Financial Shenanigans: An eye opener in accounting

I recently completed a book called Financial Shenanigans. I don’t think there are many books which simplify and yet, cover so thoroughly the manipulation techniques employed by the management. The book starts with a very interesting anecdote of a severely ill patient, not wanting to undergo treatment. “Doctor, instead of operating on me, can you just touch up the X-ray?”, the patient asks the doctor. Companies committing financial gymnastics do just that. Instead of treating the ailing business, reports are manipulated to paint a rosy picture to the investors. Management hopes that at best, the company will miraculously fix itself, and at worst, it can keep raking in healthy compensation packages and bonuses before getting caught.

First, readers are given a walkthrough of the simple techniques of messing around with revenue and expense recognition. Pulling revenue to current periods and pushing expenses to a later one are the most common tactics for bumping up the bottom line. By hiding revenues in accounts receivable, a company can easily ride a weak month by showing higher than-realized revenue. Once the bad quarter passes, the receivables can be written off and investors are none the wiser. As investors, we like to see revenues, and by extension profits, originate from a company’s regular economic activities. But many companies ‘source’ their revenues from one-time transactions, transactions that have no real economic meaning like doing business with related parties, recording revenue when the transaction didn’t involve any and so on.

Investors often say that cash flows are much harder to manipulate than account earnings. The author summarily rejects the claim by presenting a number of examples of just that happening. The way to overstate operating cash flows appears to be shifting cash outflows to other sections and moving cash inflows to the operating section. I will walk you through a simple example of a company worth 10 million being bought. Instead of simply paying 10 million, the buyer pays 11 million in exchange for selling 1 million worth of goods to the company that is being acquired at a later date. This transaction has no economic benefit other than adding 1 million to operating cash inflows.

The last type of accounting shenanigans is the one that I like the most. The author calls it the key metric shenanigans. Investors like Buffet and Munbger have also criticized analysts and management for using non-GAAP/non-IFRS metrics to present performance. “Every time you read the word EBITDA earnings, replace it with b*llsh*t earnings”, Munger had said in one of the Berkshire annual meets. And in modern financial reporting, such metrics are everywhere. ARPU, ARPOB, STS, Adjusted EBITDA, community adjusted EBITDA, and growth adjusted EBITDA are some that I found. All of these earnings essentially divert investors’ attention from the economic reality of a company to a number that the company feels is the ‘true’ representation of the company’s performance.

I had taken up this book when I read about the creative adjustments one of the famous American fund managers had done. She had shot to fame when her fund outperformed everything out of covid, betting on new-age technology and hyper-growth stocks. As the pandemic died down, those stocks too returned to their rational valuations. As a result, the fund too corrected by over 50%. Someone with a basic understanding of accounting would realise the double counting and convenient omissions of these calculations. Having read about the ‘Community adjusted EBITDA’ of WeWork a few years back, I wanted to know more about how management can window-dress their numbers.

I would have thought that such practices would only be employed by the likes of Enron and Satyam, but I was surprised to see a lot of prominent names such as Microsoft, Ford, Krispy Kreme and so on.

This book is a must-read for every student of finance who wants to work making or analyzing company financials. If you are planning on appearing for CFA or any similar exam, make sure you give this book a read.

The Pivot

In the past, I have foolishly let my old blog get deleted with all its content. When I revived it, I decided to write more about money and trading and such. But now I have a different platform it.

Bereez is the company through which I will be talking (and hopefully educating) people about money, finance, trading and all things related. You can find Bereez on its website, Youtube Channel, Instagram Handle and Telegram Group. Make sure you follow it everywhere.

This website will once again be dedicated to all things non-finance like my original site was. Research skills, books, and other nerdiness that fascinates me.

See you around on the internet!

The hidden layers of safety

action adult boots boxes

Just a few days ago a cryptocurrency named Luna blew up. And there are a few things that make this particular blow up more notable than the others.

First is the fact that it was one of the largest crypto currencies by market cap. Sitting in top 5 with Bitcoin and Ethereum. Many people invest in blue chip companies, which are 10-20 largest companies, with the assumption that their size makes it an inherently less risky investment. Luna was a one of the blue chips of the crypto world.

And that brings me to the second reason why this blow up was a big disaster. The cryptocurrency was linked to a stablecoin named TerraUSD or UST. Stablecoins also live on blockchains like other crypto currencies but instead of being an independent currency they are supposed to be backed by an equivalent number of USD or other safe securities held by the issuers of said stablecoins. So if I want to issue 100 stable coins, I will keep with me 100 dollars at all times. Since USD is the reserve currency of the world, such stablecoins are considered very safe by crypto investors.

