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How companies play with accounting policies to their advantage

How companies play with accounting policies to their advantage

The rising number of auditors' qualifications in accounts statements indicates the deteriorating state of Indian accounting standards. In times when Indian corporations run global companies, accounting practices should be conservative rather than aggressive when there is an element of uncertainty.

In late 2010, the directors of Mumbai-based Bajaj Corp, part of the Shishir Bajaj Group, were pleased. Their company's Rs 297-crore initial public offering, or IPO, had done well, and the board was eager to tackle bigger challenges, such as acquisition opportunities, that were among the objectives of the IPO. But first, they had to decide how to treat IPO expenses - a tidy Rs 20 crore - in the account books. The decision was important, as it would affect profitability.

Bajaj Corp, a mid-sized hair oil company, had three options. The first was to charge the expenses to the share premium account, where almost Rs 294 crore lay idle, in the balance sheet. This would have no effect on profitability. The second was to amortise them equally over five years, which would marginally affect the bottom line. And the third - setting off the expenses against the current year's profits - would wipe out more than 20 per cent of the profits for 2010/11. Given the slowdown in the domestic economy and the sluggish stock market, the first option seemed the best. Bajaj Corp's stock, which debuted in August 2010 at Rs 800 per share - the offer price was Rs 665 - was already showing signs of weakness.

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But Chairman Kushagra Nayan Bajaj voted for the third option. One of the directors voiced concern about how investors might react. Dilip Maloo, Chief Financial Officer and Vice President, Finance, explained that the third option would save on taxes and improve liquidity within the company. Amortisation would yield similar results, but over five years, he said. The directors unanimously agreed to Bajaj's proposal. Sure enough, investors were underwhelmed: by January 2011, Bajaj Corp's stock had dipped to around Rs 500, down almost 40 per cent from its debut. The Sensex actually gained two per cent in the same period. Had Bajaj charged its IPO expenses to the share premium account, profits for 2010/11 would have crossed Rs 100 crore, and the stock would almost certainly have outperformed the Sensex.

The decision was a bold move, as many companies crank out quarter-to-quarter profits with an eye on the short-term reaction of the stock market, unmindful of the cost of playing to the gallery. The proposal of the 34-year-old chairman was thus remarkable for its restraint and conservative approach.

Contrast this with the approach of Indosolar, a Delhi-based solar cell manufacturer, which had a Rs 357-crore IPO about a month after Bajaj Corp's issue. Indosolar already had a policy in place to amortise preliminary expenses, of which a few crore rupees were still outstanding at the time of the IPO. But it suddenly changed the policy when accounting for the IPO expenses of Rs 33.58 crore: it decided to charge them to its share premium account.

That meant the total outstanding expenses, some Rs 36.27 crore, would be set off on the balance sheet, and not in the profit-and-loss account, for 2010/11. The company was neck-deep in losses (Rs 57 crore in March 2011). The decision to charge IPO expenses to the share premium account prevented losses of a few more crores from going on the books. Indosolar refused to comment when BT asked about the change in its accounting policy.

Indosolar is a classic example of how companies play with accounting policies to their advantage. Chameleon-like policies make a company's accounts harder to understand, and confuse investors and shareholders.

Wrong message to investors

In July this year, Veritas, a Toronto-based equity research firm, launched a scathing attack on mobile phone services provider Reliance Communications, in a report that said: "The company has inflated its EBITDA, EPS and book equity." It added that year-onyear comparability in most instances was compromised because of "whimsical accounting policy changes". Such accounting practices, if true, send the wrong message to global investors.

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India will soon comply with International Financial Reporting Standards, or IFRS. This means companies here will adhere to the same accounting standards that much of the world follows. It will bring uniformity and greater transparency to Indian accounting, help attract investment into India and also help Indian companies raise money overseas. "Global investors look for reliable information that will only come from using the best accounting standards," says Dolphy D'Souza, Partner at Ernst & Young India, or E&Y. "Local investors, too, want more reliable and transparent information."

 N. Venkatram, Partner, Deloitte Haskins & Sells
Indian standards are robust, and have served us well over the years, but we need better enforcement: N. Venkatram, Partner, Deloitte Haskins & Sells
The rising number of auditors' qualifications in accounts statements indicates the deteriorating state of Indian accounting standards. In good times, high profits keep all stakeholders happy, and in bad times, accounting policy tweaks come to the rescue. Today's business environment is uncertain, because input prices are high, interest costs are ballooning and demand is slowing. Keeping profitability intact, then, is a challenge. Some companies are responding by passing up the best practices in favour of more convenient options under India's Generally Accepted Accounting Principles, or GAAP. Strong corporate lobbying against the IFRS has already pushed back India's April 2011 deadline for convergence with global standards to an indefinite date.

