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Accounting Jugglery

There is an old joke about a businessman interviewing people for a manager’s job. The last candidate was an accountant who, when asked how much two plus two was, responded with “How much do you want it to be?” Apply that to corporate balance sheets and you will find a number of ways in which numbers ‘add’ up.

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In 2008-09, the rupee depreciated over 25 per cent, and corporate India’s external debt went up by 20 per cent. Companies could have charged the depreciation losses to the profit and loss account; or, spread it over a few years, but their balance sheets would have looked vulnerable. Reliance Communications (RCom) chose the former option. But through another entry, it neutralised the adverse effect on its profit by transferring an equal amount from its General Reserve (accumulated profits earned in past years).

The following year, the exchange rate appreciated. This time, RCom gained, and that increased its profits directly. Accounting experts may have naturally disapproved of the first instance (though not the second) because it seemed to camouflage a loss.

A senior expert with the Institute of Chartered Accountants of India (ICAI), who requested anonymity, says that setting off exchange losses against the General Reserve is by no means allowed; the General Reserve also includes other restricted reserves, in particular, those that have been created by the purchase of another group company. His point: the profits of one company were used to adjust the losses of another. That, he says, is an accounting standards violation.

So how did RCom manage to get past its auditors? The company used a much-loved clause in the Companies Act — get an approval from a High Court for all the terms of amalgamation. Companies often use this route to slip in accounting changes that would otherwise earn the disapproval of its auditor.

Companies often use amalgamations that have been approved by the court to write off losses against reserves or the share premium account. The practice has vexed the ICAI because in the end it exposes accounting standards to abuse. “The ICAI has been crying itself hoarse about this kind of abuse for years,” says Y.H. Malegam, former chairman of the National Committee for Accounting Standards.
Hiding Profits
  • A sudden spurt in income/profit due to stake sale
  • This will lead to a spike in profits in one year, only to come back to normal in other years
  • Profits are split over years into smaller blocks, which leads to enduring benefit from the stake sale
Hiding Losses
  • A sudden decline in income due to volatile currency exchange rates
  • Acquire a subsidiary that has reserves; use those funds to nullify the loss; and get court approval for the set-off
  • On the books, the initial loss will not show as it has been balanced by the subsidiary’s reserves
Hiding Future Payments
  • A subsidiary’s bankruptcy may be imminent. Or, bonds may be due to mature
  • Say the loss won’t materialise or that the redemption amount cannot be estimated
  • Do not provide for an imminent outflow
In an email response to BW |Businessworld questions, RCom said that it was in compliance with the applicable accounting standards, as well as the provisions of the Companies Act. “The company, in compliance with relevant accounting standard, viz., Accounting Standard 5, charges all expenses to its statement of profit and loss in order to arrive at net profits for the reporting year and does not directly charge any operating losses against its ‘General Reserve’.”

Market regulator Securities and Exchange Board of India (Sebi) now wants listed companies seeking court approval for M&A transactions to get an auditor’s certificate that the proposed accounting complies with standards (does not apply to unlisted companies).

The Year That Was
What motivates this behaviour? Nick Paulson Ellis, country head of investment bank Espirito Santos, offers an explanation. “Analysts like a company to show steady growth in profits,” he says. “Aggressive accounting is often a way for companies to hide any unexpected bumps in that trend.”

So some companies spread a huge gain over several accounting periods, put off recognising losses for as long as legally possible and, in some cases, selectively ignore accounting conventions that might show their numbers in a less rosy light. Analysts are also outraged that auditors appear to condone the practice. In fairness, auditors have tried to draw attention to such practices.

Jamil Khatri, the partner who heads the accounting advisory team at KPMG, says this is the best an auditor can do. “The auditor’s powers are restricted to expressing an opinion on the accounts — people confuse an auditor’s role with that of an investigator.”

In MTNL’s annual report, for instance, we found 23 areas where the auditor pointed out that the accounting practice was wrong, and another four where he called the attention of shareholders — 12 out of the 29 existing accounting standards had been violated.

Accountants face tough choices, says Kamlesh Vikamsey, former president of ICAI, on whether to show an item of expenditure or income in the P&L account immediately or spread it out over years, depending upon whether the benefit is of a continuing nature or restricted to that particular period.

For example, when Reliance Industries (RIL) received $7.2 billion from BP for a 30 per cent stake in its subsidiary that owned some blocks of the Krishna Godavari (KG) basin, it chose to show the receipt as a reduction from the cost of investment rather than a profit on sale of investment in that year (capitalising receipts leads to lower depreciation and higher after-tax profits). RIL did not respond to BW | Businessworld emails asking why it chose this treatment.