UST is an algorithmic stablecoin. What that means is instead of being backed by actual USD, the blockchain mints and removes coins from the circulation through another coin called Luna. The blockchain incentivises traders to convert Luna to UST and vice versa depending upon buying or selling pressure from the market. If UST starts to fall, blockchain makes more Luna to maintain the peg. Though this sounds a little fishy, this worked for small fluctuations in the market. And because UST had very high (up to 20%) staking yields which is like an interest on fixed deposits, investors flocked to the easy money. It is backed by US dollars isn’t it! What could possibly go wrong.

On one fine day, an investor purchased a huge quantity of TerraUSD and then sold it off in the market. This selling pressure caused the algorithm to create more Luna. This caused price of Luna to fall. In markets, fear and greed both compound. People started selling Luna because the price was falling. This sent the blockchain in a death spiral flushing the blockchain with more and more coins. When the dust settled, Luna and UST had lost more than 99.5% of its value.

What made this loss terrible was that because of its high yield, many people had put their savings in Luna hoping to get a sizeable return at supposedly no risk. There are testimonies of people on the social media who have lost their life’s savings.

This keeps happening where we lose the perspective on risk. A lot of money has been lost in explicitly risky investments like penny stocks and far OTM options. But that is the nature of those investments. Nobody in their right mind invests the money they are saving up for something important in such speculative investments. But the problem comes when we completely ignore risks of a type of security that is ‘generally’ considered safe. In the case of stablecoins there are many which have been around for a number of years and have given decent returns to the investors.

Bonds are considered safer than stocks. But a hedge fund ran by economic PhDs failed spectacularly in 1998 when they levered up and invested in Russian bonds. Now sovereign debt is considered safe. Theoretically, in any country, its sovereign debt is the safest investment. So Indian bonds in India, USA bonds in USA and so on. The managers of this hedge fund must have had similar notion about Russian bonds as well. Only the uncommon happened and Russia defaulted on its debt in 1998. Irony is, the hedge fund was called Long Term Capital Management. It lasted from 1994 to 1998, only 4 years. That’s not long enough by any stretch of imagination.

Similar incidents have happened repeatedly in India. DHFL bonds were peddled as very safe to retail investors by sales persons. Retail investors being retail investors bought them with the hope of making ‘safe returns’ that are higher than bank FDs. After DHFL defaulted, many are stuck, praying to get at least some of the capital back.

Punjab Maharashtra Co-operative Bank (PMC) is another such recent example. A bank is supposed to be ‘safe’. But painting all banks with the same brush is a fatal mistake. Well run, large banks are usually the safest ones. Smaller, local banks can be potentially riskier. With smaller banks, the rules can be bent, and books can be cooked more easily. In case of PMC, a large portion of its capital was loaned to a single entity which defaulted. As a result, bank suddenly had no money to pay its depositors. RBI stepped in and froze all assets of the bank resulting in people’s savings being stuck. Though the restrictions are being gradually lifted, if I had my life’s savings in that bank, I wouldn’t be able to sleep at all.

And this is where I see the paradoxical behaviour of investors seeking safe returns. Many will not invest in a diversified equity portfolio giving an average return of 10 percent but will line up to make FDs in local banks offering high interest rates. Or invest disproportionate amount of their portfolio in high yield bonds and be surprised when some of the bonds default. The ‘risk-free’ rate is called as such for a reason. Anything that is offered to investors above that as ‘risk free’ is in fact risky. Interest that the bank pays you on FDs and a company pays you on bonds is a reflection on the bank’s/company’s quality. Higher the interest rate, riskier is the investment. It will do well for investors to keep this in mind. And not blow away their risk free portfolio in supposedly risk free assets.  

The income obsession

unrecognizable man holding wallet with money

If you read finance theory, an asset returns two kinds of returns. One comes from dividends, interest or rent that the asset pays. The other comes from the appreciation of the price itself. What do I mean?

Since 1st march 2021, TCS has increased in price from about 2950 rs to about 3550 rs. That is the price appreciation part. TCS has also paid 36rs of dividend in the same period. So an investor has made a total return of 22%. That is not a bad return.

TCS is just an example. There are other stocks. REC LTD has gone from 135 to 125 in the same period. A loss of 10 rs. It has also paid out 17.21 in dividends. Total return here? Just 5%.