The investing community is, of course, pushing for IFRS implementation. However, N. Venkatram, Partner at Deloitte Haskins & Sells, points out that "many advanced nations, such as the United States and Japan, have also not moved to IFRS". Some African countries have not done so, either. But about 100 countries have adopted these standards, and India can ignore them only at its peril. "If we delay, we will miss out on the economic advantage," says D'Souza of E&Y.

India has decided to converge with IFRS, which means it will make some changes in the standards, rather than adopt them wholesale. Convergence will have a major impact on many accounting standards, such as revenue recognition, capitalisation of expenses, fair value and acquisition accounting. In particular, stringent revenue recognition norms could give many mid-sized companies a headache. Under the Indian GAAP, revenue for the sale of goods is recognised based on the company transferring significant risk to buyers. In other words, a company only has to dispatch the goods to account for the revenue. But under IFRS, revenue recognition is based on the actual delivery of goods to the customer. In the case of construction contracts or large engineering goods, revenue is recognised based on the stage of completion, which is marked by milestones. Companies adopt different milestones for revenue recognition, depending on the nature of contract and the degree of customisation.

Dolphy D'Souza, Partner, Ernst & Young India
If we delay implementation of international accounting standards, we will miss out on the economic advantage: Dolphy D'Souza, Partner, Ernst & Young India
Take the case of Suzlon Energy, Asia's third-largest wind turbine maker. For the financial year 2010/11, Suzlon decided not to align the revenue recognition policy of its overseas subsidiary, REpower, with its own, although it had been doing so earlier under the Indian GAAP. Suzlon has been facing rough weather since 2008, because of the global recession and concerns over the quality of its turbine blades. "REpower's revenues were earlier computed by applying Suzlon's milestones for revenue recognition," says Suzlon's Chief Financial Officer Robin Banerjee. The company says the nature and level of customisation of the contracts of REpower and Suzlon are different, and maintains that there is no change in the group's revenue recognition policy. "The change is in the process of consolidation of revenues," explains Banerjee. The result of this consolidation is that Suzlon's revenue for 2010/11 is higher by Rs 974 crore, and net profit by Rs 109.57 crore. So Suzlon's first glimmer of good news in a while came in 2010/11 - but with remarks from the auditors, SNK & Co. and S.R. Batliboi & Co.

Under IFRS, companies will have to follow the same revenue recognition policy for the parent and subsidiaries. Differential accounting treatment under the Indian GAAP leaves substantial room for subjectivity, and gives companies the licence to twist accounting policies to suit their convenience.

Another example of questionable accounting practicces is the way in which some pharmaceutical companies treat research expenses. Under both the Indian GAAP and IFRS, research expenses are capitalised only after the company is certain that the new drug is ready for the market, and after it applies for the approval of the drug regulatory authority. And yet, many Indian companies capitalise research expenses even before clinical trials are over. When capitalised, expenditure goes directly on the assets side of the balance sheet, with no impact on the profit-and-loss account. If it is not capitalised, it appears on the profit-and-loss account and lowers profits.

Biotechnology firm Panacea Biotec is a case in point. Auditors S.R. Batliboi have inserted a qualification with regard to capitalisation of expenditure on clinical trials, which added up to nearly Rs 60 crore for 2010/11. The management justifies it by saying it is confident that the products in trials will be commercially viable.
Analysts uneasy
Besides investors, analysts, too, are concerned. In May this year, analysts grilled the top management of Delhibased infrastructure and energy conglomerate Punj Lloyd, including Chairman Atul Punj, because there have been auditors' qualifications in its accounts every year since its December 2005 IPO. One analyst asks: "Why don't we see similar auditors' qualifications in the annual reports of Larsen & Toubro, Gammon India, Hindustan Construction or IVRCL? Is the company's accounting treatment too aggressive?" Punj Lloyd defends itself by saying it has a good track record of receiving disputed claims through arbitration. "We have never lost a case, barring maybe a couple of cases related to tax," said Luv Chhabra, Director, Corporate Affairs, Punj Lloyd. He cites the example of a case pertaining to Pipavav Shipyard, in which the auditors' qualification was dropped.

The Pros and Cons of IFRS

India was supposed to implement International Financial Reporting Standards, or IFRS, by April 2011. It has deferred this indefinitely, and insisted on many modifications to the standards - accounting boffins call them 'carve-outs' - as they relate to areas such as agriculture, real estate, financial instruments and goodwill. It makes sense to adapt IFRS to the realities of a particular country, but a large number of carveouts defeats the purpose of global standards.