Sunil Goyal, former chairman of ICAI’s western region, clarifies on when an item can be capitalised, and when it cannot. “If the benefit accrues over a period of years, it can be distributed over that period,” he says, adding, “in all other cases, it should be recognised in the year in which the event transpired.”

In Bits And Pieces
Often, lumpsum payments can be creatively accounted for. When Biocon received such a payment as part of the termination of its partnership with Pfizer, the company sought to capitalise the amount. Chirag Talati at Espirito Santo raised a red flag in his report on the company, saying that the practice would overstate its earnings per share (EPS) by about 20 per cent for each year between 2012-13 (FY13) and FY15.

Biocon says that the sum received from Pfizer was for long-term development, and the company’s own clinical trials of the drug would still continue. This justified deferred revenue recognition over the remaining period of development which, the company points out, is a permitted accounting practice.

Accounting treatment is sometimes also driven by tax considerations. For instance, when minimum alternate tax (MAT), which is based on book profits, applies. Says Deloitte’s managing partner of audits N. Venkatram, “Companies choosing to postpone recognition of profits or accelerate booking of losses can make a lower MAT payment.”

Another consideration could be just financial capacity. Even a notional expense such as implied interest on a zero coupon bond should be routed through the P&L if it contributed to the operations of the company that year. Sometimes, though, the rules allow certain departures; the redemption premium to be paid on debentures can be set off against the share premium account. The treatment vexes analysts but cannot be technically faulted.

But companies stretch that technicality. In 2011, Suzlon did not provide for the redemption premium on its foreign currency convertible bonds (FCCB) that were to mature in 2012 (the company eventually defaulted). It treated it as a contingent liability (off the balance sheet). The company’s argument was that since it wasn’t clear how many bondholders would convert, making a provision for it was difficult.

“But Suzlon’s share price was a sixth of its redemption value then,” says an expert. “It was likely that bondholders would choose to redeem.”


“The general practice of treating redemption premium as a contingent liability cannot be justified,” says Malegam. “As long as the bond is convertible at the option of the holder, the company must still treat it as a redeemable bond and provide for the redemption premium.”

Suzlon says that if the bonds are called for redemption, it has adequate share premium reserve to cover payments. Analysts say given the company’s finances, it would have been inclined to present a favourable debt-equity ratio. A company spokesperson denied this, saying, “We are of the firm view that a degree of leverage does not — and should not — lead to a substantially different accounting practice”.

Head In The Sand
Companies often claim that making a provision for a liability that may not even materialise could skew future financial results. But prudent accounting calls for provisioning to cushion the impact of a potentially adverse outcome. Tax deferment schemes are one such category.

Essar Oil was allowed to delay payment of sales tax in Gujarat for 17 years. In 2010, when Essar Energy, the UK-listed parent of Essar Oil, went for an IPO, its income statement showed the entire sales tax collected as a revenue item, and no provision for a potential repayment. That helped the company show a profit of $40 million in the preceding nine months, instead of a loss of around $133 million (the sales tax shown as revenue was $173 million). To compound matters, the Gujarat government was contesting Essar’s eligibility to participate in the tax deferment scheme, calling for an immediate refund. The case was in the Supreme Court, and an adverse ruling could mean a payout of Rs 6,300 crore, compared to the company’s annual profit of around Rs 400 crore then.

Company executives said that as per their lawyers’ advice, they expected a favourable outcome to the case. In January 2012, Essar lost; neither the Supreme Court nor the Gujarat government was willing to accept the company’s plea of not having sufficient monies. Essar Oil finally agreed to pay in deferred instalments. Essar too did not respond to our emailed queries for this story.

If Essar Oil was optimistic, Vijay Mallya’s UB Holdings was no less so. The firm included roughly Rs 180 crore due from several subsidiaries in its income, the receipt of which may “take a protracted period of time”, according to the auditors. It has even recognised a guarantee commission due from Kingfisher Airlines (KFA), but which the beleaguered airline has not recognised in its accounts because of restrictions imposed by its creditors.

UB Holdings explains it by saying the “amounts are ultimately recoverable, taking into consideration their business plans and growth strategies”. Prudent accounting, however, required that the company should have provided for the diminution in value of its investments in KFA, and the money lent to the airline and other subsidiaries.

Unreal Profits
Unless you are Rip Van Winkle, you would have seen those full-page ads: book a flat for as little as Re 1, and win a free car. Reason would have told you that a deal of that kind didn’t make sense, but it kept prices high enough to protect returns for investors who had already committed to the project. Sadly, realty is not reality.

