Forensic Accounting Ambit 22dec2014

STRATEGY
December 2014
Ambit Client
20%
Median share price performance
15%
Zo
ne
10%
of
Speculator
Tro
5% Dodgy Auditor
ub
le
0%
D1 D2 D3 D4 D5 D6 D7 D8 D9
-5% D10 Cash Pilferage
Accounting score based deciles
-10% Revenue Manipulation
Forensic Accounting: Identifying the Zone of Trouble

Analysts:
Gaurav Mehta, CFA Saurabh Mukherjea, CFA
gauravmehta@ambitcapital.com saurabhmukherjea@ambitcapital.com
Tel: +91 22 3043 3255 Tel: +91 99877 85848
Karan Khanna
karankhanna@ambitcapital.com
Tel: +91 22 3043 3251
Strategy
CONTENTS
Forensic accounting: Identifying the ‘Zone of Trouble’…………………………..3
Methodology…………………………..…………………………..………………….. 4
Accounting quality and investment returns……………………………………… 13
Change in accounting quality and investment returns………………………… 18
Accounting quality in practice…………………………..………………………….21
What does our model not capture? …………………………..…………………..23
Sample bespoke - World Cargo…………………………………………………... 27
December 22, 2014 Ambit Capital Pvt. Ltd. Page 2

Strategy
THEMATIC December 22, 2014
Forensic accounting: Identifying the Sector-neutral accounting buckets

show a strong link between
‘Zone of Trouble’ accounting quality and investment
returns
Forensic accounting is a key component of our research, as we have Accounting Accounting Share price
time and again shown that accounting quality is not just one of the bucket score performance
many factors affecting investment returns but rather a critical hygiene Bucket A 223.7 19.2%
factor, the lack of which can be detrimental to portfolio returns. Bucket B 199.0 14.3%
Moreover, contrary to popular belief, accounting quality has stayed Bucket C 177.1 11.8%
relevant even in the recent recovery, with stocks with weak accounting Bucket D 144.2 2.0%
quality still underperforming. Through our well-established proprietary Source: Bloomberg, Ambit Capital research
model, we seek to help investors avoid this accounting ‘Zone of Trouble’
which is profoundly damaging for investment performance.
Quantifying accounting quality Weakest ten sectors on accounting
quality
Our model looks at the following key categories of accounting irregularities:
balance sheet misstatement, profit & loss misstatement, cash pilferage and audit Average Average
Sector accounting share price
quality. We use 11 ratios across these categories to quantify accounting quality score performance
for stocks with a market-cap of more than Rs 1,000mn (excluding banks and Realty 152.0 -11.6%
financial services firms). The caveat is that whilst these aggressive accounting
Conglomerate 158.0 1.9%
policies raise red flags, they may not necessarily imply accounting fraud.
E&C 159.2 -1.7%
The ‘Zone of Trouble’
Telecom 165.7 -8.1%
Accounting quality is not just one of the many factors affecting investment
Infrastructure 168.2 -1.8%
returns but rather a critical hygiene factor, the lack of which can be detrimental
to portfolio returns. An assessment of historical returns suggests that whilst the Miscellaneous 169.6 12.2%
top 6 deciles on accounting do not seem to be materially different from each Capital Goods 170.0 2.3%
other on investment performance, the performance slumps beyond D6. Textiles 172.0 10.7%
Therefore, D7-D10 is the zone of trouble to be avoided at all costs. Utilities 175.7 -2.1%
Accounting quality drives investment performance Media 183.7 4.9%
Source: Ace Equity, Capitaline, Bloomberg,
25%
Ambit Capital research; Note: Accounting
20%
Median share price
score is based on annual financials over

'Zone of Trouble' FY09-14; stock price performance is sector
performance
15%
CAGR from April 2008 to October 2014.
10%
5%
THIS NOTE CANNOT BE USED BY THE
0% MEDIA IN ANY SHAPE OR FORM WITHOUT
-5% D1 D2 D3 D4 D5 D6 D7 D8 D9 D10 PRIOR CONSENT FROM AMBIT CAPITAL.
-10%
Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on
annual financials over FY09-14; stock price performance is from Apr’08 to Oct’14 (on a CAGR basis).
Universe for this exhibit is BSE500.
Furthermore, accounting quality has remained relevant even in the market

recovery, with the last four deciles on accounting continuing to underperform
significantly (in terms of investment returns). However, it is interesting to note Analyst Details
that the biggest improvements in performance in the uptrend have come for D5
Gaurav Mehta, CFA
and D6 and not for firms with superior accounting quality (see pg 21). +91 22 3043 3255
Are you in the ‘Zone of Trouble’? gauravmehta@ambitcapital.com
Our forensic accounting model allows us to conduct a first-level health check of Karan Khanna
portfolios and helps identify whether any holdings belongs to the ‘Zone of +91 22 3043 3251
Trouble’. Further, on a bespoke basis for clients, we also supplement these karankhanna@ambitcapital.com
screen-driven red flags with bottom-up investigative research on individual Saurabh Mukherjea, CFA
companies. Please contact your Ambit sales representative in case your portfolio +91 22 3043 3174
has not been screened yet by our forensic accounting model. saurabhmukherjea@ambitcapital.com
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.
Strategy
Methodology
We use 11 ratios to score our universe (excluding, banks and financial services firms)
based on their accounting qualities. These ratios can broadly be categorised into four
buckets.
Exhibit 1: Key categories of accounting checks
Category Ratios
We focus on four categories of
(1) CFO/EBITDA, (2) change in depreciation rate, and (3)
P&L misstatement checks volatility in Non-operating income (as a percentage of
accounting checks: P&L
net revenues) misstatement, balance sheet
(1) Cash yield, (2) change in reserves (excluding share misstatement, cash pilferage and
premium) to net income excluding dividends, (3) audit quality
Balance sheet misstatement checks provisions for doubtful debts as a proportion of debtors
more than six months, and (4) contingent liability as a
proportion of net worth
(1) Non-operating expenses as a proportion of total
Cash pilferage checks revenues, (2) CWIP to gross block, and (3) cumulative
CFO plus CFI to median revenues
(1) CAGR in auditor’s remuneration to CAGR in consol.
Audit quality checks
revenues
Source: Ambit Capital research
Here is a brief description of the accounting ratios with illustrative case studies:
Note: These examples are just illustrative case studies. The objective is to
demonstrate the working of our framework and not to imply any ill-intent on
the part of the company in question.
I - P&L misstatement checks

1 CFO/EBITDA: This ratio checks a company’s ability to convert EBITDA (which can
be relatively easily manipulated) into operating cash flow (which is more difficult
to manipulate). A low ratio raises concerns about the company’s revenue
recognition policy (because this may imply aggressive revenue recognition A low CFO/EBITDA may be
through methods such as channel stuffing). We use a six-year median for this indicative of aggressive revenue
measure. recognition policies
Case study: Aurobindo Pharma

Aurobindo’s pre-tax CFO/EBITDA has consistently been significantly below the
median for its peers. The company’s CFO/EBITDA has deteriorated from 70% in
FY10 to 46% in FY14 even whilst the CFO/EBITDA for its peer group has improved
from 88% to 100% over the same period.
This deterioration in its CFO/EBITDA is mainly on account of the deterioration in
its working capital days (from 186 days in FY10 to 217 days in FY14). Given its
lack of material exposure to branded generic markets, where terms of trade are
more benign, its working capital days have remained at elevated levels
throughout.
We also note that in years when Aurobindo’s EBITDA has posted healthy growth,
CFO/EBITDA seems to have deteriorated, as working capital needs have
expanded. For instance, whilst EBITDA improved by 17% in FY11, CFO/EBITDA
deteriorated to 55% in FY11 vs 70% in FY10 owing to higher working capital
requirements (204 days in FY11 vs 186 days in FY10). Note that inventories and
debtors increased significantly during the year as well (32% and 29% respectively).

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Exhibit 2: Revenue recognition - Aurobindo Pharma vs its peers

Company/Metric Pre-tax CFO as a % of EBITDA
FY10 FY11 FY12 FY13 FY14 Average
Aurobindo Pharma 70% 55% 65% 46% 46% 57%
Cadila 88% 85% 64% 82% 98% 83%
Glenmark N/A 60% 131% 80% 102% 93%
IPCA 71% 74% 85% 77% 82% 78%
Biocon 101% 150% 123% 104% 103% 116%
Median (ex-Aurobindo) 88% 80% 104% 81% 100% 88%
Divergence (Aurobindo) -18% -25% -39% -35% -54% -32%
Source: Company, Ambit Capital research
2 Change in depreciation rate: We calculate change in depreciation rates for

each of the past six years (FY09-14). We then calculate the median of absolute
changes and then sort the companies on this ratio such that the company with the Our model penalises high
smallest change in its depreciation rate receives the best score. The rationale is to volatility in depreciation rate
penalise companies that have high volatility in their depreciation rate on a YoY
basis.
Case study: Amtek Auto
For the period under study, Amtek Auto uses the ‘Straight Line Method’ to provide
depreciation on its fixed assets in the manner and at the rates specified in
Schedule XIV to the Companies Act 1956. This method and rate of providing
depreciation are in line with that followed by most of the Indian companies.
However, note that there was a significant YoY change in consolidated and
standalone average depreciation rates in FY13. Whilst the acquisition of JMT Auto
and Neumayer Tekfor Group (NT Group) in June 2013 could partially explain the
volatility in depreciation rates for the year-ending September 2013 in the
consolidated accounts, we do not understand why the YoY depreciation rates have
declined even at the standalone level. Further, plant and machinery (subject to
higher depreciation rates) constitute ~90% of Amtek Auto’s gross block (vs ~78%
for its peers). In spite of the higher share of plant and machinery in Amtek Auto’s
gross block, its depreciation rates have historically remained lower than its peers.
Overall, Amtek Auto’s lower depreciation rate vs its peers and the volatility in its
depreciation rate suggest that further analysis would be warranted.
Exhibit 3: Depreciation analysis - Amtek Auto vs its peers
Average depreciation YoY change in depreciation
Company/metric
rate rate (bps)
FY11 FY12 FY13 FY12 FY13
Amtek Auto (consolidated) 4.4% 5.0% 3.7% 66 (131)
Amtek Auto (standalone) 4.7% 4.8% 3.7% 4 (103)
Bharat Forge 6.7% 7.0% 6.6% 26 (41)
Mahindra CIE 7.8% 7.6% 8.0% (12) 34
Nelcast 4.6% 4.6% 4.3% (3) (27)
Median (ex-Amtek) 6.7% 7.0% 6.6% (3) (27)
Divergence (Amtek consolidated) -2.4% -2.0% -2.9% 69 (104)
Divergence (Amtek standalone) -2.0% -2.2% -2.8% 7 (76)
Source: Company, Ambit Capital research. Notes: (1) FY11 and FY12 figures for Amtek Auto are June year-end
whilst FY13 is 15 months ended September 30, 2013 which has been annualised for a like-to-like comparison with
peers. March year-end for all the other companies; (2) Standalone accounts for all the peer companies.
3 Volatility in non-operating income: We calculate change in non-operating

income (as a percentage of net revenues) for each of the past six years (FY09-14). High volatility in non-operating
We then calculate the median of absolute changes and then sort firms on this income is a cause of concern!
ratio such that the company with the least volatility receives the best score. The