Comparing two stocks, you could have bought 22 shares of REC LTD for the price of one TCS share. That would have given you a nice dividend of 379rs. The dividend is 10 times more than what TCS paid but still, the overall return is just a quarter of what TCS gave over the same period.

Many people prefer dividend investing. Dividend investing is where one picks stocks that pay out high dividends. There are several problems with it. Many companies pay dividends at the cost of growth. Those that pay dividends upwards of 5% usually do not appreciate too much in price. But still, because dividends are credited in the bank account, it feels like you have made more tangible returns than just some green numbers on the screen.

There are some disadvantages to this cash in the bank though, First, dividends are taxed higher than capital gains. Second, companies paying dividends are not the most efficient capital allocators, at least in India. As a result, dividends are the only reason many shareholders buy and hold those stocks. Even a year of low dividend distribution can send the stock spiralling downwards as the investors will look for returns elsewhere. Third, most of these companies fall under the same peer group, viz. government-owned, commodity or power businesses. That adds concentration risk to the portfolio.

A much better option would be to systematically sell part of your portfolio to meet your income needs. There are ways to do it. Simplest would be to move part of your portfolio in fixed income every year and eventually withdraw it when you need money. Maybe we can discuss it in another article. But as is the name, it is called personal finance. So find what works best for you.

Understanding Net vs Gross

We are often bedazzled by the profit screenshots of full time traders on the social media. Even seemingly unknown traders appear to be making 5-10k every day. You might wonder if you can achieve same level of profits. And that is the key. Profits. The money left after paying for all the expenses.

If you have a source of income other than trading, it might already be covering all of your expenses. In that case, every single rupee you make from trading is your profit. Now consider someone who is making 10k every day from trading. She makes a handsome 2L gross profit per month. But from that she has to pay for all her expenses. And I am not talking about food and electricity. It includes, brokerage, transaction charges, taxes, data feeds etc. So her net income might be a lot less than the screenshot that is posted on the social media.

So if you ever consider going full time in the markets, please account for the loss of a consistent income from your other source. The pressure of ‘needing to make money’ is tremendous for the new full time traders and you will feel that. Because a trade doesn’t just remain a trade. It becomes ‘gas bill’, ‘movie night’, ‘rent’ and so on. And even the best of the traders admit to having some bad months where they make very subpar profit or even incur losses.

So next time you a screenshot with a large profit, take all this into account.

Always have a plan

ITC, the stock that has the butt end of jokes for almost a year now. Since December 2020, except for one occasion, the stock has been in a tight range of 20 odd rupees. Traders long in this stock were at their wits ends since the stock wouldn’t even hit their stop losses for them exit from it justifiably. Traders like me who don’t mind dabbling in options, have made decent money out of this sideways movement from what we call straddles and strangles.

But these strategies are naked. They can produce unlimited loss if not monitored properly. For a stock that was stuck in a range, rangebound strategies made sense. But what if it had broken the range?

A common way to deal with runaway options premiums for option sellers is to make adjustments. There are videos on YT of traders using up to 50 options to manage one sold call that had gone in the money. As dumb as it sounds, deep pocketed among us can do if they fell compelled to do so.

But what if we aren’t one of those? Simply taking an SL and accepting a loss is one. What if the option went so far in the money that it no longer has a reasonable liquidity? Should you bite the bullet exit at any point? Or may be hope for the market to reverse? What if there is literally zero liquidity? Then can you borrow money to somehow physically settle the contract?

There are numerous things that can go wrong in a trade. Best be prepared…

What? F&O?

If you have ever joined a telegram group, chances are you have seen a message like this:

Both calls ended in loss that day. The messages with the fire emojis stopped the minute it went into loss.

Curious why they only selectively post their winning trades?

Stock market seems simple. You buy low and sell high. That is like saying batting in a world cup final easy, just hit the ball with the bat. Both statements oversimplify the complexities massively. If you are trading in cash delivery markets, 9 out of 10 times you will not need to know about technical complexities besides the T+2 settlement cycle and the new rule of margin requirement for selling your shares. If you are trading intraday you have to learn how leverage works, and what happens when your MTM loss at the end of the day is more than the money you had in your account in the morning.

But these are still trivially simple compared to what you need to know to tread into derivatives market of equity, currency and commodities (pun intended!). If you jump in directly, you will realize that you did not know what you did not know.

I thought I will give you a small checklist of things you will need to know by heart to be safe in the market.

