Mitigating MSME Distress – Part III

Nirmala Sitharaman Press Conference. Photo PIB India

This is the third part of this series. Part I and Part II argued the need for restating the balance sheet of Indian SME and even Large companies. Some of the mails that I received after the first two parts of these series has encouraged me quite a bit to venture into the third part.

I had referred it to a few bankers and a few Chartered Accountants. It saddens me, since nobody said what I have written is wrong and everyone has concurred. A few others from the lending institutions also agreed. Chartered Accountant agreed, bankers agreed, specialized lending institutions also agreed. I have not asked taxman and it looks like taxman will also agree.

I have spoken to a few entrepreneurs. MSME will be more than happy to clean their Balance Sheet once and for all instead of roaming around with a dangling sword called “NPA leading to NCLT”. So, what’s stops us from doing it?

Need of MSME

A friend of mine who worked in top management in large corporations wrote to me thus:

Key questions that need to be answered are:

1. Will just a one time amnesty scheme get us out of the woods as the value of BS cleansing to be done is quite enormous.
2. Will that transform the informal and short term oriented and CA nexus-ed mindset of MSME Entrepreneurs or is it just a postponement of the inevitable.
3. Will the MSME Entrepreneurs consider the loan conversion under Amnesty as a long term strategic direction for themselves or an escape route. Jotted down these queries more with the intention of formulating the next steps and assessing impact of such a step on various stakeholders and implementation road map – this is required for reaching out to top echelons of bureaucracy.  We can then take to MSME or present at a right forum.

There are other things too. Multiple department have to be involved. There may be requirements for amendment to various statues. This clean up of Balance Sheet numbers and the resultant profit or loss should be recognised as “profits and gains” of business or profession – either at one time or in installments. I have been arguing that at least about Rs.10,00,000 cores are hanging precariously at the edge of the cliff and are sure to drop off as NPAs. It is not a loss in entirety. I suspect worst case scenario is 40% (Rs.4,00,000 Crs) of it will get booked as loss in Bank’s Balance Sheet. The loss of taxation will be perhaps Rs.1,00,000 Crs. (at 25%). How to take this loss? This may be 20% of corporate tax revenue. This is not something that can be foregone in a year. Just the accounting treatment of resultant loss or profit requires amendments to Income Tax Act, Company’s Act, and accounting standards. Banking regulation and RBI norms require modification. In short, a complex symphony has to be conducted by Mrs. Nirmala Sitharaman.

Need of MSME
The Need of the Hour

Before doing this one thing has to be ensured first. Accountability of Chartered Accountants, while auditing and certifying the Books of Accounts needs to be improved. Part I of this blog series discussed how the certifying Chartered Accountant does not have any opinion on roughly 90% of the assets. This needs to change. Certifying Chartered Accountants should be made accountable. Periodic stock verification and a debtors confirmation for the top 80% of the accounts should be made mandatory. It does not require lot of effort 80 – 20 rule eminently applies to receivables and the inventory. Hardly 20% of the items carry 80% of the inventory value that can definitely be verified to form a reasonable option on the correctness of the numbers. Speaking of correctness, this exercise if resorted should be retrospective and not prospective.

Let’s attend to some FAQ!

Will an amnesty scheme for correcting the Balance Sheet be of use? What are the lasting benefits? Most important asset of the business is vibrant and highly scalable cash flow. We have a banking system that largely ignores this and it resorts to asset based lending when it comes to MSME. What is the asset base of the company, what collateral securities are offered, are the most important things ascertained by the banker. Entrepreneur’s fundamental rule of the game is gaming the system. Lender’s concern before sanction of credit facility is, whether the assets are good enough to cover the investments if the company fails. Entrepreneur has just the leap of faith or survival instinct and the lender has just the opposite view and assumes business is destined to fail and that the lender has to cover the investment by selling the assets. This is SME lending in nutshell. This chaotic way of co-existence can change for good, once clean Balance Sheet is norm, availability of debt funds will be lot easier and it will help company’s growth. There is a huge immediate benefit. Bank NIFTY will stabilise. No more slippages from SME advances!

Will it transform the way SME operates? Just a couple of days back I received a Balance Sheet which showed a stock of Rs.125 Crores when the actual stock was not even Rs.20 Crs. Company’s Banker has stopped releasing funds and has appropriated all receivables. The company is in standstill. The company has the capability to generate an EBIDTA of Rs.20 crs per annum. Restructuring and reducing the liability by sale of some securities will be more than welcome by the entrepreneurs. Old ways are proving to be difficult, if not impossible, thanks to DeMo and GST. GST and DeMo have achieved one thing, If there is a reasonable half chance to go straight entrepreneurs will happily take it. They still try to game the system since the past baggage cannot be undone. If there is a way out, they will take it and course correct.