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rationale is to penalise firms where volatility in non-operating income is unusually

high as this could imply intent to inflate profitability in years of low profits by
resorting to such means as sale of assets, investments, and so on.
Case study: Akzo Nobel
Akzo Nobel’s non-operating income (as a percentage of net revenues) has
historically been higher vs its peers (see Exhibit 4 below). Akzo Nobel’s NoI has
averaged ~7% of net revenues over the last five years (vs ~1% for its paint sector
peers). Further, this has also remained quite volatile over the period. For instance,
NoI (as a % of net revenues) was 2.3% in FY14 v/s 6.3% in FY13 implying a ~394
bps YoY change. The high volatility in FY14 (~394bps) could be attributed to
lower gains on redemption of long-term investments (in FY14 vs FY13) and
interest on income tax refund in FY13.
Exhibit 4: Akzo Nobel - Volatility in other income vs its peers
Volatility in NoI (as a % of net
Company/metric NoI as a % of net revenues
revenues)
FY10 FY11 FY12 FY13 FY14 FY11 FY12 FY13 FY14
Akzo Nobel 10.1% 9.1% 5.7% 6.3% 2.3% 98 344 60 394
Asian Paints 2.0% 0.8% 1.1% 1.0% 1.1% 113 28 7 1
Berger Paints 1.0% 1.3% 1.0% 0.9% 0.9% 29 25 14 2
Kansai Nerolac 1.2% 2.1% 0.9% 0.6% 0.3% 96 125 33 26
Median (ex-Akzo
1.2% 1.3% 1.0% 0.9% 0.9% 96 28 14 2
Nobel)
Divergence (Akzo
8.9% 7.8% 4.6% 5.4% 1.4% 2 316 46 392
Nobel)
II - Balance sheet misstatement checks

4 Cash yield: This ratio is calculated as the yield earned on cash, investments and
deposits. A low ratio could be a cause for concern, as it could mean that either the A low cash yield may either imply
balance sheet has been misstated or that the cash is not being used in the best balance sheet misstatement or
interests of the firm. We use a six-year median for this measure. that the cash is not being used in
the firm’s best interest
Case study: Arshiya
Historically, Arshiya appears to have earned a significantly lower yield on its cash
and marketable investments as compared to its peers. Whilst its peers such as
Gateway Distriparks have earned cash yields of 5-8%, Arshiya International’s
yields have been much lower.
Exhibit 5: Arshiya - Cash yield vs its peers
Company Name Investment income as a % of cash and marketable investments
Arshiya International 4.2 4.8 1.4 1.9 0.4
Gateway Distriparks 7.8 8.1 4.0 5.4 7.2
Allcargo Logistics 5.9 4.7 11.4 5.5 7.0
Whilst the company’s cash yield did improve in FY13 (2.3%) and FY14 (3.2%), it is
worth noting that in January 2013, several Arshiya employees made allegations of
financial irregularities and claimed that the company had not paid salaries to its
staff since September 2012.
(Source: http://articles.economictimes.indiatimes.com/2013-01-
09/news/36237462_1_lakh-shares-cent-promoters)

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

dividends: This ratio is calculated by dividing the change in reserves (excluding A ratio of less than one on
share premium) on a YoY basis and dividing it by that year’s PAT excluding change in reserves ex-share
dividends. We then take a six-year median of this ratio. A ratio of less than one premium to net income ex-
indicates direct write-offs to equity without routing these through the Profit & Loss dividends may denote direct
account and may indicate aggressive accounting policies. write-offs through the balance
sheet
Case study: Tata Steel
Tata Steel acquired Corus (now Tata Steel Europe) in 2007. In FY08, the first year
after consolidation, the defined benefit pension plan operated by Corus (British
Steel Pension Scheme) had actuarial gains. These gains were recognised in the
P&L (consistent with the Indian accounting standards) in the consolidated accounts
of Tata Steel.
From FY09, the company has changed its policy. Since then the pension liability of
Tata Steel Europe Ltd has been computed and accounted for in accordance with
IFRS and there have been actuarial losses from this defined benefit pension plan
that do not hit the consolidated P&L. Instead, IFRS allows Tata Steel to take the
actuarial losses through ‘Reserves & Surplus’.
The justification provided by the company is that given the large share of Tata
Steel Europe Ltd in the consolidated P&L, periodic changes in the assumptions
underlying the computation of the pension liability would cause undue volatility in
the stated consolidated profits.
That said, we would like to highlight that the company has always made
appropriate disclosures in its notes to accounts. This disclosure is also made by the
company in its quarterly filings with the stock exchanges. We are highlighting Tata
Steel as an example primarily to show how a few changes in accounting policies
may cause a significant change to the reported bottom-line.
In fact, the auditors of Tata Steel too have, since 2009, highlighted this in the
audit report. For example, in the FY14 Annual Report, the auditors have made the
following comments:
“Attention is invited to Note 42 to the financial statements regarding accounting
policy for recognition of actuarial valuation change of Rs. 628.23 crores (net of
taxes) [Gross: Rs. 917.66 crores] in the pension and other post retirement benefit
plans of Tata Steel Europe Limited, a subsidiary for the reasons specified therein.
Had the Company recognized actuarial valuation changes in the Consolidated
Statement of Profit and Loss, the deferred tax expenses would have been lower by
Rs. 289.43 crores and the Profit after taxes, minority interest and share of profits of
associates would have been lower by Rs. 628.23 crores. Our opinion is not qualified
in respect of this matter.”
If Tata Steel had followed the previous policy of recording actuarial valuation
changes in the consolidated P&L, its restated earnings would have been different
(as shown in the exhibit below). Especially interesting is the impact in FY09, the
year in which Tata Steel Europe switched to the new method for estimating its
pension liability.
Exhibit 6: Tata Steel - Restated earnings if the previous policy had been followed
(Fig in INR mn) FY08 FY09 FY10 FY11 FY12 FY13 FY14
Consolidated Profit after taxes [A] 123,500 49,509 (20,092) 89,827 53,898 (70,576) 35,949
Actuarial gain/ (loss) [B] 59070* (54,966) (35,412) (4,028) (23,723) (3,173) (6,282)
Net profit (had the actuarial gains/(losses) been charged to the P&L)
123,500 (5,457) (55,505) 85,799 30,175 (73,749) 29,667
[C=A-B]
Impact on net profit (as a % of stated profit) [(C-A)/A)] 0% -111% -176% -4% -44% -4% -17%
Source: Company, Ambit Capital research, Note: * has already been reflected in the P&L.

Strategy
6 Provision for doubtful debts as a proportion of debtors more than six

months: This ratio checks the conservativeness of a company’s provisioning A low provisioning raises the
policy. A low ratio raises the spectre of earnings being boosted through aggressive spectre of earnings being boosted
provisioning practices. We use a six-year median for this measure. through aggressive provisioning
practices
Case study: Jindal Steel and Power
Historically, JSPL’s standalone debtors outstanding for more than 6 months (as a
percentage of gross debtors) have been 5-13%, slightly more than its steel peers.
However, note that JSPL has provided for less than 1% of its debtors more than six
months as of FY14. This is materially below the 60% figure for its steel peers.
Even on a consolidated basis, JSPL’s debtors outstanding for more than six months
(as a percentage of gross debtors) have been 8-12%, slightly more than its power
sector peers. In spite of a higher share of debtors outstanding for more than six
months, on a consolidated basis, JSPL has provided for less than 1% of its debtors
more than six months (vs ~60% by Tata Power in FY13 and FY14). Had the
company’s provisioning for debts more than six months been in line with its peers
(i.e. 60%), consolidated PBT for FY14 would have been lower by ~5%.
Exhibit 7: Jindal Steel and Power - Provision for old debtors lower than its peers
Provision for doubtful debts as a Debtors over six months as a
Company/metric
% of debtors over six months % of gross debtors
FY11 FY12 FY13 FY14 FY11 FY12 FY13 FY14
JSPL (standalone) 4.3% 2.9% 1.4% 0.7% 3.9% 5.0% 6.7% 12.7%
JSPL (consolidated) 4.3% 1.0% 0.8% 0.6% 2.5% 10.1% 8.4% 11.8%
Steel players
Tata Steel (standalone) 34.4% 32.9% 43.5% 63.0% 9.6% 3.8% 4.1% 3.2%
SAIL (standalone) 59.3% 35.4% 27.4% 23.1% 5.6% 7.0% 10.0% 10.1%
JSW Steel (standalone) 82.2% 39.8% 5.3% 61.1% 1.3% 1.5% 5.6% 21.1%
Median (steel players) 59.3% 35.4% 27.4% 61.1% 5.6% 3.8% 5.6% 10.1%
Divergence -55.0% -32.5% -26.1% -60.4% -1.7% 1.3% 1.1% 2.6%
Power players
NTPC (consolidated) 92.8% 88.7% 0.0% 0.0% 35.0% 12.6% 3.3% 6.8%
Tata Power (consolidated) 75.9% 71.5% 56.5% 61.1% 9.0% 9.1% 10.4% 6.8%
Median (Power sector players) 84.3% 80.1% 28.2% 30.6% 22.0% 10.9% 6.9% 6.8%
Divergence (JSPL Consolidated vs Power peers) -80.0% -79.1% -27.4% -29.9% -19.5% -0.7% 1.5% 5.0%
7 Contingent liabilities as a proportion of net worth: This is a check on a

company’s off-balance-sheet liabilities. If this ratio is high, it raises concerns A very high proportion of
regarding the strength of the company’s balance sheet in the event that the contingent liabilities to net worth
contingent liabilities materialise. Given that contingent liabilities also include indicates disproportionately high
genuine items such as letters of credit, bill discounting and capital commitments, off-balance-sheet risk
we seek to eliminate as many of these items whilst computing the figure for
contingent liabilities. We use a six-year median for this measure.
Case study: Gillette India
An example of a firm that gets penalized in our framework due to relatively high
contingent liabilities as a proportion of net worth is Gillette India.
FMCG companies in general have an asset-light model (implying relatively low
networth) and hence this ratio might appear unusually high for some of these
names. However, Gillette India has seen a meaningful rise in contingent liabilities
over the last few years led by disputes around direct and indirect taxation matters,
for which the company has chosen to appeal to the appropriate authorities.
Contingent liabilities as a percentage of net worth have historically averaged
~45% for Gillette India (see Exhibit 8 below). Whilst contingent liabilities have
historically remained high owing to disputes with respect to excise, service tax and
customs matters, note that contingent liabilities in FY14 have increased

Strategy
significantly on account of income tax disputes. This is with respect to matters

related to income tax disputes on inventory write-off, allowability of losses carried
forward from merged entities and others.
Exhibit 8: Gillette India - Contingent liabilities analysis
Company/metric Contingent liability as a % of net worth
FY11 FY12 FY13 FY14
Gillette 26.4% 37.8% 43.8% 70.3%
Dabur* 6.8% 7.5% 6.5% 8.9%
Emami 17.1% 2.3% 8.8% 7.8%
HUL 29.0% 21.7% 28.6% 28.0%
Median (ex-Gillette) 17.1% 7.5% 8.8% 8.9%
Divergence (Gillette) 9.3% 30.3% 35.0% 61.4%
Source: Company, Ambit Capital research. Note: *this does not include LCs, bills discounted.
III - Cash pilferage checks

8 Non-operating expenses as a proportion of total revenues: This ratio checks
a company’s expenditure policy. A high ratio raises concerns regarding the A high proportion of non-
authenticity of such expenses. We use a six-year median for this measure. operating expenses raises
concerns regarding the
Case study: Unity Infra genuineness of such expenses
Historically, Unity Infra’s miscellaneous expenses (as a percentage of net sales)
have been higher than its peers. Whilst this ratio has declined from ~1.5% in
FY10 to ~0.9% in FY14, this is still well above the sector median of 0.14%. Higher
miscellaneous expenses indicate less-than-ideal financial reporting practices and
hence raise concerns regarding the authenticity of such expenses.
Exhibit 9: Miscellaneous expenditure analysis - Unity Infra vs its peers
Company/metric Miscellaneous expenses as a % of sales
FY-11 FY-12 FY-13 FY-14 Average
Unity Infra 1.49% 1.60% 1.01% 0.94% 1.26%
Supreme Infra 0.21% 0.30% 0.42% 0.73% 0.41%
MBL 0.83% 0.74% 0.89% 0.48% 0.73%
JMC 0.14% 0.16% 0.06% 0.13% 0.12%
Pratibha 0.21% 0.32% 0.11% 0.22% 0.22%
KNR 0.07% 0.07% 0.11% 0.14% 0.10%
J Kumar 0.19% 0.28% 0.51% 0.08% 0.27%
Ahluwalia 0.06% 0.06% 0.04% 0.04% 0.05%
Median (ex-Unity Infra) 0.19% 0.28% 0.11% 0.14% 0.22%
Divergence (Unity Infra) 1.30% 1.32% 0.90% 0.80% 1.04%
9 CWIP to gross block: The idea here is to penalise firms that show consistently
high CWIP relative to the gross block, as this may either indicate unsubstantiated A high CWIP to gross block ratio
capital expenditure or a delay in commissioning (which may in turn be motivated may either indicate
by a delay in the recognition of the related depreciation expense). We calculate unsubstantiated capex or delay in
the proportion of capital work in progress to gross block for each of the last six commissioning
years and then take the 25th percentile observation (instead of a simple six-year
median like in most other ratios).
The reason for using the 25th percentile over the last six years for this measure as
opposed to the median (which would be the 50th percentile observation) is to
allow the benefit of doubt to firms that have invested wisely during the recent
downturn. Hence we are penalising companies only if the ratio has been
consistently high over most of the last six-year period.

