turn our attention to customer retention money. Usually in an EPC contract, the
customer retains a certain percentage of the contracted amount – usually 10% for a period of
time – to cover for the defect liability period. This is usually done so that the contractor (VA
Tech Wabag) will rectify any defects that arise within a reasonable time period after
commissioning of the project. The defect liability period varies depending on the type of
project, but we may estimate it to be say about a year. The project then enters a phase of
operation & maintenance.
However, for VA Tech Wabag, the money that customers have retained with themselves has
significantly increased in the last 7 years

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Customer retention money has increased by 4 times from Rs 125 Cr to Rs 553 Cr o 2019, whereas
sales (projects executed) have hardly doubled in the last 8 years.

Let us come to the last piece.

Let us look at note 46 to the standalone financial statements
Dues from a project in consortium with a bankrupt company – Tecpro Systems

This is a well-known issue by the investors of VA Tech Wabag as the origin of this matter dates
back to 2010. However, one needs to put this piece of information in perspective when
analyzing the company. Rs 416 Cr is yet to be received for a government contract executed
long back. VA Tech Wabag was a consortium partner alongwith Techpro Systems and Gammon
India for a Government of Telangana power project. Techpro Systems of the consortium lead
and both Techpro and Gammon India have gone bankrupt.
One has to factor in that since this issue in pending since 9 years, there is a significant chance
that VA Tech Wabag may never get the Rs 416 Cr due to it.

What is more, Rs 69.5 Cr needs to be recovered from Tec Pro Systems – a company which has
gone bankrupt.

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Tecpro systems has not only gone bankrupt, it is also alleged that the promoters have
defrauded and tried to siphon off money.

Final resolution of Tecpro Systems came on 15th May-19

http://www.tecprosystems.com/forms/Final_order_of_NCLT_dated_15.05.19.pdf

The secured creditors of Tec Pro systems will receive only 5.8% of their original (equivalent to
interest earned in 6 months). The operational creditors (VA Tech Wabag is one of them) will
receive only 0.22% of the original amount.

Actually, as per the corporate resolution of Tecpro Systems, the operational creditor claim of
VA Tech Wabag has already been rejected by the insolvency and resolution professional.
http://www.tecprosystems.com/forms/Opertational_Creditors_of_Tecpro_Systems_Limited_
2nd_May_2018.pdf

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The claim of Rs 588 Cr of VA Tech Wabag has been rejected by the resolution professional. The
company will probably get directly paid Rs 416 Cr directly the government agency (APGENCO).
However, at least the Rs 69 Cr being recovered from Tech pro systems will have to be written
off.

Its amazing how much information one can get by a simple reading of the annual report of a
company and a little bit of google search.
Like human beings, businesses have their own good times and bad times. Sometimes, the
economy, competition, interest rates, GDP growth etc. will be favourable and sometimes not.
However, companies that hide the reality from the investors through accounting “adjustments”
are hiding the truth from themselves.

Buy and hold fundamental investors typically have an optimism bias. They believe that if a stock
they hold is down, it is only a temporary phenomenon. With time, when the economy recovers,
stock markets recover, their stock will also eventually go up.

However, buy and hold does not work, investors need to adopt the buy-check-hold strategy.

Online Workshop – “Forensic Accounting for Investors”

If you are more curious and want to buckle up your skills at detecting accounting frauds check out
our online workshop (pre-recorded sessions) – “Forensic Accounting for Investors”
https://candorinvesting.com/online-workshop/

Disclaimer
This article is an illustration of the kind of analysis that goes into fundamental
research and equity investing. I do not hold the shares of VA Tech Wabag.
Please consult your investment advisor before making any investment decisions.
The author (@amey_candor) is a SEBI registered Investment Advisor.

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