Polycab may have done some tax fraud

Sometimes the choice is between money and trust

Polycab’s investors stuck in a mesh of wires.

Whenever a company does some fraud I like to think of it in terms of who really did the company defraud. If a company pays less tax than it owes, it has defrauded the government and/or the tax-paying public. If a company fakes its revenue to show that it has earned more (or less) than it has, it has defrauded its investors.

Depending on who the company has defrauded, investors may or may not like the company. If a company is accused of defrauding the public, for instance, investors might even like the company better. Defrauding the public means more money and making more money is (nearly) always better than making less money, as I like to say.

I’m being a bit facetious. If a company publicly does some fraud, investors are going to be wary of investing in that company and if it’s a listed company its share price is more likely than not going down.

But still, when investors evaluate a company that’s accused of fraud, a useful question for them is “who is it that’s getting shafted?” If it’s the investors, it’s bad. If it’s anyone else, not so bad.

Anyway, last week the Income Tax Department said that it conducted massive raids on Polycab India’s offices, factories, even distributors, and found evidence of tax evasion. Polycab’s stock price fell by 23% in a single day when this news came out.

Here’s the press release from the tax department:

Preliminary analysis suggests that the flagship company indulged in unaccounted cash sales, cash payments for unaccounted purchases, non-genuine transport and sub-contracting expenses, etc for suppression of its taxable income.

Credible evidences recovered during the search have established that the flagship company has made unaccounted cash sales of around Rs. 1,000 crore which are not recorded in the books of accounts. Evidences of unaccounted cash payments of more than Rs. 400 crore made by a distributor, on behalf of the flagship company towards purchases of raw materials, have also been seized. Further, non-genuine expenses in the nature of sub-contracting expenses, purchases and transport expenses, etc. aggregating to about Rs. 100 crore have also been identified in the seized evidences from the premises of the flagship company.

If a company is trying to pay less tax, it has to show a lower profit. It can do this by either reducing its revenue or increasing its expenses. The tax department says that Polycab did both. It says that the company:

1. Understated its sales or revenue by ₹1,000 crore ($120 mn).

2. Exaggerated its expenses by ₹100 crore ($12 mn).

3. But also.. understated its expenses by ₹400 crore?? ($48 mn)

Points (1) and (2) are straightforward. Polycab sold some cables and wires in cash and didn’t account for that money in its books. And it faked some bills to show expenses which it didn’t really have. Classic. But point (3) is tricky. The tax department says that Polycab’s distributor bought some stuff worth ₹400 crore on behalf of Polycab and the company didn’t account for it in its books?

Am I missing something? Please let me know if I am. But it makes absolutely no sense for Polycab to simultaneously fudge its books to show ₹100 crore more in expenses while also hiding ₹400 crore of perfectly legitimate expenses. Sure, steal that ₹100 crore if you must but also take those legit expenses!¹

Who was shafted?

Let’s assume the tax fraud stuff is true. Polycab understated its revenue, exaggerated its expenses, and committed tax fraud. Who was shafted?

The government was, no doubt. Polycab paid less tax. But Polycab’s investors were also shafted. It showed a lower profit, so ultimately its investors made less money.

But if the tax department is right, Polycab actually has a pot of cash that it hid from investors all this time. Sure, in the short term, Polycab would have to pay that tax it escaped along with whatever penalties. But once that’s done, what would have been a hidden pot of cash from the next year onward will come right into the company’s books and to the investors.² So if the tax department is right, Polycab’s value should actually go up! The government is helping Polycab’s investors find their hidden pot of cash.

To plug in some numbers: Polycab’s market capitalisation was at around ₹71,000 crore ($8.2 bn) before the tax fraud news. After the news, it fell by ₹15,500 crore ($1.9 bn). Even if Polycab has to pay the entire value of the newly discovered pot of cash—₹1,000 crore—as penalties, this seems excessive.³

Of course, when investors buy a company’s stock, they don’t just pay for its discounted future cash flows, they also pay for the trust in the company’s management. If Polycab has defrauded its investors today, it might very well defraud them again in the future. So some investors would rather stay away.

Ultimately, Polycab would be worth more (because of the discovery of the pot of cash) but also worth less (because of the loss of trust).⁴ Right after the tax fraud news investors decided that Polycab was worth 23% less, but the stock has gone up 10% in the last few days so looks like they’ve started to think it’s worth a bit more.

1. One reason to do this would be to help the seller save on GST. If whatever was bought cost ₹400 crore excluding taxes, a legitimate transaction would include tax and would cost more. Yet, the reduced expenses (18%) here don’t compare with the possible gain (25–30%) with the expense being accounted for.

2. It would be funny if Polycab did some tax fraud this year, got caught, and did some tax fraud again in the forthcoming years.

3. I have no idea what the penalties could be so please don’t take this figure at face value.

4. There’s also the possibility of SEBI coming in and penalising Polycab or its management for fudging the company’s financial statements.