Strategy
Case study: Balkrishna Industries

Balkrishna Industries is an example of a firm that gets penalised on this measure
in our accounting model compared to its Auto Ancillary peers. Whilst the
company’s CWIP relative to its gross block was in line with its peers in FY11, the
ratio has remained at elevated levels over the last three years. This seems to be
on account of the capex incurred in connection with its green-field tyre project at
Bhuj in Gujarat which has only been partly commissioned so far. As per the
company, this plant will be fully commissioned by end-FY15. Hence, we believe
CWIP (and thereby the CWIP/gross block ratio) should decline significantly in
FY15.
On bottom up coverage, we are BUYERs of the stock with a target price of Rs760
(27% upside).
Exhibit 10: Balkrishna Industries - Capex analysis
Company/metric CWIP/Gross Block
FY11 FY12 FY13 FY14
Balkrishna Industries 0.05 0.37 0.54 0.18
Apollo Tyres 0.05 0.04 0.04 0.00
MRF 0.27 0.08 0.07 N/A *
JK Tyre 0.06 0.22 0.02 0.04
Ceat 0.06 0.01 0.01 0.04
Median (ex-Balkrishna) 0.06 0.06 0.03 0.04
Divergence (Balkrishna) (0.00) 0.31 0.52 0.15
Source: Company, Ambit Capital research. Note: *N/A since MRF is a September ending company.
10 Cumulative CFO plus CFI to median revenues: We calculate the cumulative

CFO (cash flow from operations) plus cumulative CFI (cash flow from investing Our model penalises firms that
activities) over the last six years and divide this by the last six-year median have not generated positive cash
revenues for the company. The higher the ratio, the better our perception of the flows even on a six-year basis
company’s accounts. The idea is to penalise firms which over such large 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.
Case study: Amtek Auto
Amtek Auto’s standalone and consolidated gross block turnover has historically
remained significantly below its peers. Plant and machinery have historically
averaged ~90% of Amtek Auto’s gross block (vs ~78% for its peers). Even with a
higher share of Plant and machinery in overall gross block (which would imply a
greater share of productive assets in its gross block versus its peers), Amtek Auto’s
gross block turnover hasn’t picked up.
Further, in spite of the lower gross block turnover, Amtek Auto’s cumulative CFI
over the last three years has consistently eaten away the cash generated from
operations raising questions regarding the reasonability of its capex.

Strategy
Exhibit 11: In spite of the lowest gross block turnover vs Exhibit 12: …Amtek Auto’s free cash flows have been negative
its peers… (Rs mn)
Company/metric Gross Block Turnover Cumulative CFO
Cumulative Median
Company/metric plus CFI to median
FY11 FY12 FY13 CFO plus CFI revenues
revenues
Amtek Auto (consol) 0.6 0.7 0.5 (FY11-13) (FY11-13) (FY11-13)
Amtek Auto (stan) 0.5 0.6 0.4 Amtek Auto (consol) (85,847) 76,222 (1.1)
Bharat Forge 1.0 1.2 0.9 Amtek Auto (stan) (19,601) 24,539 (0.8)
Mahindra CIE 1.3 1.4 1.3 Bharat Forge 3,841 31,512 0.1
Nelcast 2.5 2.7 2.0 Mahindra CIE 999 4,325 0.2
Median (ex-Amtek) 1.3 1.4 1.3 Nelcast 1,924 5,076 0.4
Divergence (Amtek Median (ex-Amtek) 0.2
(0.6) (0.7) (0.8)
consolidated)
Divergence (Amtek
Divergence (Amtek (1.36)
(0.8) (0.8) (0.9) consolidated)
standalone)
Divergence (Amtek
(1.03)
standalone)
Source: Company, Ambit Capital research. Notes: (1) FY11 and FY12 Source: Company, Ambit Capital research. Notes: (1) FY11 and FY12 figures for
figures for Amtek Auto are June year-end whilst FY13 is 15 months ended Amtek Auto are June year-end whilst FY13 is 15 months ended September 30, 2013
September 30, 2013 which has been annualised for a like-to-like which has been annualised for a like-to-like comparison with peers. March year-end
comparison with peers. March year-end for all the other companies; (2) for all the other companies; (2) Standalone accounts for all the peer companies.
Standalone accounts for all the peer companies.
IV - Audit quality checks

11 CAGR in auditor’s remuneration to CAGR in consolidated revenues: We
calculate CAGR in standalone auditor’s remuneration and consolidated revenues We penalise firms where growth
over FY08-14. A lower ratio of CAGR in auditor’s remuneration relative to CAGR in auditor’s remuneration has
in consolidated revenues receives a high score. The rationale is to penalise been higher than the growth in
companies whose growth in auditor’s remuneration has exceeded the growth in the firm’s revenues
the firm’s revenues.
Case study: Crompton Greaves
Crompton’s consolidated auditor’s remuneration of Rs63.2mn in FY11 was far
higher than the consolidated auditor’s remuneration of Rs20mn paid by Infosys
and standalone auditor’s remuneration of Rs28.1mn paid by Larsen & Turbo in
FY11. Further, whilst the company has stopped reporting consolidated audit fees
since FY12 (as this was not required under the revised Schedule VI), Crompton’s
auditor’s remuneration was significantly ahead of its peers whilst these numbers
were still being reported.
Exhibit 13: Crompton Greaves - Auditor’s remuneration vis-à-vis peers
FY11 FY12 FY13
Crompton (consolidated)
Net Sales (Rs mn) 100,051 112,486 120,944
Auditor’s remuneration (Rs mn) 63.2 93.4 Not disclosed
Auditor’s remuneration as a % of Total revenues (%) 0.06 0.08 Not available
Siemens (standalone)
Net Sales (Rs mn) 120,289 129,199 113,526
Auditor’s remuneration (Rs mn) 23.0 33.0 39.0
Auditor’s remuneration as a % of Total revenues (%) 0.02 0.03 0.03
ABB India (consolidated)
Net Sales (Rs mn) 62,871 74,518 76,105
Alstom T&D India* (consolidated)
Net Sales (Rs mn) 40,200 33,113 31,519
Thermax (standalone)
Net Sales (Rs mn) 48,524 53,041 46,909
Source: Company, Ambit Capital research; Note: * FY12 numbers have been annualised.

Strategy
Cumulating scores: We cumulate scores across these 11 parameters to arrive at the

final accounting score for each firm. Based on these parameters, we rank 370 BSE500
firms and 767 sub-BSE500 firms on accounting quality in this year’s forensic exercise.
From the BSE500 universe, we have excluded 85 banks and financial services firms.
Further, 8 firms were excluded because their FY14 annual reports had not been
published at the time of running this exercise (see the table on the right). A further 37
firms have been excluded due to sketchy data availability/corporate
restructuring/year-end change/limited listed history.
Whilst we have extended this year’s forensic accounting exercise to include all List of firms whose FY14 data is
firms with mcap above Rs 1,000mn, the exhibits and discussion that you find not available (cut-off date is 31
in the subsequent sections are only for the BSE500 universe (excluding October)
Financial Services firms). Financial
Company name
Year end
Data sources: We have used Ace Equity and Capitaline as data sources for the Trinity Tradeli. March
underlying financial data whilst stock price data has been sourced from Bloomberg. India Cements March
We had to use Ace Equity for some data items and Capitaline for some others in order
Sunrise Asian March
to minimise data errors. Unfortunately, neither of these databases (nor any other
database in India) is entirely reliable by itself. Alok Inds. September
Ballarpur Inds. June
Please note, however, that several adjustments need to be made to each of the
individual variables which we have not detailed here. For further details on these Kappac Pharma March
adjustments, kindly email the authors of this note. Orchid Chemicals September
Luminaire Tech. March
Source: Ace Equity, Ambit Capital research
Note: For the purpose of this exercise, we
have included Essar Oil (March-ending),
MRF, Siemens, Amtek Auto, Amtek India
and BF Utilities (September-ending) based
on their FY08-13 financials.

Strategy
Accounting quality and investment returns

Absolute scores
In this section, we seek to answer the following question: ‘Does accounting quality, as
quantified by our model, impact stockmarket performance?’ For this we assess the link
between the blended forensic accounting scores for the BSE500 universe of firms,
derived based on the methodology explained above using the last six years’ data, and
the stock price performance for these stocks from April 2008 to October 2014.
1. Universe level: We find that for the BSE500 universe as a whole, stock-specific
accounting scores and stock price returns do not have a significant relationship
(see the exhibit below). Such a lack of correlation is not surprising given the
multitude of other factors (such as the underlying fundamental performance)
which influence stock price returns.
Exhibit 14: Scatter plot of accounting scores vs stock price performance for all BSE500
stocks does not bring out any significant relationship
160% R² = 18%
140%
Share price performance
120%
100%
80% Stock-level noise leads to a weak
60% relationship between accounting
40% scores and stock returns at the
20% universe level (370 firms)…
0%
-20% 50 100 150 200 250 300
-40%
-60%
Accounting score
Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual
financials over FY09-14; stock price performance is from April 2008 to October 2014 on a CAGR basis. Universe
for this exhibit is BSE500.
2. Decile level: To control for noise around individual stocks, we arrange these
stocks into deciles based on their accounting scores. We then find a strong
relationship between the average accounting scores of these deciles and the
average stock price performance of their constituent stocks, suggesting that
accounting quality is a significant driver of stock returns.
Exhibit 15: Decile-level analysis points to a strong link between accounting scores and
stock price performance
30.0% R² = 86%
25.0%
…however, deciles constructed
Median share price
D5 D3
20.0% D1
on accounting scores
performance
15.0% D2 demonstrate the power of

D6 D4
10.0% D8 accounting quality in shaping
5.0% stock returns
D9 D7
0.0%
-5.0%100 120 140 160 180 200 220 240
-10.0%
-15.0% D10
Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accouting score is based on annual
for this exhibit is BSE500.

Strategy
In terms of individual decile performances, the first decile (D1) has delivered stock
price returns of 24.2% CAGR since April 2008. In contrast, the last decile (D10)
has delivered returns of -9.7% CAGR over this period, thus implying a close to
34% CAGR outperformance for D1 vs D10. The performance differential across
deciles becomes more evident from the exhibit below.
Exhibit 16: Decile-level analysis suggests accounting quality is important
25%
20%
'Zone of Trouble'
Median share price
15%
performance
10% Top accounting decile

outperforms the bottom decile by
5% 34% on a CAGR basis
0%
D1 D2 D3 D4 D5 D6 D7 D8 D9 D10
-5%
-10%
Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accouting score is based on annual
financials over FY09-14; stock price performance is from April 2008 to October 2014. Shaded area denotes ‘Zone
of Trouble’. Universe for this exhibit is BSE500.
The most crucial takeaway from the above exhibit is that whilst the top 6 deciles
on accounting do not seem to be materially different from each other on
investment performance, the performance just slumps beyond D6. Therefore,
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; D7-D10 is the zone of
trouble to be avoided at all costs.
3. Sector-agnostic buckets: 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 for 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 17 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.