An example of necessary tweaking is China's decision to modify the IFRS on 'related party transactions' to reflect state ownership of many companies on the mainland. The 'related party' clause will not necessarily apply to Chinese companies. But in India's case, the European Commission, an executive body of the European Union, has warned that the country risks "creating a country-specific version of the IFRS that differs from those used worldwide".

Among those who defend India's right to choose its own accounting standards is N. Venkatram, Partner at Deloitte Haskins & Sells, a global consulting firm. "Every government has a responsibility towards its own economy," he says. He cites the example of India's conservative standards for banking, saying they ensured the sector was rock-steady when the global downturn traumatised the industry worldwide.

Dolphy D'Souza, Partner, Ernst & Young India, has a different view. "The initial modification may be a starting point, but ultimately, the market reality will bind India to adopt IFRS in totality," he says. Many accountants and analysts agree that the main concern that global standards seek to address is clarity in accounting, so that companies do not take investors for a ride. Where there is scope for differing interpretations, they say, the standards tend to be principle-based. IFRS may not be able to put a definitive end to accounting jugglery and auditors' qualifications. However, D'Souza says: "Given that many countries have already adopted IFRS, ambiguity and the scope for multiple interpretations are substantially reduced."

Repeated auditors' qualifications point to the larger issue of corporate governance, and the sustainability of the business in the long term. But is it fair to fault accounting standards? "Existing Indian standards are robust, and have served us well over the years," says Deloitte's Venkatram. The laxity of independent directors can also enable creative accounting. Consider the case of Kolkata-based Dhunseri Petrochem & Tea. In March this year, a fire broke out at the raw material storage facility at the company's plant in Haldia, West Bengal, disrupting operations, and causing the loss of inventory, fixed assets and production. Dhunseri filed an insurance claim for Rs 65 crore, and wanted to include this amount under 'other income' for the financial year ending March 31, 2011.

Dhunseri's auditors Lovelock & Lewes insisted on a qualification, because the amount that would be approved by the insurance company was not received. The claim remained unsettled beyond the end of the financial year. But Dhunseri's audit committee, which included the independent directors and Executive Chairman C.K. Dhanuka, insisted the money be shown as other income for 2010/11, on the grounds that other companies had done similar things before. Another reason given was that if the insurance claim were not shown as income, profits for 2010/11 wouldbe depressed, and the next year's profits would be inflated. By accounting for the unrealised claim in 2010/11, Dhunseri increased its other income from Rs 81 crore to Rs 146 crore, and its profits, from Rs 76 crore to Rs 127 crore.

With regard to insurance claims, there is again an element of subjectivity under both the Indian GAAP and IFRS. In a case like Dhunseri's, if certainty levels are high, the insurance claim should be immediately recognised. If they are not high, it should not be recognised.

Global implications
In an age when Indian corporations run global companies, accounting practices should be conservative rather than aggressive when there is an element of uncertainty. Bharti Airtel, Infosys and Wipro are among the few Indian companies which voluntarily follow global financial reporting standards.

"Nothing stops Indian companies from adopting IFRS on their consolidated accounts," says D'Souza of E&Y. The Securities and Exchange Board of India, or SEBI, allows listed companies with subsidiaries to publish consolidated financial results in accordance with IFRS. But apart from information technology companies, few others do so. "IFRS is more relevant to companies which have international operations, or who wish to raise capital overseas," says Venkatram of Deloitte. There is no dearth of such companies in India.

A bad accounting policy can devastate a company, as the cases of Enron, WorldCom, Tyco International and AIG have shown. Regulators are becoming more proactive. For example, SEBI quietly did investors a favour last month by making it mandatory for listed companies to announce fourth quarter results along with audited annual results. Some companies had been conveniently filing only annual results, and not fourth quarter results - an unhealthy practice that makes it harder for investors to gauge quarter-to-quarter performance. Accounting standards are like signs on a long highway - the driver has to make the right judgment.

Venkatram argues for maturity in disclosure standards. "We need better enforcement," he says. Independent directors, market regulators and other stakeholders - especially domestic and foreign institutional investors - need to be vigilant and challenge promoters if they stray from the road. Satyam Computers became India's first information technology company to adopt IFRS, way back in 2008. History has shown that it was not enough.

Published on: Sep 08, 2011, 12:00 AM IST
Posted by: Navneeta N, Sep 08, 2011, 12:00 AM IST