GAAP: a Game All Accountants Play

Sub Heading : June quarter has seen a host of companies adjusting profits

Author : Vivek Kaul & Khyati Dharamsi

Content : In the quarter ended June 30, 2008, Jet Airways declared a net profit of Rs 143 crore.
In an environment where oil prices have been shooting up and the airline industry does not have a great pricing power, the company surely has done well, right?
Wrong, because this has been a quarter were many companies have gone innovative on accounting — all of which are perfectly legal, legitimate steps; the only question is about the spirit in which it has been done.
What Jet did was to change its depreciation policy from written-down value (WDV) method to straight line method (SLM) on its narrow-bodied aircraft, which helped it write back Rs 923 crore to its profit and loss account.
Depreciation is essentially a 'non-cash' expense, which takes into account the reduction in value of an asset due to obsolescence, wear & tear etc.
Companies largely follow two methods of depreciation — written-down value or straight line.
"Depreciation keeps declining under WDV, while there is a uniform charge under SLM," said Hitesh Gajaria, executive director, KPMG India, the audit and consultancy giant.
In other words, if WDM is followed, chances are that in the initial years the company depreciates much more than if it were to follow SLM.
"Unless the nature of the industry is changing or there are new assets which depreciate on a slower basis, companies need not change the methodology. If the business continues to be the same and the company changes the calculation method to understate profits, it is fine. But if it is done to overstate, certainly not good," said the head of research of a leading brokerage, who did not wish to be named.
KPMG's Gajaria says companies would in most cases have a legitimate reason to explain why the switch over has happened.
"According to the Securities and Exchange Board of India norms, if there is any change in a method of accounting and if there is a material effect on the results following the change, companies must give reasons for it and quantify the effect that such a change will have," Gajaria said.
TCS, India's biggest software company, changed depreciation assumptions and boosted profit by Rs 50 crore last quarter.
Aniruddha Dutta and Anshu Govil of CLSA Asia-Pacific Markets say TCS did so by extending its depreciation policy on computers from 2 years to 4 years.
"Ultimately, if the change is done for reasons other than the assets or business itself changing, then there is only one reason why companies show a lower depreciation —- to overstate profits," says the broking house research chief.
Another tactic involves selling stake in a subsidiary to a group company and pocketing some profit.
Dutta and Govil point out in their report that Tata Motors transferred 24% stake in Tata Automotive Components, a company with revenues of $675 last fiscal, to Tata Capital, a group company, and booked a profit of Rs 110 crore in the June quarter.
Vijaya B Marisetty, senior lecturer at Monash University in Australia and a visiting scholar at National Institute of Securities Markets and the Indian School of Business in Hyderabad, says in the last one-and-a-half decades, "other means" have boosted flagging profit numbers of the Tata group companies.

"I checked for the correlation between earnings and the possible channels of earnings management for all Tata group companies for the last 15 years (about 1,500+ observations). There is strong correlation between earnings and 1) other income 2) extraordinary income and 3) miscellaneous expenses. Hence a partial conclusion can be made that when companies (in Tata group) do not perform well then their performance is boosted by other means," says
Or take the case of real estate major DLF.
The number one customer of the company is DLF Assets (DAL), which also happens to be a group entity.
As much as Rs 1,560 crore or 40% of the sales of DLF in the June quarter were to DAL.
What is interesting is the fact that the increase in receivables from DAL quarter on quarter was Rs 1,450 crore, a number very close to the sales to DAL during the quarter.
Write Dutta and Govil: "The share of DAL has increased during the quarter with DAL receivables increasing by Rs 1450 crore quarter on quarter. During 1QFY09, sales to DAL were Rs 1,560 crore, which is marginally higher than the increase in receivables from DAL."
The total receivables from DAL now stand at Rs 3,380 crore.
A high amount of receivables on the balance sheet of any company shows its inability to convert sales to cash. Meaning, profit remains just on paper.
Some companies such as Reliance Communications have boosted profits by not recognising translation losses on their foreign currency convertible bonds (FCCBs).
FCCBs offer investors a certain interest, as well as the option to convert the amount of debt raised, partially or fully, to equity.
The conversion is set at a certain price.
If at the time of conversion, the market price of the stock is below the issue price, it does not make sense for the investor to convert; he'd rather have his money back along with the accumulated interest.
Given this risk, it makes utmost sense for companies to plan for this and keep setting aside some amount of money every quarter for the eventuality of the investor not converting the debt into equity.
Currently the price of stocks of most companies are quoting at prices lower than the conversion prices of their FCCBs.
"The company has not recognised Rs 399 crore of translation losses on FCCBs, since the FCCBs can potentially get converted, although the FCCBs are out of money," Dutta and Govil said.
The bigger question here is what happens in the next quarter? Will companies have to find out newer ways of generating profits?
"This is only a one quarter effect. Investors need not worry if companies are making whole and true disclosure of the facts. More than the results, investors should look forward to views from the management on how the company is shaping up rather than the current quarter performance," says KPMG's Gajaria.
"But", says the research head of brokerage, "If you do it only once, there will be no meaningful change in the subsequent quarters. But not repeatedly."
k_vivek@dnaindia.net & d_khyati@dnaindia.net