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 If
corporate America's explosive series of accounting frauds have shocked
you, wait till the unmentionable hits the ceiling in India Inc.
Things could be far worse. True, you may not find the kind of multi-billion
dollar shenanigans that have rocked companies like WorldCom, Xerox,
Enron and others but in terms of its prowess in the dirty tricks
department, India Inc. ranks rather high. A recent McKinsey survey
of 188 companies drawn from the emerging markets of India, Malaysia,
Mexico, South Korea, Taiwan, and Turkey, rated Indian companies
at the bottom of the list in terms of transparency. The criteria
for determining transparency was disclosure and auditing.
That's a grim picture. Now here's the beef.
We list out the some of the most common sleight-of-hand tricks that
companies play on unsuspecting investors. And lest you feel that
as a retail investor you can't do much about them, an accompanying
box gives you a primer on sniffing out the fishy business. But first,
the games corporates love to play.
TRICK #1:
The art of bloating the topline
Or simply booking sales when there aren't any.
This apparently brazen trick is most common among consumer durables
companies, which are usually hard-pressed to meet sales quarterly
targets. The modus operandi is simple: stocks are shipped out from
the factory to the dealers and, although actual transactions don't
happen, sales are booked. After the quarter ends, the goods could
be shipped back to the factory. Some large companies book intra-divisional
sales of assets in the P&L account. So even if an actual sale
doesn't occur, a movement of goods or services from one division
to another shows up as increase in the topline.
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BEYOND BALANCE SHEETS
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| How do you know
that there's more than what meets the eye in a company's accounts?
BT provides investors a checklist of how to spot common accounting
tricks.
Look beyond the obvious. "Don't
go by the face value of accounts presented by the company;
read between the lines and come to meaningful conclusions,"
advises Rajesh Mokashi, Executive Director, care. It helps
to look at figures in the context of the industry.
For example, a software company might depreciate its computers
(assets) at a much faster rate than an FMCG company. First,
the rate of obsolescence is very high for computers and, since
a software company's business is dependent on that, it has
to upgrade faster than an FMCG company.
Read, read, read. A common
mistake some investors make is to go through the numbers in
an annual report with a fine toothcomb but ignore all the
written stuff. Like the chairman's report, the directors'
report and the critical notes to accounts.
The notes to account and the auditors' report give details
of most of the adjustments that are made in the accounting
statements. The length of the auditor's report itself can
raise some doubts about a company. To get a true picture of
the accounts of a company, you have to read these notes. Typically,
notes mention changes in accounting policies and other non-recurring
adjustments. Some companies even mention what key figures
would have looked like if the adjustments were not made. It's
important to read the notes to get the correct perspective.
Learn the basics. Learning
how to read a balance sheet is crucial, particularly if you
invest in stocks or other securities yourself and don't depend
on fund managers. Consider companies that push goods to their
dealers to boost their toplines. If you check sundry debts
and the break up of the sales figure, you may be able to see
the true picture.
Do your own clean-up job. Once
you know how to read a balance sheet well, you could de-adjust
the accounts and unravel the real financial position of the
company. Says Mokashi: "You can re-adjust below-the-line
expenses, bringing them above the line and make all the adjustments
you want to arrive at a value you think the company deserves."
Check the cash flow. Accounting
norms anywhere in the world permit companies to be flexible
while making their financial statements. The best example
is depreciation. Depreciation on fixed assets is an important
expense and part of the P&L account. There are two widely
used methods of calculating depreciation-the straight-line
method (SLM) and written down value (WDV). While companies
are legally allowed to adopt any one of these methods, income
tax authorities favour the latter. A company following the
SLM method will charge lower depreciation, resulting in higher
profits on the books for investors to see. A small adjustment
in depreciation can make a change in the profit figure. The
time-tested way to gauge a company's profitability is by looking
at its cash profits rather than its net profit. Analysts worldwide
use cash flow as an important indicator of corporate performance.
Ask questions. Most companies
now have investor relation departments that will assist you
in getting additional information about the company. If you
have doubts about a company's statement of accounts, just
ask for clarifications.
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TRICK #2:
Simulating income streams
With quarterly disclosures now mandatory, companies
are under a lot more pressure to meet their projections. If results
don't match projections, a company's stock price suffers. So companies
do a nifty adjustment. In a good quarter, when revenues are higher
than projections, they make extra provisions for expenses, which
can be conveniently written back when the going gets tough. There's
even a term for it in accountant-speak. Says Rajesh Mokashi, Executive
Director, care: 'This is called 'income smoothening process'. Income,
though not predictable, is made so artificially."
TRICK #3:
The big bath syndrome
Last year, when most banks made a killing through
treasury operations because the debt markets were buoyant and gave
supernormal returns, many of them grabbed the opportunity to write
off large expenses or losses that were sitting in their books for
a while. Some wrote off non-performing assets, others long-standing
expenses. In accountant-speak this is called the 'Big Bath' and
is resorted to by companies usually when they ramp up supernormal
profits in a particular period. There's nothing wrong in that. But
as an investor it pays to see why a company's profits suddenly spikes
and what it does with the bonanza.
TRICK #4:
A below-the-line trick
A favourite trick of accountants is to capitalise
expenses-that is, not show them as part of the P&L account.
It's a common way of understating expenses and, thereby, increasing
profits. So even if a sum is actually revenue expenditure, it is
shown as a capital expenditure and hence doesn't feature in profit
and loss account. Instead it is set off against reserves. Companies
that have racked up huge expenses in past years can use this trick
to fatten its bottomline, at least seemingly.
What should be worrisome for investors is that
all of these tricks and their innumerable variants are legal. You'll
find companies switching the methods of computing depreciation from
the written down method to the straight-line method, capitalising
expenses in one year and accounting for them in the P&L account
in the next year, treating recurring costs as investment... the
list can go on. But nothing is illegal. Indian accounting norms
are malleable ones and, as for creative accountants, there's no
dearth of that breed in India Inc.
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