  1. Expiry time – Know the expiry time and date for the contract you are trading. Equities expire on Thursdays at the end of the day. Currencies expire on Fridays at noon. Recheck the details yourselves. I may be wrong, or rules might have changed since publishing this article.
  2. Type of settlement – Nifty and Banknifty contracts are cash settled, meaning you receive the gains or pay the losses and the contract is considered settled. Stock futures and in the money stock options are physically settled. Meaning, depending upon the side of the contract you hold, you must either take delivery or give delivery equal to the number of lots you hold. An ITM Reliance contract would be settled with 505 shares of Reliance. That requires full value of contract i.e. 505 x CMP of Reliance and not just 2.5L margin that the broker takes.
  3. Margin Maintenance – Unlike cash trades where once you buy the shares and pay for them, you do not need to maintain any money in the account, derivatives need cash or margin. (Cash can be given as margin but margin cannot be paid as cash!). If you go long in a futures contract and market goes down a little, resulting in an MTM loss of 5000 Rs. Then you must pay 5000 Rs cash at the end of the day. If you are holding an option position however, just some margin will be blocked. So, you can get a margin call if you run out of cash to pay for the futures MTM settlement EOD even if you have plenty of non-cash margin left. Some brokers require additional margin two days prior to the expiry of physically settled contracts. If you are carrying the position throughout the month for about 1.5L margin, you will need about 3L margin to keep the position open on the last two days of expiry. Your trade could very well have ended in profit had you been able to keep it open till expiry. But if you get a margin call on Wednesday, you might be forced to close the position at a loss.
  4. Liquidity – F&O market is much more illiquid than stock. It might be quite easy for a seasoned trader to enter and exit from a 10,000-share position of GODREJCP. But it will be difficult for her to square off 10 call options at slightly OTM strike of the same stock since the liquidity is much less. So, your position might show 2000 rupees profit, but by the time you exit fully, you might have paid 400-500 rupees to slippages. That is 20-25% less than the profit you were expecting. This is especially true for multi leg option strategies.

There are many more factors you need to look out for while trading in F&O market, but hope this post gets you started on at least some of them…

Also read my article on starting to trade in FnO market: What is the ideal size?

Black Swan Events

two black ducks on grass lawn

This is the catch phrase every single news channel likes to throw around. It is an event that is beyond what is normally expected. The word ‘normally’ is a bit subjective. When you start trading, for the first few months upper or lower circuits would seem like abnormal events. Soon you would get used to extreme volatility where 8% up and 9% down happens one day after another. You will see a stock tanking 10% after a historically bumper result. And through all this if you manage to keep your account afloat, you will see the shortest bear market in the history lasting about a month from peak to trough.

But let us see some events that would have surely caught many ‘professional’ traders off guard too.

There is one event I would like to talk about. One where the value of crude oil contracts went negative.

No, it did not mean that you could go to petrol pump and get paid to fill the tank of your car. It was a time where world was locked down due to COVID-19. There was little demand for crude. People holding long futures of crude would have to take delivery of oil on expiry of their contract. It is worth mentioning here that crude contracts are physically settled in US unlike on MCX where they are cash settled. So long traders would have been stuck with barrels upon barrels of crude which had no demand in the market or any economically viable place to store. So, traders started selling the contracts. Selling did not stop. Eventually the ask side of the orders started working in negative. Traders were ready to pay money to close their long positions because taking a delivery would have meant an astronomical loss.

At least in the US the exchanges could process negative orders and the market kept running. In India last traded price of April month future contact was 965 rupees but the final settlement price was assigned as negative 2884 rupees.

A lot of traders and brokers have moved to various courts of appeal. Traders and brokers claim that MCX had no system to submit negative price in spreads and hence it cannot assign a negative price for settlement.

The cases are still in the court. The difference between LTP and settlement price was over 3500 Rs. Multiply that by 100 barrels per contract and a long trader could have potentially lost 3.5 lakhs per contract that day. That is more than the margin requirement for the same contract at that time.

Results from the court are still awaited. The traders who lost big that day might get some of their money back. But that will take time. And they would have lost precious opportunities that presented themselves from April till today.

Nobody, not even our exchanges had anticipated negative prices before this event. Since then the margin requirement on crude oil has increased a lot. Currently it is more than even the notional value of the contract.

Black swan events are unexpected. So naturally there are little safeguards in place against them. But there is always a way to prevent large losses. Here I mean losses large enough to mess with your psychology, make you lose confidence. It might reduce your capital so much that it is no longer viable for you to trade.