Real estate companies did not have codified accounting rules till early this year. So, companies used the liberty of adopting one of several possible accounting methods and then tweaking them to suit their purposes, mostly for tax advantage. An analysis of the top 15 listed realty companies’ accounting policies would show that no three had the same criteria for recognising revenues. The internationally accepted practice (followed by HDIL and Sunteck Realty in India) is to recognise revenues only after completion of the project.

The percentage of completion (PoC) method of computing revenues allows firms to recognise revenues every year as a percentage of the stage of completion in that year, or as a proportion of estimated costs already incurred. For example, if 35 per cent of a project is completed by the end of the year, then 35 per cent of the revenues from its sale can be recognised. How this rule is sliced and diced is the cream of accounting imagination.
Here are a few samples of auditors’ notes:
From the auditor’s report in Reliance Communication’s annual report of 2008-09 approved by the Hon’ble High Court of Judicature at Mumbai, the Company has withdrawn from General Reserve III and credited to the Profit and Loss Account Rs 4,464.57 crore in respect of loss on account of change in foreign exchange rate relating to loans/liabilities.

From the auditor’s report in Suzlon’s annual report of 2010-11
The Phase I, Phase II, Phase I New, Phase II New, and Phase III bonds are redeemable subject to satisfaction of certain conditions.... The Company has not provided for the proportionate premium... aggregating Rs 579.21 crore (Rs 377.22 crore)...

From Essar Energy’s notes to accounts in the IPO prospectus of 2010
Under these incentive schemes, the Group is able to defer the payment of up to approximately Rs 91 billion ($1.95 billion) collected as sales tax... until the financial year ending 31 March 2021..., after which it is required to repay the retained amounts... in six equal annual instalments.
DLF, Unitech, Godrej and Parsvnath include the cost of land in their cost of construction. A company that follows this formula can start recognising revenues even before it lays a single brick. And if the land comes up to 30 per cent of the total project’s cost, a company can show 30 per cent of the potential revenue receivable from the sale made as revenue in the books. That makes using the Re 1 scheme very attractive for a builder.

But the real number to watch is cash flow. Ambit Capital’s Rakshit Ranjan compared companies using a simple ratio: cash flow from operations to its operating profit as shown in the P&L account. A ratio of over 100 indicates that a company has net cash flows at least equal to the profit it is showing. But no company in Ranjan’s list had a ratio that crossed 100. In fact, nine out of the 15 companies had negative cash flows, yet showed strong profit growth.

Ranjan points to another metric: the average number of days it takes for a company to receive payment from its debtors after it becomes due, or debtor days. Against an average of around 40 days for BSE 500 companies, the 15 realty companies had an average of 130. In the case of Parsvanath, it was over 500 days.

A year ago, the ICAI prescribed guidelines for realty accounting. Going forward (on projects that commenced after 1 April 2012), only the PoC method would be permitted; cost of land would not be included in project cost for computation of percentage of completion. Revenue recognition would start only after 25 per cent of the project had been completed.

In Letter And Spirit
Accounting is more art than science, but an art in which creativity abounds. Perhaps accounting is where science meets art. Where accountants use their flair to be creative, and the rest of the ecosystem, the auditors, analysts, regulators, et al, stand, ruler in hand, to measure whether the departure from rules was within permissible limits. But accounting, for its inherent limitations, often gives companies the luxury of deviating from the stated rules when it is not practical to stick to the rule of law. It becomes even more subjective when the treatment is different under a foreign standard, such as IFRS. But the end result is not always bad. Take pension liabilities.

Tata Steel’s profits would have been lower by a third in FY12 if it accounted for pension liabilities at Tata Steel Europe the same way it accounted for its Indian liabilities. So also with Hindalco’s subsidiary Novelis. Tata Steel said in its annual report that the European pension fund rules result in much larger volatility in actuarial valuations (even a change in interest rates could cause a huge swing, say experts), distorting operational results.

Malegam says the argument is valid because overseas operations constitute an overwhelmingly large proportion of the company’s global operations. The practice followed is permitted under international financial reporting standards or IFRS.

The assumptions used in actuarial valuation abroad are different to those used in India. However, others argue that accounting is also about presentation. And while that may be true, accounting principles that companies use must be consistently applied, not changed when convenient. 


(This story was published in Businessworld Issue Dated 25-03-2013)

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.

Abraham C Mathews

The author is an Advocate, practicing in Delhi, and a Chartered Accountant

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