Strategy
Exhibit 17: Strong link between accounting quality and stock performance even after
controlling for sector effects (the first entry is the accounting score over FY09-14, the second
entry is the median CAGR stock returns in that bucket from April 2008 to October 2014)
25.0%
224, 19.2%
20.0% Sector-agnostic buckets
199, 14.3% constructed with homogenous
15.0% sectoral make and differentiated
177, 11.8% only on accounting quality show
accounting quality drives
10.0%
investment performance even
after controlling for sector effects
5.0%
144, 2.0%
0.0%
Bucket A Bucket B Bucket C Bucket D
financials over FY09-14; stock price performance is from April 2008 to October 2014. Universe for this exhibit is
BSE500.
The above exhibit yet again highlights the vitality of avoiding the lowest rung firms
on accounting for a healthy portfolio performance.
4. Sector level: Next, arranging the BSE500 firms into sectors and assessing the link
between the average accounting scores of these sectors and the average stock
price performance of their constituent stocks suggests that accounting quality
makes a difference at the sector level as well (i.e. sectors with higher accounting
quality, such as FMCG, Auto Anc and Consumer Durables, perform better than
sectors with poor accounting quality such as Realty, Engineering & Construction
and Infrastructure).
Exhibit 18: Link between accounting quality and stock price performance at the sector level is relatively high
60%
Consumer Durable
50% R² = 40%
Average share price
40% Auto Agri

performance
Chemicals inputs Auto

30% Pharma Logistics
IT Anc FMCG
20% Misc. Industrials
Capital Textiles Media Retail
10% Conglomerate Cement
goods Oil &
E&C
0% Gas
-10%150.0 160.0 170.0 180.0
Utilities
190.0
Metals &
200.0 210.0 220.0
Telecom Infra.
-20% Mining Shipping
Realty
Average accounting score
Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY09-14; stock price performance is
from April 2008 to October 2014. Universe for this exhibit is BSE500.
With an average score of 213, FMCG is amongst the best sectors in our
accounting model. The sector has generated average stock price returns of 25%
Link between accounting scores
CAGR over the last six-year period since April 2008. On the other hand, Realty is
the worst sector on accounting on our model with an average score of 152. The and price performance is
average stock price performance in the sector has been -12% CAGR over the last relatively high at the sector
six-year period. level…
Also, stocks within the same sector exhibit a significant link between accounting
scores and stock price returns in many cases. Three sectors which show strong
links are Utilities, Auto and Industrials.

Strategy
Exhibit 19: Within the sector, the link between accounting and price performance for
Utilities
30% R² = 61%
20%
10%
…Even within a sector, stock
0% returns show significant
50 100 150 200 250 300 dependence on accounting
-10% scores
-20%
-30%
Accounting score
for this exhibit is stocks from the Utilities sector in the BSE500 index.
Exhibit 20: Within the sector, the link between accounting and price performance for
Auto
90% R² = 21%
80%
70%
60%
50%
40%
30%
20%
10%
0%
100 150 200 250 300
Accounting score
for this exhibit is stocks from the Auto sector in the BSE500 index.
Exhibit 21: Within the sector, link between accounting and price performance for
Industrials
70% R² = 50%
60%
50%
40%
30%
20%
10%
0%
-10% 100 120 140 160 180 200 220 240
-20%
Accounting score
for this exhibit is stocks from the Industrials sector in the BSE500 index.

Strategy
5. Size buckets: Finally to address the size dimension, we split our universe of
stocks into four size buckets, as shown below. Bucket 1 comprises the largest 50 Accounting quality is better for
stocks on market cap, Bucket 2 of the next 100, Bucket 3 of the next 100 and larger-caps on average
Bucket 4 of the lowest 120 stocks on market cap (thus, taking the total to 370
firms).
Exhibit 22: Larger capitalisation firms have better accounting scores on average
Size Number of firms Market cap range Market cap range Average accounting Average share % stocks in 'Zone
Bucket in the bucket (Rs bn) (US$ bn) score price performance of Trouble'
Bucket 1 top 50 Rs331bn-5,108bn US$5.4bn-83bn 202 17.1% 24%
Bucket 2 next 100 Rs68bn-330bn US$1.1bn-5.4bn 190 17.2% 31%
Bucket 3 next 100 Rs28.4bn-66.8bn US$0.5bn-1.1bn 189 17.1% 37%
Bucket 4 bottom 120 Rs4.4bn-28.3bn US$0.07bn-0.5bn 173 4.9% 56%
Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY09-14; stock price performance is
from April 2008 to October 2014 (on a CAGR basis). Universe for this exhibit is BSE500.
As one would expect, we find that the average accounting score as well as the
stock price performance varies directly with market cap, i.e. the larger market-cap
buckets 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 Trouble’ (i.e. stocks that fall in D7
and below) too varies directly with market-cap. Whilst 24% of firms belonging to
the largest market-cap bucket fall in the ‘Zone of Trouble’, ~56% of the firms
belonging to the smallest market-cap bucket fall in this zone.
Delving further into the stocks that fall in Bucket 4 of market-cap, we note that
~38% of these names also fall in Bucket ‘D’ discussed earlier (i.e. the bottom
quartile stocks from each sector). In contrast, the remaining ~62% stocks are
evenly distributed amongst Buckets ‘A’ to ‘C’ (see Exhibit 23 below).
Exhibit 23: Distribution of the smallest market-cap firms across the four accounting
quality buckets
Accounting quality As a % of total number of firms in Bucket '4'
Number of firms
bucket (i.e. the smallest 120 firms in the BSE500)
Bucket A (best quality) 24 20%
Bucket B 25 21%
Bucket C 26 22%
Bucket D (worst quality) 45 38%
Total 120 100%
Source: Company, Ambit Capital research. Universe for this exhibit is BSE500.

Strategy
Change in accounting quality and

investment returns
Change in scores
The decile level and sector-agnostic buckets from the previous section suggest that
accounting quality is a significant driver of stock prices and that this holds true even
after controlling for sector effects. In this section, we seek to answer the question:
‘Does a change in accounting score impact stockmarket performance?’
To calculate the change in accounting score, we break the six-year period (from FY09
With accounting quality showing
to FY14) that we have used so far to calculate absolute accounting scores into two
a strong link with stock price
sub-periods—FY09-11 and FY12-14. We then use the 11 parameters to quantify
performance, change in
accounting scores for each of the two sub-periods separately using the same
accounting quality is another
methodology as earlier (but for a three-year period now vs a six-year period earlier).
dimension meriting attention
Change in accounting score is calculated as the change in the FY12-14 sub-period’s
score over the FY09-11 sub-period’s score. Finally, we assess the link between this
change in accounting score for the BSE500 universe of firms and the stock price
performance for these stocks from April 2011 to October 2014.
1. Universe level: We find that for the BSE500 universe as a whole, the change in
accounting scores and individual stock prices does not have a meaningful
relationship (see the exhibit below). Such a lack of correlation is not surprising
given the multitude of other factors (such as the underlying fundamental
performance) which influence stock price returns.
Exhibit 24: Scatter plot of change in accounting scores vs stock price performance for
all BSE500 stocks does not bring out any significant relationship
250% R² = 0%
200%
150%
Again stock-level noise prevents
100% any strong link between change
50%
in accounting scores and stock
performance
0%
(150) (100) (50) - 50 100 150
-50%
-100%
Change in accounting score (FY12-14 over FY09-11)
Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score change is for the
FY12-14 subperiod over FY09-11; stock price performance is from April 2011 to October 2014. Universe for this
exhibit is BSE500.
2. Decile level: Similar to the methodology used in the preceding section to control
for noise around individual stocks, we arrange these stocks into deciles based on Decile-level analysis points to a
their accounting scores. Arranging these stocks into deciles based on the change moderate link between change in
in accounting scores points to a moderate relationship between the change in accounting scores and stock
accounting scores of these deciles and the average stock price performance of performance
their constituent stocks.

Strategy
Exhibit 25: Decile-level analysis points to some link between the change in accounting
scores and stock price performance but only a moderate one
30.0%
Average share price
25.0%
D6 D2 R² = 21%
performance
D8 20.0%
D4
15.0% D1
D3
D7
10.0% D5
D10 D9
5.0%
0.0%
(80) (60) (40) (20) - 20 40 60 80
Change in accounting score based deciles
Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score change is for the
FY12-14 subperiod over FY09-11; stock price performance is from April 2011 to October 2014 on a CAGR basis.
3. Market and sector level: When looking at changes in accounting scores over
time, one is keen to know: (1) At the market level, are accounting ratios improving
or worsening over time? (2) At the sector level, are accounting ratios improving or
worsening over time?
In the exhibit below, we highlight the proportion of ratios that are improving over
time (i.e. in the FY12-14 period vs the FY09-11 period). It is heartening to see that
on aggregate 80% of ratios have improved for India Inc.
Exhibit 26: Improvement in accounting ratios at the overall market and sector level
Oil & Gas, Pharma and Auto Anc
Proportion of ratios improving Average stock price
Sector
(FY12-14 over FY09-11) performance
are amongst the most-improved
Aggregate 80% 15.5%
sectors on accounting quality…
Oil & Gas 90% 4.3%
Pharma 90% 25.9%
Auto Anc 90% 35.7%
IT 80% 25.2%
Logistics 80% 36.2%
Realty 80% -2.1%
Utilities 80% -3.5%
Retail 80% 19.3%
Infrastructure 70% 1.3%
Cement 70% 28.3%
Metals & Mining 70% -11.6%
Conglomerate 70% 6.6%
Industrials 60% 21.6%
FMCG 60% 22.6%
Auto 60% 33.0%
Engineering & Construction 60% 1.4%
Shipping 60% -0.8%
Telecom 60% 3.7%
Textiles 60% 10.0%
Consumer Durable 60% 33.0%
Agri Inputs 50% 29.9%
Media 50% 17.8%
Chemicals 50% 25.6%
Capital Goods 50% 4.0%
Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score change is for the …whilst improvements are more
FY12-14 subperiod overt FY09-11; stock price performance is from April 2011 to October 2014 on a CAGR basis.
modest for Agri inputs, Media,
Chemicals and Capital Goods

Strategy
At the sector level, the ratios of Oil & Gas, Pharma and Auto Anc have improved
the most. Agri inputs, Media, Chemicals and Capital Goods bring up the rear of
this table even with half of the parameters improving for these sectors.
4. Size buckets: Finally, we split our universe of stocks into four size buckets exactly
in accordance with the method described in the preceding section. We find that
the improvement in accounting scores is the most for the lower market-cap
buckets.
Exhibit 27: There does not appear to be link between capitalisation and change in accounting scores
Number of Proportion of ratios Average stock
firms Size Bucket Market cap range (INR bn) Market cap range (USD bn) improving (FY12-14 price
in the bucket over FY09-11) performance
top 50 Bucket 1 Rs 331bn-Rs 5,108bn US$ 5.4bn-US$83bn 40% 16.8%
next 100 Bucket 2 Rs 68bn-Rs 330bn US$ 1.1bn-US$5.4bn 70% 17.9%
next 100 Bucket 3 Rs 28.4bn-Rs 66.8n US$ 0.5bn-US$1.1bn 70% 24.3%
bottom 120 Bucket 4 Rs 4.4bn-Rs 28.3bn US$ 0.07bn-US$0.5bn 90% 5.7%
Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score change is for the FY12-14 subperiod overt FY09-11; stock price
performance is from April 2011 to October 2014 on a CAGR basis. Universe for this exhibit is BSE500.
Overall, here are some of the key findings from our analysis of accounting quality Improvement in accounting is the
change over time: most for lower capitalisation
stocks, helped by a lower base to
 At the universe level, the accounting quality of India Inc seems to be
start with
improving.
 At the sector level, Oil & Gas, Pharma and Auto Anc have improved the most.
 On the other hand, improvements have been more modest for Agri inputs,
Media, Chemicals and Capital Goods
 Improvement in accounting ratios is more prominent for lower market-cap
stocks.