Remember, in trading, not losing money is more important than making a lot of money. It is prudent to hope for the best but prepare for the worst.

What is risk management?

This is the first article of a 4-part series of articles on risk. I often hear people saying stock markets are risky. I am going to try and classify and quantify the risks that they perceive. Once they know what to and what not to be afraid of, may be the fear will subside a little.

We all have heard the following;


Not just the adverts, but you all will have at least one each from the following categories in your friends and family:

The one who is terrified of the thought of stock market and actively advises everyone against it.

The one who has tried and burnt her hands in stock market.

The one who’s doing it for a long time but has neither made nor lost too much money.

The one who knows what she is doing and makes consistent money from the market.

The last one is very rare and usually flies under the radar. Except the one who has lost a lot of money, everyone else of the above have done a decent job of managing their risk. And yes, I am including the person who stays away from the market, since she has already made sure she never makes a loss in the market. (There are other ways she will lose her money but we will talk about it in subsequent articles).

If you look up the definition of risk management, you will find something along the lines of identifying and mitigating threats. That is a generic definition. Let us rephrase it to suit our profession. The overarching risk in securities market is losing money. And why do we lose money? Usually because our view of the market is wrong or the tool that we used to express our view of the market is wrong.

You can have 7 views for the market:

  1. Up
  2. Down
  3. Sideways
  4. Up or sideways
  5. Down or sideways
  6. Up or down.
  7. Arbitrage – This is not a feasible stance for most retail investors so we will ignore that.

For example, if your view is that the market might stay sideways, but market makes a directional move beyond your expected range you will lose. Your risk management principles will dictate how much you lose when your trade goes wrong.

I would like to give an example of picking the wrong tool for your directional view as well. Let us say your view was that Reliance will move up in the next 30 days. Instead of buying shares you thought you’ll receive higher ROI if you take a position using options. You buy an OTM call. For half the month Reliance doesn’t move up very much. Due to theta decay, your option loses premium and the stop loss on the option’s premium is hit. You exit the position and a couple of days later Reliance Starts an explosive rally on the back of some good news. You could have held on to the position if you had made a spread with options or simply taken a cash position.

We will talk about many factors that are often overlooked while taking a position in the next article.

Ask the right questions…

question mark illustration

Every time an IPO or NFO comes on the block, the first question everyone asks is “Should I subscribe to XYZ?”. The overwhelming marketing material biases ones opinion towards a “Yes”. I think it is the wrong question to ask.

Whenever we want to buy something, lets say a watch, we ask ourselves, “Where is a shop which sells watches?”. We don’t just walk into any store, and then figure out what to buy.

So just a couple of days ago one of the mutual fund AMCs came up with an NFO. It wouldn’t have been much of a news if it had been any of its peers. But this one in particular has been very adamant about not needing to do ‘AUM seeking activities of releasing a fund for every category’. Plus their flagship fund has posted one of the best performances not just in multi cap across categories. Investors trust the fund managers and their philosophy of value investing. So much so that they were amongst few AMCs who had seen net inflows through the uncertain times that was the year 2020.

Recently they launched a liquid fund which would hold only T-bills and G-secs and would be mostly used as an STP vehicle for people not wanting to put lump sum in equity fund.

The third fund now is a conservative hybrid fund. It’s marketing material says it is for generating income from debt and money market instruments. Capital appreciation from equity and REIT, InvIT components as well as some income from the latter.

There’s nothing to worry about in debt part. The AMC is known to be conservative and hence wont take any credit risk. Equity component is limited to 25% so my guess is that it will be a scaled down version of their flagship fund itself. But with such small allocation, I don’t think exposure to international equities will be there.

The last component is up to 10% exposure in REITs and InvITs. There are several points to discuss here. Most Indian investors are highly exposed to real estate market anyways so logically anyone investing in REITs should take that into account. The 10% exposure in itself isn’t high enough to contribute to the returns of the fund in any meaningful way. And unless this fund forms the core of someone’s portfolio, the exposure to REIT, InvITs will be miniscule. Think of it as 10% of 10%. The AMC is also known to include provisions in their scheme documents which it may not use. The flagship fund has had the provision for REITs for a while but to the best of my knowledge REITs haven’t been part of its portfolio till date. Same is the case with the provision for covered calls.

A doctor doesn’t see the available medicines in the market and then decide what to prescribe to the patient. They first examine the patient and then come up with the best treatment based on available medications. We should look at our portfolios the same. Before looking at funds, stocks etc., we should know what we are looking for…