Clean ups always reveal dirt

The recent resignations of auditors of some companies is actually a positive indication of improving accounting standards

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In recent weeks, the stock prices of three companies have crashed because their auditors have resigned. These companies are Vakrangee, which fell by 67.5 per cent, Manpasand Beverages, which fell by 52.9 per cent, and Atlanta, which fell by 31.7 per cent. In each case, the stocks have fallen precipitously, wiping out a huge chunk of investor value. Amusingly, Vakrangee's stock set some kind of a record by hitting the lower circuit-breaker 28 trading days in a row.

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The three companies are very different. Vakrangee has had a long history of investors being sceptical about its business, and has a lot of puzzles in what is publicly known about it. Atlanta is a micro-cap real estate company and really, that's all I need to say.

However, the most disturbing case of the three is that of Manpasand Beverages. It's scale--both in revenues, profits, as well as in market-cap--is much larger than the others. It's in the FMCG industry, where the true scale of a company should be relatively transparent to whoever wants to verify anything. Large chunks of the company's stock are owned by institutional investors, including mutual funds. Presumably, these investors would have researched the company competently.

So what exactly is the big deal in an auditor resigning? Is it something that justifies such a huge crash in stock prices? Well, practically speaking, it does. To investors, auditor resignations mean that there is something seriously wrong with the financial information that the company is trying to give to the public in the future. And presumably, in the past as well. Audited financials are the central source of information upon which the equity market bases a company's value and thus its stock prices.

The important thing to note here is that the actual amount of the decline in the company's valuation has no real meaning. If Manpasand Beverages' stock price has declined by 49 per cent, then that 49 percent is not actually a valuation. Rather, it's an indicator of the fact that no valuation is possible because the market does not trust what it knows about that company. A fair decline could be 75 percent, it could be 25 per cent, the number could be anything! Currently, there is no trustworthy way of calculating it. The number on the ticker is just a byproduct of investors rushing for the exit and short-sellers piling into the stock.

So what are investors to do about such risks? The obvious answer to that is diversification. All company specific risks are to be managed by having a portfolio that is spread across many stocks of all shapes and sizes. However, even so, these kind of events are deeply unfair to investors. Diversification should be a defence against natural business risks, not against a promoter doing something shady.

Practically speaking, no serious investor in India is naive enough to take the audited books of a smaller company at face value. There are hundreds of small companies in India and no one has the research capacity to keep physical tabs on each. This is precisely the problem that the entire accounting and auditing industry is supposed to solve. Except that in India, historically, it doesn't. It's a sad fact that we, as investors, take audited financial information as a probabilistic statement, rather than a factual one. For any given combination of company scale, promoter group and auditor, there is a certain probability as to how close the audited books are to the truth. In fact, the Satyam affair showed that such blow ups can happen in large companies and auditors with reputed brands too.

Having said that, I see these auditor resignations as a step forward. Till the Modi government started tightening the regulatory screws on the accounting industry, it was highly improbable for such resignations to occur. To understand the issue, do watch this video where the PM reads out the riot act to India's CAs in a speech he gave last year at the annual jamboree of the ICAI.

There are plenty of signs that the entire business of financial reporting is undergoing a transformation. It's entirely likely that there will be many more blow-ups triggered by auditor resignations in the near future but they should be seen as part of a clean up process that has been triggered.

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