Strategy
Accounting quality in practice

In this section of the note, we now turn to some practical observations on accounting
quality based on our experience over the last few years.
Accounting quality matters, even in a bull run
That accounting quality drove alpha in the bear phase of 2008-13 is a point we have
The ‘Zone of Trouble’ on
observed over the past few years. However, contrary to popular belief, accounting
accounting quality has stayed an
quality has remained relevant even in the recent uptrend, with the last four deciles on
underperformer in the uptrend of
accounting continuing to underperform over the past 12 months.
the past 12 months
Exhibit 28: Lower deciles on accounting quality have underperformed even in the
uptrend
75%
Median share price
60%
performance
45%
30%
15%
D1 D2 D3 D4 D5 D6 D7 D8 D9 D10
Source: Bloomberg, Ambit Capital research. Note: Price performance has been measured over the period 21
November 2013 to 15 December 2014.
However, it is interesting to note that in the uptrend the biggest improvements in

performance have come for D5 and D6 and not for firms with champion accounting
quality.
Exhibit 29: Middle deciles have shown the best share price performance in the uptrend
Stock price performance
last 12 months* 12 months prior to that** Delta
D1 48% 3% 45%
D2 59% -4% 63%
D3 44% 1% 44%
D4 59% -7% 66%
D5 64% -8% 72%
D6 70% -10% 80%
D7 44% -15% 59%
D8 56% -19% 74%
D9 31% -30% 61%
D10 19% -33% 52%
Average 49% -12% 62%
Source: Bloomberg, Ambit Capital research. Note: * Defined as price performance over the period 21 November
2013 to 15 December 2014 ** Defined as price performance over the period 21 November 2012 to 21 November
2013.
Accounting quality not priced in

Satyam traded at a P/E discount to Infosys and Wipro even before the promoter
owned up to aggressive accounting. Yet Satyam’s share price crashed by over 90% Accounting quality is not properly
within two days of the fraud being made public. Thus, the market does not already discounted by the markets
know and properly discount firms that have poor accounting quality.

Strategy
We also find no correlation between P/E and accounting scores at the market level
nor do we find anything significant at an intra-sector level. Accounting quality is not
already priced in (and that is why it is worth investigating and assessing)!
Exhibit 30: No correlation between accounting quality and Exhibit 31: No correlation between accounting quality
P/E at the market level and P/E for FMCG stocks
120.0 R² = 1% 120.0 R² = 0%
100.0 100.0
Trailing P/E
Trailing P/E
80.0 80.0
60.0 60.0
40.0 40.0
20.0 20.0
- -
50 100 150 200 250 300 50 100 150 200 250 300
Accounting score Accounting score
Source: Company, Ambit Capital research; Note: Trailing P/E has been Source: Company, Ambit Capital research; Note: Trailing P/E has been
restricted to 100. Universe for this exhibit is BSE500. restricted to 100. Universe for this exhibit is stocks from the FMCG sector in
BSE500 index.
Not all Nifty firms have good-quality accounts

Whilst the top size bucket, bucket 1 (Exhibit 22 on page 18), has the best accounting
score, this overall average hides a great deal of variation even within the large caps.
For example as many as 45% of Nifty firms have accounting scores below the universe Not all firms from the Nifty have
(BSE500) average. Further, for the weakest nine of these firms, the accounting scores clean accounting
are actually so low that these firms fall in bottom four deciles of accounting quality
for the BSE500. In other words, nine Nifty firms are in the ‘Zone of Trouble’.
Avoiding the ‘Zone of Trouble’
We can give interested clients an accounting heatmap of their portfolio within five
working days of receiving it if the constituent stocks are in our accounting model. This
will enable clients to identify if any of their holdings are in the ‘Zone of Trouble’. A
sample screenshot of what such a diagnostic looks like is presented below.
Exhibit 32: Indicative portfolio heatmap
Scores
CAGR in PFD-% of
Vol. in NoI Non-oper Cum. FCF/ Change in
CFO Cont Liab- Change in auditor’s remn Cash debtors Overall
Companies Ambit sector (as a % of exps-% of median reserves/(PAT
EBITDA % of NW depr rate to CAGR in yield more than Score
sales) total revs revs ex dividend)
consol revs six months
ABC Industrials 11 12 13 8 2 13 6 13 11 3 8.5
XYZ Utilities 13 8 12 9 5 12 2 7 7 3 7.3
PPP Utilities 1 5 8 10 8 8 11 11 6 3 7.4
DEF Metals 12 10 4 5 6 3 3 6 13 3 7.1
GHI Metals 10 6 7 6 1 2 12 5 12 3 6.6
RRR IT 3 2 10 12 7 10 8 10 5 3 6.7
TTT Oil & Gas 6 11 5 4 4 7 1 1 10 2 5.3
PQR Oil & Gas 7 13 3 2 3 1 4 1 2 3 4.3
Note: ORANGE denotes sub-par accounting quality relative to the sector average; Red denotes that the stock falls in the ‘Zone of Trouble’
For a more detailed analysis, we also do extensive bottom-up company-specific

bespoke research for clients. A sample bespoke has been attached towards the end of
this note (page 27 onwards) as an example of our past work on this front.

Strategy
What does our model not capture?

Whilst our accounting model uses 11 objective, quantifiable parameters to assess the
overall quality of a firm’s accounts, it has certain limitations too. For example, there
are certain subjective assessments on governance standards that one can make only
after going through the annual reports and which cannot be quantified. Our bottom-
up analysis therefore plays a vital role in helping our clients identify these parameters.
Some such examples are discussed below.
Subjective checks- Related party transactions

Investors should lookout for suspicious related party transactions undertaken by listed
entities. At its simplest, the extent of related party transactions and the trend in these Suspicious related party
transactions are important; a sudden increase can be bad news. However, it is often transactions would merit further
trickier than this, as shown in instances illustrated here. attention
Parties would be considered ‘related’ if at any time during the financial year, one
party is able to either control the other party or can exercise significant influence over
the other. Thus, related parties would include subsidiaries, associates, joint ventures,
key management personnel and their relatives, etc. Ideally, transactions between
related parties should be at arm’s length. An arm’s length transaction would mean
that both the parties seek to execute the transaction in their best interests. However,
in several cases, related party transactions are conducted in a manner that is not in
the best interests of one party. Overpaying for an asset purchased from a related
party, sale of goods or other assets to related parties at a significant discount to their
fair market values, loans given to related parties at exceptionally concessional rates or
loans taken from related parties at exorbitant interest rates are just a few examples of
how these transactions might not be in the best interests of the minority shareholders.
Likewise, unwarranted transactions with related parties should raise a red flag.
This point can be better understood by analysing certain related party transactions
that Crompton Greaves has undertaken over the last 5-6 years.
(Note: Crompton Greaves falls in the second quartile in its sector on our accounting
model).
Case study: Crompton Greaves
During FY08, Crompton Greaves purchased co-ownership rights in an aircraft from a
related party, M/s Asia Aviation Ltd, for `562.5mn. Mr. Gautam Thapar, MD & CEO of
Crompton Greaves, was also a director of M/s Asia Aviation Ltd, a company in the
business of providing air charter services.
Whilst it is arguable that the aircraft purchase was unwarranted, the fact that it had
been executed with a related party in the business of providing aircrafts on a lease
basis also raises concerns regarding the appropriateness of such a transaction, given
that Crompton Greaves could have simply hired the aircraft.
This transaction was followed by the purchase of another aircraft during FY11 for
`2700mn. However, no disclosures were made by the company in its annual report
for FY11 as to whether or not this was a related party transaction. When these issues
were raised by investors with the management in 2QFY12, the management
transferred the entire block of aircrafts at book value to its unlisted related parties,
M/s Asia Aviation Ltd (`411.7mn) and M/s Avantha Holdings Ltd (`2,405mn). This last
point can be detected from the FY12 Annual Report.
Subjective checks - Issues raised by the auditor

Amongst the first things to look for whilst analysing an auditor’s report is to keep an
eye out for any qualifications made by the statutory auditor. Whilst there are several Investors should keep an eye out
reasons why an auditor may qualify his reports, one common reason is when the for any qualifications made by
accounts have not been drawn up according to the generally accepted accounting the statutory auditor
principles.

Strategy
This can be better understood by looking at the issues raised by Lanco Infratech’s
auditors, PwC, in the auditor’s report in FY07 and FY08.
(Note: Lanco Infratech falls in the bottom quartile in its sector on our accounting
model).
Case study: Lanco Infratech
In FY07, the auditors of Lanco Infra had raised the following issues with respect to the
consolidated financial statements:
 Profits were higher by `169.29mn (or 9% of consolidated profits for FY07) due to
non-elimination of intra-group transactions and unrealised profits pending
clarification from ICAI.
 The consolidated financial statements were presented considering M/s Lanco
Kondapalli Power Private Limited (LKPPL) as a subsidiary with effect from 1 April
2006 when in fact, LKPPL became a subsidiary of the company with effect from 15
November 2006. As a result, profits were higher by `242.94mn (or 13% of
consolidated profits in FY07).
Not only did the company not meet the requirements of AS-21 on the consolidated
financial statements (given that according to AS-21 issued by the ICAI, consolidation
should have been carried out from 15 November 2006, the date on which holding
subsidiary relationship came into existence), the above treatment resulted in the
profits for FY07 being higher by `412.23mn (or 22% of consolidated profits for that
year).
The excess profit of `412.23mn, which was recognised in the P&L account of Lanco
Infra in FY07, had to be reversed in FY08. According to the generally accepted
accounting principles, such a reversal should have been made against current-year
profits (i.e. FY08 profits in this case) as a prior-period adjustment. Lanco Infra instead
chose to adjust these excess profits against the balance of profit brought forward from
the previous year. Consequently, the correction to FY08 profits was not made as
required. The auditors too had raised their issues on such a treatment in their report
on the consolidated financial statements for FY08.
Issues raised by Lanco’s auditors in FY07 Annual Report (on Page 63)
“Attention is drawn to the following:
 As detailed in note 4(xvi) of Schedule 19, pending clarification from the ICAI on
non-elimination of intra group transactions and unrealized profits arising out of
construction of projects under Build Operate Own and Transfer basis, the Company
has not eliminated revenues and unrealized profits in the consolidated financial
statements. As a result the consolidated revenue and net profit after minority
interest are higher by `1692.97 millions and `169.29 millions respectively.
 M/s Lanco Kondapalli Power Private Limited (LKPPL) has become a subsidiary of the
Company with effect from November 15, 2006. However the consolidated financial
statements have been presented considering LKPPL as a subsidiary with effect from
April 01, 2006. As a result the consolidated revenues and net profit after minority
interest are higher by `3270.90 and `242.94 millions respectively.”
Issues raised by Lanco’s auditors in FY08 Annual Report (on Page 71)
“Attention is drawn to Note 4.viii on Schedule 19 to the consolidated financial
statements regarding the adjustment of excess profits recognised in the previous year
aggregating to `412.23 million against the balance of profit brought forward from the
previous year, which in our opinion and according to the generally accepted accounting
principles in India should have been adjusted against the current year’s profit as a prior
period adjustment. Consequently the net profit after tax and minority interest for the
current year has been overstated by the above amount.”

