Netsol's Accounting Troubles

As one of my four “picks from the rubble,” I had high hopes for NetSol (NTWK).  The software and outsourcing company appeared poised to deliver strong profits and top line growth, even amidst the market slump.  For a short time, the pick paid off handsomely, as the stock bounced over 30% from my entry just above 1.30.

I should have taken profits.  Soon after, the bottom dropped out.   On November 10, 2008, NetSol filed 8-K’s revealing that its CFO had resigned and that it would restate its financials to eliminate a good part of its earnings.  The company blamed the discrepancy on “computational errors in connection with the allocation of appropriate amounts to minority interest in the statement of income (operations) and calculation of minority interest ownership.”

Departing CFO Tina Gilger gave a little more color on the conference call:

At the timing of our IPO firm, our Pakistan subsidiary we conducted in August 2005, we made classified certain purchases, including officers and directors as affiliate with the parent. As they were classified as affiliate, we included their ownership as part of the parent’s ownership for purposes of calculating the minority interest adjustment and subsidiaries. In recent discussions with our auditors, it was determined that although these parties were affiliates, the affiliate ownership should not be included in the parent’s ownership. Together with the auditors, it was determined that minority adjustment involved from this changing ownership percentage of 9.26% was material and necessitated a restatement of the fiscal years ended 6/30/06, ’07, and ’08.

In fiscal ’08, the subsidiary issued bonus share dividends to shareholders. In calculating the amount of the minority interest adjustment, the net income of the subsidiary is multiplied by the minority interest percentage. The calculation had inadvertently reused the net income after the bonus dividend rather than before it. It was only after filing of our 10-K and during the preparation of our 10-Q that this formula error was detected. We immediately took measures to correct the error, and as it was material, a restatement was necessary. The only changes in the restatement relates to the change in the ownership percentage of the parent versus all of the holders and the miscalculation of the minority interest dividend. There was no effect on all other amounts in the income statement. Please refer to our detailed finances as provided in our recently filed amended form 10-K for additional information.

This explanation troubles me.  If they miscalculated share count, that’s sloppy but not a sign of long-term problems.  However, a stock dividend by a subsidiary should not change the ownership percentage of the parent. 

Typically, stock dividends are distributed equally to all shareholders of a given class, so the percentages should remain stable.  The only way they change is if NetSol allowed NetSol PK to distribute shares to all shareholders except the parent (in other words, diluting NetSol’s ownership for the benefit of Pakistani holders of NetSol PK). 

Is that what happened?  Until I find out, I want nothing to do with this company.  I have sold all but a few hundred shares, which remain only because of a partial fill on my sell order.

DISCLOSURE: Long NTWK (until my sell order fills completely).

Comments

[Flighit:]

This observation only showes that you never knew anything about NTWK in the first place PK has been paying dividends for a long time to stimulate growth in a slow economy - dividends paid to pk sharholders were also payed back to the parent since NTWK owns 60%. The issue is that the dividend was counted as profit before it was paid out. It should not have been counted this way. However, this was approved by the accounting company and was only found by the SEC's audit - so this seems to be something that no one was clear on.
Again we knew they were getting the divided years ago this was not new information - however, as a share holder we have urged them to not pay new dividends and as far as we know they have no plans to pay dividends in the future once there stock market rebounds.

2008 Nov 18 03:31 PM