Why Diageo is struggling with United Spirits’s books

Bangalore: For a company that prides itself on high standards of corporate governance, Diageo Plc has suffered several embarrassments after buying a 25% stake in United Spirits Ltd (USL) from India’s largest liquor company and Vijay Mallya-controlled UB Group in July 2013.

Diageo, the world’s largest distiller, now owns roughly 54.78% of USL after it bought an additional 26% of the company’s shares from public shareholders for £1.11 billion in July. Soon after the company finally reported its thrice-delayed fourth-quarter earnings in September, the new management of USL initiated an inquiry into the accounting practices of the company as several cases of suspected financial impropriety surfaced.

As many as four USL board members appointed by Diageo, all of whom are among the most respected corporate professionals in India, have quit over the past six months.

Earlier this month, proxy advisory firm Institutional Investor Advisory Services India Ltd (IiAS) recommended that shareholders vote against the resolutions for chairman Vijay Mallya’s reappointment at USL and also suggested that chief financial officer P.A. Murali should resign as director.

USL failed to get its fourth-quarter results cleared three times either by its board or by the company’s independent auditors BSR and Co. On 4 September, when USL finally published its results, it said it was investigating whether the company and its executives had violated rules by lending money to UB Group companies.

USL, the owner of popular whisky brands such as McDowell’s No.1 and Bagpiper, said the “detailed and expeditious inquiry” would look at the intercompany loans between USL and UB Group entities that were used to prop up the now defunct Kingfisher Airlines Ltd.

The inquiry will also cover some agreements allegedly entered into by USL with a Kingfisher creditor and certain claims made by USL debtors, some of whom are now refusing to repay the company.

The fourth-quarter earnings report also included “qualifications” by USL’s independent auditor BSR. Auditors typically issue qualifications when they believe there isn’t enough information for them to make a judgement, or if the auditors believe the accounting violates rules.

In this case, BSR said it couldn’t comment on the accuracy of USL’s accounting in certain instances partly because of the pending inquiry referred to above. BSR also brought up the possibility of fraud and said it would only be able to pass judgement on this once the inquiry is complete.

BSR is the third independent auditor USL has hired since 2010. The two others were Price Waterhouse and Walker Chandiok and Co. (Grant Thornton), both of which chose not to offer themselves for reappointment.

Mint has put together a list of points on which BSR issued a “qualified opinion”. Two independent accounting experts and former chief financial officers (CFOs), T.V. Mohandas Pai and Prabal Basu Roy, studied the auditor’s report and gave their views on the qualifications made by BSR. Pai is a former CFO at Infosys Ltd and chairman of Manipal Global Education Services. Roy is an ex-CFO at Polaris Software and chief executive of Diptish Investments and Fund Advisors.

The company’s response and excerpts from BSR’s observations are included below.

USL holds its annual meeting on 30 September, when its shareholders are to decide whether Mallya will continue as a director on the company’s board.

Issue 1

United Breweries (Holdings) Ltd (UBHL), the holding company of the UB Group, owes ₹ 1,337.4 crore, which is payable over eight years. Several lenders to Kingfisher Airlines have filed petitions to liquidate and shut down UBHL, which guaranteed Kingfisher’s debt. Considering the financial difficulties UBHL faces, USL has made a provision of ₹ 330.3 crore assuming that the company may not be repaid to that extent by UBHL. As of 31 March, USL assumes that UBHL would be able to repay the rest of the loan.

Company statement: USL is reviewing the loan agreements to see whether it has any legal remedies to recover the loan, whether it should use such remedies and whether the company needs to renegotiate the terms of the loan. In an email, a USL spokesperson said: “The United Spirits management performed an assessment of the net asset value of UBHL in addition to relying upon valuation reports from reputed independent valuers furnished to us by UBHL, and has made appropriate provisions based on its assessment of the recoverability of the loan. Although we have made such provisions, United Spirits will make every attempt to recover the entire amount of the loan including interest. There will be an ongoing assessment of recoverability of the UBHL loan at the end of every quarter based on events related to UBHL occurring during the course of the quarter.”

Auditor’s observation: Given the uncertainties involving the court cases against UBHL, and the extended period for loan repayment, “we are unable to comment on the level of provision established”.

Expert comments:

Pai: “This provision is clearly inadequate and it is unlikely that United Spirits will ever see most of the money that it loaned to UBHL. The time of the loan repayment is too generous. It shows that money was misused by the management of prior years and they should answer how they let so much money go to a troubled entity. The previous auditors should’ve spotted this.”

Roy: “I don’t see how UBHL will be able to repay that much money. These intercompany dealings within the UB Group were very well known to most, but they’re coming out only now. Diageo needs to take full control of the finance function and make sure that they get to the bottom of these issues. Even if they do, it’ll still take them at least a year to clean up the books.”

Issue 2

Debtors, who together owed ₹ 590.7 crore to USL, claimed that they were owed money by UB Group entities. Some of the debtors, who owed ₹ 322.5 crore to USL, warned that they won’t repay USL unless the UB Group entities paid them their dues.

Company statement: The USL board has asked the management to launch a detailed inquiry into this issue and has authorized the initiation of “suitable action and proceedings” for recovering the company’s dues. “Appropriate other action will also be taken commensurate with the outcome of the inquiry.”

Auditor’s observation: These claims may indicate that all or some of the amounts were “improperly advanced from the company to such parties for, in turn, being advanced to UB Group entities”. However, this can only be confirmed by the inquiry.

Expert comment:

Roy: It looks like UBHL was being used as a conduit by UB to move money from USL to Kingfisher and other UB Group entities and this is another example of that. All of this shows that USL had weak finance controls.

Issue 3

A creditor who is owed ₹ 200 crore by Kingfisher wrote to USL saying his company had certain claims on USL’s assets based on agreements entered into in earlier years. However, USL pointed out that its board had not approved these agreements, and the creditor backed off.

Company statement: The board did not approve these agreements and USL does not expect any liability because of the agreements.

Auditor’s observation: It cannot comment on the “validity of these agreements; any required compliance with the provisions of the Companies Act, 1956; and any consequential impact of the same”. Additionally, until the completion of USL’s inquiry, BSR is “unable to conclude whether these instances can be termed as ‘fraud’ and whether there are other instances of a similar nature”.

Expert comment:

Pai: Though the board did not approve the agreements, the very presence of agreements indicates that some people from the previous management of USL or other UB Group companies may have been involved in some way. If that is the case, it’s a serious offence and USL should take action against such individuals.

Additional company comment: The USL spokesperson said that the company has already made initial inquiries into the matters and the company’s board has directed chief executive officer Anand Kripalu to conduct “a detailed and expeditious inquiry” into the following matters:

(1) certain outstanding receivables owed to USL;

(2) the intercompany loan between USL as lender and UBHL as borrower; and,

(3) claims made by a claimant relating to an alleged lien on certain assets of USL given as security for an alleged loan given by the claimant to Kingfisher Airlines.

“The inquiry will also look at the possible existence of any other transactions of a similar nature and the role of individuals involved. Until that inquiry is completed, it is inappropriate for us to comment further,” the spokesperson said.