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How some firms cook up balance sheets
Vishal Chhabria, Outlook Money | August 23, 2006
So you have crunched the numbers, admired a spectacular balance sheet and are ready to invest in the company? But what if the numbers are not an accurate and fair portrayal of the company's financial health? While some Indian companies publish complete and prudently represented balance sheets, others use various tricks to dress them up through legal yet unethical methods.
Why do companies misrepresent accounts? Mainly because of the stock markets. Some companies paint a healthy picture to get higher valuations at the bourses. Listed companies are under pressure to report higher growth rates, and some resort to accounting jugglery.
The rules are clear as laid down by the Institute of Chartered Accountants of India, but some gray areas exist as this is an ongoing process and the list of regulations is not conclusive.
Secondly, these are mere guidelines and the auditing company can only mention the same in its Auditor's Report (attached with the annual report). Lastly, a company can seek a court approval and the legal judgment can supersede the accounting standard. Investors should ideally re-adjust for these changes to arrive at a fair picture. To learn more about unfair accounting practices, read on.
Write off: A popular way of inflating profit is to write off business expenses. By this, research and development, employee separation, miscellaneous business expenses and so on are written off from balance sheet reserves like general reserve and share premium reserve. The right way to provide for every business related expense is to charge it to the profit and loss account.
Companies use some innovative methods of write-offs. Madhu Dubhashi, CEO, Global Data Services of India (GDSIL, a wholly owned subsidiary of Crisil) says that when companies make an investment (in shares, for example), there is an accounting standard that there should be a provision for diminution in the value of the investment under certain circumstances.
This should be provided in the P&L account as per Accounting Standard 13. But many companies write it off against reserve, "which is not correct". Likewise, companies also write off the value of impairment in assets' against reserves.
Impairment is basically the reduction in value of a fixed asset. Says Tridib Pathak, CIO, DBS Chola: "Impairment of fixed assets should be passed on through the P&L account and not by writing off of reserve."
Through these methods of write-offs, companies manage to report higher profits to the extent of the value of the expense, impairment or diminution in that particular year.
Booster dose: Companies can also inflate profits by manipulating the value of their inventories. The correct way, say experts, is to value the inventory at cost or market value, whichever is lower.
During the past few years, many loss-making companies have entered into debt-restructuring deals with their lenders who waive the loan taken and the interest payable. Some companies show this as an income in their P&L account.
Ideally, only the interest waiver (if it was accounted as an expense in the P&L account in earlier years) should be shown separately as adjustment for previous years and the loan waived should be shown as capital receipt. By not doing so, these companies manage to show lower losses or, in some cases, even a profit.
Revaluation game: There are other ways of ticking off accounts. Explains Dubhashi: "Eveready Industries created revaluation reserve by creating a brand value, which is not permitted by accounting standards.
Against this fictitious reserve, the company has written-off bad loans and advances as well as receivables - a double whammy! Firstly, there was no reserve at all. Then real expenses were written off through fictitious reserves. In any case, it should have been routed through P&L."
This practice helped the company project higher profits. Likewise, some companies resort to revaluing their assets, which strengthens their balance sheet and improves their ability to raise resources.
Redemption premiums: Borrowing money for business through various instruments like debentures and bonds is nothing unusual for companies. When such instruments are issued, the company agrees to pay a premium on redemption.
This is nothing but cumulative interest, which should find its way to the P&L account. However, some companies write off such expenses against the share premium reserve.
Certain other areas too warrant a closer look. If accounting policies are changed frequently (the method of depreciation, for instance), it needs an examination.
"What's more disturbing is that many companies have stopped giving production and sales data and accounts of subsidiaries saying that they have applied to the Department of Company Affairs for exemption," says a research analyst.
Experts believe that these developments are not positive and investors should demand such information. Some firms defer the write-off of revenues expenses over 3-5 years instead of charging it in the year it was incurred by arguing that its advantage would accrue beyond a year. It only shows higher profits in the first year, while profits are lower in subsequent years.
The exception here is the FMCG sector, which does not carry forward advertising (brand building) expenses to subsequent years. The ideal route is to write off revenue expenses, including product development expenses in as short a duration possible, even if their advantage goes beyond a year.
Analysing accounts. The treatment of each item in the accounting statement means different things to different people. For instance, providing for ESOP expenses does not affect a lender but does impact the shareholder.
Likewise, a deferred tax is important for the lender as the company's obligation to pay the tax takes priority over the amount payable to the lender if the company winds up.
These are some of the popular methods of manipulating accounts. Personal judgment is required while analysing the accounts, and we need to make a choice while classifying these entries.
And lastly, it is advisable to read the account statements in conjunction with the auditors' report and notes to the accounts. These help in demystifying the accounting practices of the company so that you can see the true picture of its financial health before you put your money on it.