Need of MSME
The Need of the Hour

Would this not amount to postponing the inevitable? Not really. If the working capital term loan (converted from working capital) is properly matched to the cash flow, this will not be a burden. In fact, tenure can be 10 to 25 years depending on cash flow. All companies availing this scheme should be asked to corporatize the setup, dematerialize the shares, and mark a lien on shares to the respective banks. This way in case of future default, a company can be taken over straight away. In most cases there are real estate properties that are given as security. Any asset other operational assets and self-occupied house, property can be treated as floating assets. In case of default bank should be given the liberty to simply transfer the asset to them by adjusting the market value and then putting it on sales. So, when clean up comes with strong condition, such as this, there will be responsibility. Further, generally speaking, entrepreneurs are tired too. They would like to have this headache behind their back.

Okay, how do we go about doing it? They typically have book debts and stocks which are stated higher than the actuals and some times, certain liabilities are understated. A confirmation mechanism of top 80% receivables and stock taking for top 80% of the stocks will do. based on the current year’s GST numbers and Stocks Statement given to bank, this can be reasonably estimated. However, I believe both entrepreneurs and Chartered Accountants will be more than forthcoming to provide the exact situation once and for all. They will be quite happy to remove the burden from their shoulders.

Still there may be some misuse. Even that misuse is good. After, reducing this number based on the present level of the inventory, if we calculate maximum permissible bank finance there will be substantial excess borrowing. This excess borrowing can be carved out as a term loan to be repaid over a period of 10-25 years depending on cash flows. There can be an interest reduction if there can be a pre-payment at a later date and closure of liability. This term loan can be charged at the present interest rate based on the risk profile.

Need of MSME
The Need of the Hour

Will it not go the demonetisation way? With creative Chartered Accountants, it is possible. The date of the adjustment of Accounts should be retrospective or not prospective. The reasons are obvious. Starting with License Quota Raj, we have successfully created a chaotic and absolutely immoral echo system. God fearing great Indian ethos may be anything. Uncompromising honesty, being on the right side of the law or paying taxes are not among them. We are unfortunately a morally compromised society. Companies and Chartered Accountants will have ideas to create an under-valued Balance Sheet which is more than beneficial. This was done during monetisation time and this will be done now. This has to be avoided. Strict accountability norms for CAs should hekp.

What about prosperous companies? They normally create lot of hidden reserves. They understate inventory, inflate expenses and creditors. One other standard feature of prosperous company is that they write off lot of bad debts in their books. Next year they collect the money and write it back as miscellaneous income only to write off some more bad debts. Bringing stocks to books or deflating creditors or not writting off random book debts will result in higher income. This is again an income concealed over a period of time. If taxes are collected over a period of 10 years, there may be compliance. Acceptance may be muted and will not be enthusiastic as in case of stress.

What about Banks? What security do they have? Banks already hold a set of securities. In the past real estate assets given as security have appreciated multi fold and this alone enabled the companies to get more loans. Now, this leverage has diminished, though they are still available in most cases. However, there are assets to back up the loans. Once, promoters’ shares are pledged, whole business is hypothecated. Some sort of market play mechanism can be worked out among lenders and Mergers and Acquisition of business is possible in case of stressed assets. NCLT is not going any where. All the present redressal mechanisms are still in place. If you don’t restate the balance sheet and apply Basel IV norms, they will be in bigger mess.

Need of MSME
The Need of the Hour

What about revenue loss to the exchequer? Adjusting all the losses in one go, will result in a tax shield to the extent of loss shown. These losses are accumulated over a period of time. There is no reason why it should be allowed in one go. A ten-year framework for adjusting these losses with a current pretax income will help both the company and the exchequer. This means annual loss of revenue will be only minimal. Further more, in the future years buoyancy in the economy generated by this method will help. There is another logical reason why tax credit should be allowed. The companies have anyway been paying taxes on income they have not generated in the past. They are only recovering the excess tax paid in the future years.

All told, this is a clear way forward. No new NPAs. Old NPAs also can also be structured. Borrowing SMEs will be corporatised and they will go straight. MSME stress will be alleviated. Buoyancy will return in the sector. However, multiple agencies are involved. We live in a country where one of the Government lays roads. Once the road laying is complete another agency digs it up. Finance Minister has to be a symphony conductor to make this happen.

To re capitulate:
1) All companies should be allowed to restate the Balance Sheet from a retrospective date – say 31st March, 2019.
2) Excess working capital borrowings without Drawing Power should be treated as long term debt.
3) If cash flow is not sufficient to meet the restructured loans, the company should be taken to NCLT and logical course should be followed.
4) Resultant loss should be adjusted over a period of 10 years and the company will get tax shield to that extent.
5) Prepayment incentive should be provided for early closure of loans.
6) In addition, share pledge of promoters can be obtained as additional comfort.
7) Existing securities will continue.
8) Non operative assets – collateral or prime other than self occupied property – should be sold to reduce the liability.
9) Government should actively encourage an ecosystem to be developed wherein stressed SME assets can be offered to strategic investors/buyers who are clients of other banks/institutions.

Hope, the Government gives it a serious thought. There is hope. There should be a reason why the Government postponed the classification new NPAs till 31st March, 2020. I like to assume, evolving a mechanism for Balance Sheet restatement is the reason.

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