Strategy
Subjective checks - Cash repatriation to foreign parent

Ideally, cash held by the subsidiary belongs as much to the minority shareholders as it
does to the controlling shareholder. However, in recent times, we have seen how the Cash repatriation to foreign
parent can abuse its position as the dominant shareholder to pull out cash from the parent is another aspect that
subsidiary without the minority shareholders having any say in this decision. investors should watch out for
In order to protect the interests of minority shareholders, SEBI came out with a
Circular in early February (which was later amended in May), wherein it directed that
listed entities would need the support of majority of the minority shareholders in case
of M&A transactions. Ambuja Cement is a recent example of a firm that has seen
repatriation of cash to the foreign parent.
(Note: Ambuja Cement falls in the top quartile in its sector on our accounting model).
Case study: Ambuja Cement
What was proposed?
In July 2013, the Board of Directors of Ambuja Cement unanimously approved the
proposal to amalgamate Holcim (India) Private Limited (HIPL) with the company. HIPL
is a wholly owned subsidiary of Holderind Investments Ltd, Mauritius. As a result of
the scheme, Ambuja acquired a 50.01% stake in ACC and paid `35bn in cash and
issued incremental 433.7mn shares worth `83bn for the same to Holcim (see Exhibits
33 and 34).
Exhibit 33: From a complicated structure earlier… Exhibit 34: …Holcim transfers all its holdings to Ambuja
Source: Company, Ambit Capital research Source: Company, Ambit Capital research
Issues with the proposal

As highlighted by our Cement analyst and Head of Research, Nitin Bhasin, in his 25
July 2013 note (click here for the detailed note), the rearrangement would not result
in any value creation for Ambuja’s shareholders because:
 The controlling shareholders stood to benefit at the expense of the minority
shareholders. The rearrangement offered a relatively raw deal for minority
shareholders, as it would result in an indirect holding in ACC.
 It is difficult to decipher how the transaction in which the cash is taken from
Ambuja and replaced with investment in ACC made the capital structure of the
standalone Ambuja entity any better.
 Holcim took out `35bn cash giving in return only the promise of some future
synergies. The synergy potential of `9bn do not seem likely to accrue in the near
future (see Exhibit 35).
Exhibit 35: Expected synergies and benefits highlighted by Ambuja Cement’s management to be extracted over the next two
years
Synergy/
Source Through Our view
cost benefits
Supply Chain This is a likely source of immediate benefit and with the change in the management
`3.6bn-4.2bn Clinker swaps, cement swaps
Optimisation structure, these benefits could accrue soon; we expect benefits of this in CY14 itself
Procurement; fixed cost reduction Our primary data sources suggest that both the companies are already working on
Shared services /
`4.2bn-4.8bn through shared services in back-end most of these together especially procurement and hence we do not expect such
Fixed Costs
processes; financial optimisation large benefits immediately
We model total benefits of `4.5bn in CY14, equally for ACC and Ambuja and then
Total `7.8bn-9bn
increasing marginally every year

Strategy
The eventual outcome

As discussed earlier, under the new norms proposed by SEBI, issuance of new shares
to the promoter or promoter group in deals involving acquisitions, mergers and
demergers would require a simple majority (i.e. 51%) of non-promoter shareholding
for passing such a resolution.
The results of the postal ballot conducted were as under:
 ~87% of the institutional shareholders had voted, out of which ~68% had voted
in favour of the resolution whilst just over 32% had voted against the resolution.
 Only ~10% of the remaining public shareholders had voted, out of which ~88%
had voted in favour of the resolution whilst less than 12% had voted against the
resolution.
Thus, in spite of widespread criticism of the deal and opposition from minority
shareholders, Ambuja could get 68.5% of public shareholder votes in favour of the
deal. Post that, Ambuja had also received the EGM approval for a reduction in its
share capital. As a result of this scheme, Holcim’s stake in Ambuja will go up by 10%
whilst the minority shareholders’ stake will be diluted by over 20%.
Incorrect penalisation? - Volatile depreciation as a

means to improved cash flow generation
Whilst a company with a volatile depreciation rate gets penalised in our accounting
model, note that there could be certain instances where this volatility in depreciation
could stem from a management’s strategy around improving its cash flow generation.
One such example of a company where a focus on cash profits over book profits has
resulted in the management following an aggressive depreciation policy is Shree
Cement.
(Note: Shree Cement falls in the top quartile in its sector on our accounting model).
A volatile depreciation rate may
Case study: Shree Cement sometimes be a result of
management’s cashflow
Shree Cement follows the written-down value method of depreciation due to which its
optimisation strategy
depreciation is volatile and increases materially in the years of capacity addition (due
to accelerated depreciation in the first year of operation). Front-loading depreciation
in the initial years reduces the NPV of taxes although the book profits are lower in that
year. The management highlights that the company is focussed on increasing cash
profits and not book profits and hence its follows an aggressive depreciation policy.
Thus, whilst the company gets penalised on our accounting model because of a
volatile depreciation rate, we like the stock from a bottom-up perspective, as the
company has displayed the best capital discipline (low cost capacity additions, high CE
turnover) and cost efficiencies which will ensure superlative EBITDA growth and RoCEs
in the cement demand upcycle.
Exhibit 36: Volatile depreciation rate - Shree Cement vs its peers
Company/metric Depreciation rate Volatility in Depreciation rate (bps)
FY11 FY12 FY13 FY14 FY12 FY13 FY14
Shree Cement 19.3% 18.8% 7.8% 8.6% 52 1,101 77
UltraTech 5.9% 4.9% 4.7% 4.5% 100 16 20
ACC 5.3% 5.4% 5.4% 5.3% 9 6 12
Ambuja 5.2% 4.8% 5.7% 4.7% 34 87 102
Ramco 4.4% 4.6% 4.5% 4.6% 18 6 11
Median (ex-Shree Cement) 5.2% 4.9% 5.1% 4.6% 26 11 16
Divergence 14.1% 14.0% 2.7% 3.9% 26 1,090 61

World Cargo
Sample Bespoke Analysis – World Cargo
SAMPLE BESPOKE ANALYSIS
High hopes but poor accounts

Whilst the Real Estate and Metals background of the promoter couple may not
provide relevant industry experience, they do provide them with capital and
relationships. Using these advantages the promoters have built World Cargo
into a force to be reckoned with in the logistics industry. Whilst primary data
and peers highlight the long-term potential of the business being created by
World Cargo through superstar employees, a marquee advisory board and the
“right regulatory reach”, the company’s accounts raise lots of questions.
Plenty of RED FLAGS

Revenue booking seems aggressive
World Cargo’s industry leading debtor days rose at a much faster pace than its
peers (Gateway, Allcargo and Concor) in FY10 whilst its revenues increased
marginally by 4%. Despite the highest receivable days in the industry,
provisions for doubtful debts remain very low at 0.3% compared to 2-20% for
its peers. Concerns on revenue booking are accentuated by the appallingly
low investment income return rates for FY09 (4.8%) and FY10 (1.4%) on cash
holdings whilst peers have posted 3-5% investment returns on cash.
Understated depreciation expenses boosting earnings?
Significantly low depreciation rates vis-à-vis peers on buildings and the Rail
License Fee appear to be inflating the net earnings of the company. Despite
peers amortising the Rail License Fees on a straight line method over the 20
years of concession period, World Cargo’s choice of amortising it using
management estimates of revenues and operational usage over 20 years
appears to be aggressive (given that investments and operations may not pan
out as expected by the management).
Auditor certification for not even half of the income and balance sheet!
World Cargo changed its auditors at the beginning of FY10 to ABC & Co. from
Big4 as Big4 expressed its unwillingness to continue (source: BSE). Whilst we
do not consider the accounts of other companies audited by ABC & Co. (Zee
Group and Welspun) as topnotch, what worries us the most that neither Big4
nor ABC has audited ~50% of revenues and Balance Sheet for the last
2-3 years. Whilst international revenues dominance does explain the gap on
account of audited revenues, we fail to understand that why the main auditor
does not audit the nearly 10% of consolidated revenues and 30% of the
consolidated assets of the Indian subsidiary World Cargo Rail Infrastructure
(audited by LMN & Associates).
Snapshot
Section Notable findings
Accounting analysis RED FLAG in respect of CFO/EBITDA and debtor days
Expense manipulation RED FLAG in respect of depreciation
Cash manipulation RED FLAG in respect of unclassified loans and advances
Fictitious revenues booking RED FLAG in respect of investment income returns
Debtors provision RED FLAG
Auditors RED FLAG Analyst Details
Source: Ambit Capital research Nitin Bhasin
+91 22 3043 3241
nitinbhasin@ambitcapital.com
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.
Accounting analysis
Exhibit 1: Revenue Recognition
Company\Metric CFO as a % of EBITDA Debtor days
FY08 FY09 FY10 FY08 FY09 FY10
Gateway Distriparks (Gateway) 85% 75% 132% 38 38 46
Allcargo Global Logistics*(Allcargo) 88% 37% 86% 47 41 47
World Cargo 18% 44% 24% 59 83 143
Container Corporation of India (Concor) 78% 86% 65% 1 2 2
Average (A) 67% 60% 77% 36 41 60
Average (ex-Concor) (B) 64% 52% 81% 48 54 79
World Cargo divergence from peer group
-49% -16% -53% 23 42 83
average (A)
World Cargo divergence from peer group
-45% -8% -57% 11 29 64
(excl Concor) average (B)
Source: Company, Ambit Capital research, Note: (a)* Dec year end, year end for other companies is March; (b) We have used Annual report of CY07, CY08 and
CY09 for Allcargo and Annual report of FY08, FY09 and FY10 for other companies; (c)CFO/EBITDA for Allcargo is calculated after adjusting for the exceptional
items of Rs-26.3mn and Rs5.6mn in CY08 and CY09, respectively and World Cargo’s EBITDA for FY08, FY09and FY10 is adjusted for the forex losses and loss on
sale of asset included under other expenses
 World Cargo’s CFO/EBITDA declined significantly in FY10 as CFO declined

by 35% due to increased working capital investments while EBITDA increased
21% on a YOY basis. However, after detailed analysis of the CFO and EBITDA for
World Cargo for FY09 and FY10, we find the following “unexplained anomalies”,
which raise a RED FLAG:
1 In FY10, World Cargo reported “Loss on foreign exchange fluctuations (net)”
of Rs31.3mn under “Administrative and Other Expenses” in its P&L while
reporting a GAIN under “Exchange Adjustments” of Rs167.3mn in the
cashflow statement, and
2 In FY09, World Cargo reported “Gains on foreign exchange fluctuations
(net)” of Rs37.7mn under “Other Income “in its P&L while reporting a LOSS
under “Exchange Adjustments” of Rs161mn in the cashflow statement.
 If the above amounts were to be adjusted from CFO and EBITDA (considering
that such foreign exchange investments were on account of operations) then the
CFO/EBITDA for FY09 and FY10 would be 18% and 52%, thus trending in line
with its peers. Non-disclosure of the nature of these foreign exchange
adjustments needs explanation by the company.
 World Cargo’s debtor days have always been ahead of its peers and have shot up
significantly in FY10. Debtor days for Gateway and Allcargo have been
considerably lower and more stable compared to World Cargo. Whilst World
Cargo’s debtors increased nearly 100% on a YOY basis (Rs2.7bn in FY10 from
Rs1.47bn in FY09), revenues grew by a nominal 4%. Part of the increase in
debtors can be explained by a substantial increase in revenues from the rail
freight business (FY10 revenues of Rs482 mn from Rs20 mn in FY09). But such a
high jump in debtor days (when the industry has not witnessed such a trend) and
a low and declining provision for doubtful debts (see exhibit 6) raise a RED FLAG.
Ambit Capital Pvt. Ltd. Page 28

