Investors backing off as auditors continue to resign from leading firms

When auditors resign, it is a clear sign of trouble. It makes sense to cut losses in such firms

In the past few weeks, a number of auditors have resigned from companies citing non-supply of crucial information by management. Deloitte, Haskins and Sells recently resigned as the auditor of Manpasand Beverages, while Price Waterhouse quit as the auditor of construction and infrastructure company Atlanta Limited. Price Waterhouse had, towards the end of April, also quit as the auditor of Vakrangee Limited. The market regulator, the Securities and Exchange Board of India (Sebi), has launched its own scrutiny of Manpasand and Vakrangee. Shares of these companies have tanked 29-64 per cent as investors, smelling a rat, have dumped these stocks.    

Red flag for investors: Experts are unanimous in their view that if an auditor resigns before completing the audit and signing the opinion for the year, it raises a massive red flag for investors. No auditor would do so, they say unless compelled by circumstances, such as the client’s refusal to provide crucial information. “The auditor would have given the client an opportunity to provide the information before going public with such an extreme step. One can, therefore, infer that the withheld information must be really unfavourable to the client,” says Sanjay Kallapur, professor of accounting and deputy dean at Indian School of Business. Adds Shriram Subramanian, founder and managing director, InGovern: “These developments indicate that there are issues with the numbers being put out by these companies, and they need to be re-examined.”

Some experts see positives in these developments. “It is a good sign that auditors are beginning to resign rather than acquiesce to unreasonable actions of the client. If the auditor had not resigned, investors would never have known of the existence of a problem and its seriousness,” says Kallapur. Others feel that auditors have a greater responsibility to shareholders. “The auditors are doing a disservice by just resigning. They should write a letter to the shareholders stating what irregularities they have noticed in these companies,” says Subramanian. 

More resignations likely: The frequency of resignations by auditors may rise in the near future. The banning of Price Waterhouse from auditing work for two years in the Satyam case has sent out a strong signal to auditors. Moreover, the National Financial Reporting Authority (NFRA), a watchdog for the auditing profession, will come into existence soon.  “These developments are making auditors wary about associating with companies that have corporate governance issues, as it could pose a major reputational risk to them. Hence they are beginning to resign before it is too late,” says Pranav Haldea, managing director, Prime Database.

Exit, even if it means booking a loss: Most experts are of the view that investors should sell the stocks of these companies and exit, even if it means booking a loss. Subramanian says that investors have thousands of companies to choose from, so they should not stick to those about whose numbers there are doubts. He adds: “The  past has shown repeatedly that once the reputation of a company gets marred, it is almost impossible to regain it.” Only some experts we spoke to suggested that investors should hang on to these stocks, provided they are confident that these are temporary issues that will blow over in due course. 

Need for greater due diligence: Investors should invest directly in stocks only if they are capable of diving deep into the books of accounts. Here are a few things they should look out for. One, keep a close eye on sales growth. Experts say that it isn’t possible for sales to keep growing smoothly quarter-on-quarter and year-on-year, as every company is subject to business cycles that cause hiccups. “If a company’s sales are growing seamlessly, it could be a pointer to accounts being manipulated,” says Ankur Kapur, founder, Ankur Kapur Financial Advisory Services. Two, check the correlation between sales and accounts receivable (sales done on credit). If the growth in accounts receivables is far higher than the growth in sales, it indicates that the company is booking too much sales on credit. This could cause problems later if it is unable to recover its dues. Three, there should be a correlation between net income and cash flows from operations. Both should move in tandem over time. If they don’t, it could be a sign of trouble. Finally, if the auditor’s remuneration has been growing at a speed far higher than the inflation rate, that, too, should raise a red flag. To be able to check these trends, stick to companies that have been listed for at least 10 years.
 

Diversification advantage in mutual funds: Experts are divided on what investors should do if the fund they have invested in owns one of these stocks. Some highlight the fact that only a limited number of funds have exposure to the Manpasand stock, and there too the exposure did not exceed 1-3 per cent. Investors in mutual funds, they say, will be protected because of the diversified nature of portfolios. "If the positions were bigger, say, 6-10 per cent, the impact would have been significant. But with a smaller exposure, the good performance of some other stocks will neutralise the losses that the fund may sustain in a tainted stock. So investors should stay invested," says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

Other experts have a tougher view. According to them, the fund managers should have been able to spot the problems in these stocks and exited them earlier. It is not enough for them to claim that these are black swan events that can't be foreseen. "If a mutual fund has invested in such stocks, it means that its risk management process is not effective. An investor should exit such funds," says Kapur.