Exhibit 2: Depreciation rate comparison

YoY change in depreciation
Company\Metric Depreciation rate (%)
rate (bps)
Gateway 5.1% 5.4% 4.7% 33 (69)
Allcargo* 5.6% 7.1% 6.7% 145 (39)
World Cargo 17.1% 8.7% 4.9% (838) (376)
Concor 5.0% 4.7% 4.8% (25) 6
Average 8.2% 6.5% 5.3% (171) (120)
World Cargo divergence
8.9% 2.2% -0.3% (666) (257)
from peer group average
Source: Company, Ambit Capital research , Note: (a)* Dec year end, year end for other companies is March.(b)
We have used Annual report of CY07, CY08 and CY09 Allcargo and Annual report of FY08, FY09 and FY10 for
other companies
 The depreciation rate for World Cargo has sharply declined over FY08-10
because World Cargo has added nearly Rs2.3bn of gross block in its logistics
business over last two years on the Rs301mn of gross block of its erstwhile
technology business. Moreover, a high proportion of land in the gross block
(FY10: 22%, FY09: 14%, FY08: NIL) and a significant decline in the software
gross block (FY10:0.3%, FY09: 21%, FY08:71%) has led to a sharp decline in the
depreciation rate. Freehold land accounts for 3% and 17% of the gross block of
Allcargo and Gateway, respectively.
 Despite a lower proportion of land in gross block, Allcargo’s high depreciation
rate is on account of high depreciation rates (9-13%) on Plant & Machineries,
heavy equipment and furniture (which account for 42% of gross block).
 Whilst World Cargo’s FY10 depreciation rate is closer to the peer , we highlight
that World Cargo’s depreciation policy should be read taking note of the
following:
1 World Cargo depreciates “Rail License fees” after considering the matching
concept of revenue, on a weighted of the agreement period, projected
numbers of rakes to be utilized over the said period and annual usage period
of the operational rakes since put to use. The Rail License agreement period is
20 years from the date of commencement of commercial operations in 2007.
This depreciation policy is materially different to Gateway’s policy of
amortising Rail License Fees on a straight line method over the life of the
agreement i.e., 20 years. Effective Rail License Fee amortisation rate for World
Cargo in FY10 was 0.8% as against 5% for Gateway. Underreporting of
depreciation forms the basis of management’s comment “Our unique model
has resulted in World Cargo Rail being the most profitable private container rail
operator in India” in FY10 annual report (see pg27).
2 Depreciation rate on buildings (2% of FY10 gross block) for FY10 is 2.6%,
which is lower than the 3.3% and 4% provided by Allcargo and Gateway,
respectively.
3 World Cargo provides depreciation on its “logistics operations and related
services’” tangible assets on a written down value (WDV) method whereas
others depreciate it on a straight line method. However, adoption of WDV
policy is not visible in the reported low depreciation charges.
4 The depreciation rate for World Cargo would have been higher at 5.5%
in FY10 had it not capitalized pre-operative depreciation of Rs12mn.
Considering the above points, the company’s reported depreciation charge
seems low to us. RED FLAG

Exhibit 3: Cash Manipulation?

Loans and adv to
Unclassified loans and Loans and adv to
related parties as a %
Company\Metric adv as a % of net related parties as a %
of total loans and
assets of net assets
advances
FY08 FY09 FY10 FY08 FY09 FY10 FY08 FY09 FY10
Gateway 1.2% 1.8% 1.9% 3.1% 2.0% 1.0% 0.1% 0.1% 0.1%
Allcargo* 14.5% 23.2% 19.3% 0.5% 11.8% 7.0% 0.1% 3.6% 1.6%
World Cargo 3.4% 3.7% 6.5% 6.9% 4.8% 6.6% 0.3% 0.2% 0.6%
Concor 2.7% 2.3% 2.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Average 5.5% 7.8% 7.4% 2.6% 4.7% 3.7% 0.1% 1.0% 0.6%
World Cargo divergence
-2.0% -4.0% -1.0% 4.3% 0.2% 3.0% 0.2% -0.7% 0.0%
from peer group
Source: Company, Ambit Capital research Note: (a)* Dec year end, year end for other companies is March.(b)
We have used Annual report of CY07, CY08 and CY09 for Allcargo and Annual report of FY08, FY09 and FY10
for other companies (c) Employees, directors, promoters, promoter group companies and associates form part of
related parties (d) Loans and advances to related parties include receivables as well
 Whilst World Cargo’s “unclassified loans and advances” as % of net assets are
lower than its peer , the concerning fact is that the ratio nearly doubled in FY10
when the peer numbers either declined or remained stable. World Cargo’s ratio
doubled as the unclassified loans rose by 94% to Rs434mn, whilst net assets and
revenues grew by a nominal 12% and 4%, respectively. Such a sudden increase
without adequate disclosure and a proportionate increase in revenues is
concerning. RED FLAG
 World Cargo’s loans and advances to related parties mainly comprise of
receivables from “Enterprise owned or significantly influenced by Key
Management Personnel or their relatives.” Whilst revenues from these entities
have declined by 31% YoY in FY10 to Rs371mn, the receivables from these
entities increased by 178% to Rs39mn (31 receivable days on these revenues in
FY10 as against 9 days in FY09). Revenues from these entities account for 7% of
consolidated revenues but receivables from these entities account for just 1% of
receivables.
Exhibit 4: Fictitious Revenue Booking?
Investment income as a % of cash and marketable
Company\Metric
investments
FY08 FY09 FY10
Gateway 7.8% 8.1% 4.0%
Allcargo * 6.1% 6.1% 14.9%
World Cargo 4.2% 4.8% 1.4%
Concor 9.8% 10.3% 7.8%
Average 7.0% 7.3% 7.0%
World Cargo divergence from peer group -2.8% -2.5% -5.6%
Source: Company, Ambit Capital research Notes: (a)* Dec year end, year end for other companies is March.(b)
for other companies. (c) Investment income comprises of interest income, dividend income, profit/loss on sale of
(current and not strategic) investments (d) Investments comprise of marketable/current investments and exclude
investments in associates.
Whilst high holdings of cash can be the reason for low level of investment income
returns for World Cargo in FY09 (cash accounted for 100% of “cash and marketable
investments”), the significant drop in investment return rate in FY10 despite cash
levels rising raises a RED FLAG. Cash accounted for 99% of “cash and marketable
investments” and grew by 10% in FY10 to Rs723mn. However, cash also accounts for
84% and 100% of “cash and marketable investments” for Gateway and Concor,
respectively, and yet those firms post higher investments return rates.
Whilst Concor’s cash holding is relatively very high (Rs16 bn), World Cargo’s cash
holding (Rs688mn) is very close to Allcargo’s (Rs964mn) and Gateway’s (Rs775mn).

Hence prima facie there should not be much of a difference between the cash returns
posted by the latter three.
Concor’s high investment return rates can be explained by the interest income that
the company may be booking on its loans to employees that does not form part of
the cash and marketable investments and high cash holdings parked in high return
fixed deposits. Allcargo’s high investment return in FY10 was on account of
“unexplained” “profit from sale of shares” of Rs204mn (81% of the investment
income) from untraceable and undisclosed shares in the balance sheet. Adjusting for
all other investment incomes, Allcargo and Gateway posted 4% and 4.4%
income on cash holdings as against 1.4% reported by World Cargo. Could it
be the case that the company has under-reported investment income?
Detailed analysis of World Cargo’s investment income return is more
concerning as it shows that despite cash and marketable securities remaining nearly
stable in FY10 (see exhibit 6), investment income has shown a sharp dip. Further
analysis highlights that the interest income includes interest received on loans and
advances and cash deposits. As highlighted in exhibit 4 loans and advances have
doubled in FY10, which means that interest income should increase in FY10
compared to FY09, but there is a sharp decline in interest income of Rs31mn in FY10.
This inconsistency supports our earlier ascribed RED FLAG on this front.
Exhibit 5: Interest and Dividend Income for World Cargo as % of Loans and
Advances, Investments and Cash
Rs mn, unless otherwise stated FY08 FY09 FY10
Interest income on loans, deposits etc. 25 41 10
Dividend on Investments in liquid mutual funds 35 31 0.4
Total Interest and other income 60 71 10
Loans and Advances 186 273 547
Cash and Marketable Investments 2,313 657 723
Total Loans +Investments+ Cash 2,500 930 1,270
Other Income as % of loans, investment and
3.9% 4.1% 0.9%
cash (%)
Exhibit 6: Debtors Provisions

Company\Metric Provision for bad debts as % of Debtors
FY08 FY09 FY10
Gateway 20.6% 17.4% 20.0%
Allcargo* 0.4% 1.8% 1.7%
World Cargo 0.3% 0.7% 0.3%
Concor 6.4% 9.0% 12.0%
Average 6.9% 7.2% 8.5%
World Cargo divergence from peer group -6.6% -6.6% -8.2%
Source: Company, Ambit Capital research Note: (a)* Dec year end, year end for other companies is March.(b)
for other companies.
 Despite World Cargo having the highest debtor days (see exhibit 2) amongst its
peer set, World Cargo has maintained the lowest provisioning for its doubtful
debtors. Given such a low number and given that it is early days for World
Cargo’s logistics business, we assign a RED FLAG on this front.

Exhibit 7: Contingent Liabilities for World Cargo

FY09 FY10 Contingent Liability Contingent Liability
Particulars
(Rsmn) (Rsmn) as a % of Networth as a % of Networth
Disputed Income -tax demands 22 7 0.40% 0.10%

Claims against the company not
16 30 0.30% 0.40%
acknowledged as debts
Guarantees issued by bank on behalf of
18 58 0.30% 0.90%
the group
Guarantees and counter guarantees
609 4,359 10.20% 65.10%
given by the company
Amount outstanding towards Letters of
544 644 9.10% 9.60%
credit given to bank
Custom duty on pending export
obligation against import of capital 60 138 1.00% 2.10%
goods
Total Contingent Liabilities 1,268 5,236 21.20% 78.20%
 Contingent liabilities as a % of networth has increased by 2.7X because the

guarantees and counter guarantees given by the company have increased by
6.2X in FY10. These guarantees are given to the banks in respect of secured loan
facilities granted to wholly owned subsidiaries of the company for Rs2.1bn in
FY10 (Rs495mn in FY09); these numbers for guarantees and counter guarantees
remain same as in the stand-alone accounts.
Auditors
World Cargo International changed its auditors in FY10 (Aug-09) from Big4 to
ABC & Co., a firm engaged in business consultancy, tax regulation, advisory services,
internal audit and risk consultancy.
ABC & Co also audits the accounts of Zee Group and Welspun Corp (flagship
company of Welspun Group) neither of whom are corporates whose accounts would
be rated first rate by us.
We assign a RED FLAG for World Cargo’s audit quality:
1. Big4’s unwillingness to audit the accounts of World Cargo at the end of FY09;
and
2. Continuing non-disclosure of the auditors auditing nearly 50% of revenues
and now 58% of the group’s assets. What is more concerning is the fact that
nearly 29% of these assets are from an Indian subsidiary “World Cargo
Rail Infrastructure.” Accounts of World Cargo Rail Infrastructure are audited by a
Mumbai based firm, LMN & Co for the last two years.
Exhibit 8: Rising share of unaudited balance sheet by the main auditor
Sales Assets
In mn, unless otherwise stated FY08 FY09 FY10 FY08 FY09 FY10
Consolidated (A) 4,012 5,034 5,259 5,061 7,291 12,431
Amounts not audited by the main auditor (B) 2,018 2,499 2,530 929 3,364 7,182
B as % of A 50.3% 49.6% 48.1% 18.4% 46.1% 57.8%

Exhibit 9: Audit Fees comparison with peers

Company\Metric Audit fees as % of sales
FY08 FY09 FY10
Gateway 0.10% 0.07% 0.06%
Allcargo * 0.18% 0.11% 0.19%
World Cargo 0.16% 0.17% 0.18%
Concor 0.01% 0.01% 0.01%
Average 0.11% 0.09% 0.11%
World Cargo divergence from peer group 0.05% 0.08% 0.07%
Source: Company, Ambit Capital Research: Notes: (a)* Dec year end, year end for other companies is March.(b)
for other companies. (c) Audit Fees includes - Statutory fees, Out of pocket expenses and other audit expenses
Whilst the audit fees as % of sales has marginally increased over the years for World
Cargo, it is significantly higher compared to the Gateway and Concor on account of
higher out of pocket expenses and other audit expenses. These expenses have
doubled in FY10 compared to FY09. Hence we attach a RED FLAG.
Exhibit 10: Break-up of Audit fees of World Cargo International
FY09 FY10 % of total % of total
Auditors' Remuneration
(Rs mn) (Rs mn) audit fees audit fees
Statutory audit 7.9 7.0 91.3% 73.2%
Other Services 0.6 1.6 7.3% 16.4%
Out of Pocket Expense 0.1 1.0 1.4% 10.4%
Total 8.7 9.5 100.0% 100.0%

Strategy
Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 saurabhmukherjea@ambitcapital.com
Research
Analysts Industry Sectors Desk-Phone E-mail
Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 nitinbhasin@ambitcapital.com
Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 aadeshmehta@ambitcapital.com
Achint Bhagat Cement / Infrastructure (022) 30433178 achintbhagat@ambitcapital.com
Aditya Bagul Consumer (022) 30433264 adityabagul@ambitcapital.com
Aditya Khemka Healthcare (022) 30433272 adityakhemka@ambitcapital.com
Ashvin Shetty, CFA Automobile (022) 30433285 ashvinshetty@ambitcapital.com
Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 bhargavbuddhadev@ambitcapital.com
Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) 30433202 dayanandmittal@ambitcapital.com
Deepesh Agarwal Power Utilities / Capital Goods (022) 30433275 deepeshagarwal@ambitcapital.com
Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 gauravmehta@ambitcapital.com
Karan Khanna Strategy (022) 30433251 karankhanna@ambitcapital.com
Krishnan ASV Real Estate (022) 30433205 vkrishnan@ambitcapital.com
Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 pankajagarwal@ambitcapital.com
Paresh Dave, CFA Healthcare (022) 30433212 pareshdave@ambitcapital.com
Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 paritaashar@ambitcapital.com
Rakshit Ranjan, CFA Consumer / Retail (022) 30433201 rakshitranjan@ambitcapital.com
Ravi Singh Banking / Financial Services (022) 30433181 ravisingh@ambitcapital.com
Ritesh Gupta, CFA Midcaps – Chemical / Retail (022) 30433242 riteshgupta@ambitcapital.com
Ritesh Vaidya Consumer (022) 30433246 riteshvaidya@ambitcapital.com
Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 ritikamankar@ambitcapital.com
Ritu Modi Automobile (022) 30433292 ritumodi@ambitcapital.com
Sagar Rastogi Technology (022) 30433291 sagarrastogi@ambitcapital.com
Sumit Shekhar Economy / Strategy (022) 30433229 sumitshekhar@ambitcapital.com
Sandeep Gupta Media / Midcaps (022) 30433211 sandeepgupta@ambitcapital.com
Tanuj Mukhija, CFA E&C / Infra / Industrials (022) 30433203 tanujmukhija@ambitcapital.com
Utsav Mehta Technology (022) 30433209 utsavmehta@ambitcapital.com
Sales
Name Regions Desk-Phone E-mail
Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 sarojini@panmure.com
Deepak Sawhney India / Asia (022) 30433295 deepaksawhney@ambitcapital.com
Dharmen Shah India / Asia (022) 30433289 dharmenshah@ambitcapital.com
Dipti Mehta India / USA (022) 30433053 diptimehta@ambitcapital.com
Hitakshi Mehra India (022) 30433204 hitakshimehra@ambitcapital.com
Nityam Shah, CFA USA / Europe (022) 30433259 nityamshah@ambitcapital.com
Parees Purohit, CFA UK / USA (022) 30433169 pareespurohit@ambitcapital.com
Praveena Pattabiraman India / Asia (022) 30433268 praveenapattabiraman@ambitcapital.com
Production
Sajid Merchant Production (022) 30433247 sajidmerchant@ambitcapital.com
Sharoz G Hussain Production (022) 30433183 sharozghussain@ambitcapital.com
Joel Pereira Editor (022) 30433284 joelpereira@ambitcapital.com
Nikhil Pillai Database (022) 30433265 nikhilpillai@ambitcapital.com
E&C = Engineering & Construction

Strategy
Aurobindo Pharma (ARBP IN, SELL) - Stock price performance
1,500
1,000
500
0
Dec-11
Dec-12
Dec-13
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Feb-13
Apr-13
Jun-13
Aug-13
Oct-13
Feb-14
Apr-14
Jun-14
Aug-14
Oct-14
AUROBINDO PHARMA LTD
Source: Bloomberg, Ambit Capital research
Amtek Auto (AMTK IN, NOT RATED) - Stock price performance
300
250
200
150
100
50
0
Dec-11
Dec-12
Dec-13
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Feb-13
Apr-13
Jun-13
Aug-13
Oct-13
Feb-14
Apr-14
Jun-14
Aug-14
Oct-14
AMTEK AUTO LTD
Akzo Nobel (AKZO IN, NOT RATED) - Stock price performance
1,500
1,000
500
0
Dec-11
Dec-12
Dec-13
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Feb-13
Apr-13
Jun-13
Aug-13
Oct-13
Feb-14
Apr-14
Jun-14
Aug-14
Oct-14
AKZO NOBEL INDIA LTD
Arshiya (ARSL IN, NOT RATED) - Stock price performance
200
150
100
50
0
Dec-11
Dec-12
Dec-13
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Feb-13
Apr-13
Jun-13
Aug-13
Oct-13
Feb-14
Apr-14
Jun-14
Aug-14
Oct-14
ARSHIYA LTD

Strategy
Tata Steel (TATA IN, BUY) - Stock price performance
700
600
500
400
300
200
100
0
Dec-11
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Dec-12
Feb-13
Apr-13
Jun-13
Aug-13
Oct-13
Dec-13
Feb-14
Apr-14
Jun-14
Aug-14
Oct-14
TATA STEEL LTD
Jindal Steel & Power (JSPL IN, NOT RATED) - Stock price performance
800
600
400
200
0
Dec-11
Dec-12
Dec-13
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Feb-13
Apr-13
Jun-13
Aug-13
Oct-13
Feb-14
Apr-14
Jun-14
Aug-14
Oct-14
JINDAL STEEL & POWER LTD
Gillette India (GILL IN, NOT RATED) - Stock price performance
4,000
3,000
2,000
1,000
0
Dec-11
Dec-12
Dec-13
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Feb-13
Apr-13
Jun-13
Aug-13
Oct-13
Feb-14
Apr-14
Jun-14
Aug-14
Oct-14
GILLETTE INDIA LTD
Unity Infra (UIP IN, NOT RATED) - Stock price performance
60
50
40
30
20
10
0
Dec-11
Feb-12
Apr-12
Aug-12
Dec-12
Feb-13
Apr-13
Aug-13
Dec-13
Feb-14
Apr-14
Aug-14
Jun-12
Oct-12
Jun-13
Oct-13
Jun-14
Oct-14
UNITY INFRAPROJECTS LTD

Strategy
Balkrishna Inds (BIL IN, BUY) - Stock price performance
1,000
800
600
400
200
0
Dec-11
Dec-12
Dec-13
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Feb-13
Apr-13
Jun-13
Aug-13
Oct-13
Feb-14
Apr-14
Jun-14
Aug-14
Oct-14
BALKRISHNA INDUSTRIES LTD
Crompton Greaves (CRG IN, SELL) - Stock price performance
250
200
150
100
50
0
Dec-11
Dec-12
Dec-13
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Feb-13
Apr-13
Jun-13
Aug-13
Oct-13
Feb-14
Apr-14
Jun-14
Aug-14
Oct-14
CROMPTON GREAVES LTD
Lanco Infratech (LANCI IN, NOT RATED) - Stock price performance
25
20
15
10
5
0
Dec-11
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Dec-12
Feb-13
Apr-13
Jun-13
Aug-13
Oct-13
Dec-13
Feb-14
Apr-14
Jun-14
Aug-14
Oct-14
LANCO INFRATECH LTD
Ambuja Cement (ACEM IN, SELL) - Stock price performance
250
200
150
100
50
0
Dec-11
Feb-12
Apr-12
Dec-12
Feb-13
Apr-13
Dec-13
Feb-14
Apr-14
Jun-12
Aug-12
Oct-12
Jun-13
Aug-13
Oct-13
Jun-14
Aug-14
Oct-14
AMBUJA CEMENTS LTD

Strategy
Shree Cement (SRCM IN, BUY) - Stock price performance
10,000
8,000
6,000
4,000
2,000
0
Dec-11
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Dec-12
Feb-13
Apr-13
Jun-13
Aug-13
Oct-13
Dec-13
Feb-14
Apr-14
Jun-14
Aug-14
Oct-14
SHREE CEMENT LTD

Strategy
Explanation of Investment Rating

Investment Rating Expected return (over 12-month)
BUY >5%
SELL <5%
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
Disclaimer
This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of Ambit Capital. AMBIT Capital Research is disseminated and available primarily
electronically, and, in some cases, in printed form.
Additional information on recommended securities is available on request.

Disclaimer
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Forensic Accounting Ambit 22dec2014

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Forensic Accounting Ambit 22dec2014

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STRATEGY

Forensic Accounting: Identifying the Zone of Trouble

Accounting quality and investment returns……………………………………… 13

Change in accounting quality and investment returns………………………… 18

Accounting quality in practice…………………………..………………………….21

What does our model not capture? …………………………..…………………..23

Sample bespoke - World Cargo…………………………………………………... 27

December 22, 2014 Ambit Capital Pvt. Ltd. Page 2

Forensic accounting: Identifying the Sector-neutral accounting buckets

score is based on annual financials over

Furthermore, accounting quality has remained relevant even in the market

I - P&L misstatement checks

Case study: Aurobindo Pharma

December 22, 2014 Ambit Capital Pvt. Ltd. Page 4

Exhibit 2: Revenue recognition - Aurobindo Pharma vs its peers

2 Change in depreciation rate: We calculate change in depreciation rates for

3 Volatility in non-operating income: We calculate change in non-operating

December 22, 2014 Ambit Capital Pvt. Ltd. Page 5

rationale is to penalise firms where volatility in non-operating income is unusually

II - Balance sheet misstatement checks

December 22, 2014 Ambit Capital Pvt. Ltd. Page 6

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

December 22, 2014 Ambit Capital Pvt. Ltd. Page 7

6 Provision for doubtful debts as a proportion of debtors more than six

7 Contingent liabilities as a proportion of net worth: This is a check on a

December 22, 2014 Ambit Capital Pvt. Ltd. Page 8

significantly on account of income tax disputes. This is with respect to matters

III - Cash pilferage checks

December 22, 2014 Ambit Capital Pvt. Ltd. Page 9

Case study: Balkrishna Industries

10 Cumulative CFO plus CFI to median revenues: We calculate the cumulative

December 22, 2014 Ambit Capital Pvt. Ltd. Page 10

IV - Audit quality checks

December 22, 2014 Ambit Capital Pvt. Ltd. Page 11

Cumulating scores: We cumulate scores across these 11 parameters to arrive at the

December 22, 2014 Ambit Capital Pvt. Ltd. Page 12

Accounting quality and investment returns

15.0% D2 demonstrate the power of

December 22, 2014 Ambit Capital Pvt. Ltd. Page 13

10% Top accounting decile

December 22, 2014 Ambit Capital Pvt. Ltd. Page 14

40% Auto Agri

Chemicals inputs Auto

December 22, 2014 Ambit Capital Pvt. Ltd. Page 15

December 22, 2014 Ambit Capital Pvt. Ltd. Page 16

December 22, 2014 Ambit Capital Pvt. Ltd. Page 17

Change in accounting quality and

December 22, 2014 Ambit Capital Pvt. Ltd. Page 18

Change in accounting score based deciles

December 22, 2014 Ambit Capital Pvt. Ltd. Page 19

December 22, 2014 Ambit Capital Pvt. Ltd. Page 20

Accounting quality in practice

However, it is interesting to note that in the uptrend the biggest improvements in

Accounting quality not priced in

December 22, 2014 Ambit Capital Pvt. Ltd. Page 21

Not all Nifty firms have good-quality accounts

For a more detailed analysis, we also do extensive bottom-up company-specific

December 22, 2014 Ambit Capital Pvt. Ltd. Page 22

What does our model not capture?

Subjective checks- Related party transactions

Subjective checks - Issues raised by the auditor

December 22, 2014 Ambit Capital Pvt. Ltd. Page 23

December 22, 2014 Ambit Capital Pvt. Ltd. Page 24