The Investor’s Perspective
The last few months have unearthed a huge number of accounting scams in the world and especially in USA. Although this is not a new phenomenon what has come as a rude shock to markets and investors is the scale and the blatancy involved in these recent scandals. Most of these cases belong to the erstwhile reputed and giant companies and the ‘cooking’ done by them has surely left the investor with a very bad taste in his mouth. What has certainly not helped is the fact that the numbers involved are in billions and the fall of the company so meteoric that the investor had no time to take corrective action.
This note aims to provide the reader with a deeper understanding of some of the critical issues involved in this subject and the entire discussion has been presented with a clear focus on the Indian context. The key issues covered in this note are:
· Spread of scams: Are the recent discoveries just small blots on a largely clean slate or is there sufficient data to suspect that the practices are more prevalent?
· Methods used in these scams: Are these scams a manifestation of the loopholes present in the current accounting standards or is it a case of illegal accounting done in connivance with the auditors?
· Reasons for these scams: What are the basic reasons for the occurrence of these scams? Is the market itself partly responsible for these scams?
· Possible solutions: Now that these scams have surfaced, what are the various options available with the government and the regulatory authorities to protect the interest of the investor in future?
Spread of scams – How deep does it go
The following facts give an idea about the prevalence of such cases of:
· A recent study conducted last year by Global Data Services, a subsidiary of the credit rating agency CRISIL, has come out with alarming figures related to misreporting of figures. Out of 639 companies included for the study, 139 companies were found to have overstated their profits, some to the extent of 1000 per cent over the norms set by CRISIL.
· Department of Company Affairs (DCA) charged as many as 73 companies last year of fund-diversion, inadequate disclosure of information in balance sheets, misleading reports on utilization of funds/cash-flows and violation of accounting standards.
· Kanpur based Midas Touch Investors’ Association has prepared a list of 229 companies that have been identified as ‘having vanished ‘ with investors’ funds in the post 1993 IPO mania.
So even though some of the high-profile cases capture the attention of the investor, the problem is deep-rooted.
Methods used – the art of ‘creative accounting’
An understanding of the various ways in which the accounts are fudged, is helpful for investors so that they can take a well informed decision. Some of these methods are discussed here:
· The big path ploy: Taking a large write-off to book costs now and report earnings in the future
· The vendor financing ploy: Overstating revenues by lending to the fragile customers so that they buy more products and the sales are boosted
· The ‘before its time’ ploy: Treating pending sales as if they have already occurred and booking sales without reducing the rebates
· The backdoor bargains ploy: Promoting sales by buying a big customer’s stock or granting it cheap warrants
The list is not exhaustive and presents only the most common and easy ways to ‘cook the books’. The following is a description of some cases related to misreporting in the Indian context:
· Nestle India’s contingency provision swelled from Rs 42.08 crore in 1998 to Rs 103.8 crore in 2001 accounting for around 12% of Nestle’s total assets. This helped Nestle present a more stable growth in profit in that period and also left a sufficient buffer to cover up for a bad year in future.
· Hindustan Level Limited (HLL) has been using a method of accounting whereby it proportionately allocates the “restructuring charge” (charge related to mergers and disposals etc) to all the four quarters of a year to smoothen the profits. Also interestingly, in the forth quarter HLL finds that the restructuring costs have been lower than estimates and hence it is able to show better figures for year-end profits.
· Proctor and Gamble (P&G) Hygiene division explained its 42% slide in net profits in 2001-2002 compared to the previous year by mentioning in the annual report that the previous year’s figures contained an exceptional income of Rs 10.05 crore. Interestingly this fact was never mentioned in the annual report of 2000-2001 when the income was actually realized.
The list of cases that can be presented here is endless and contains renowned companies like Reliance, Ranbaxy, Dr Reddy’s Labs etc. It can be seen that if the so-called pioneers of the industry are indulging in such activities, then the state of affairs at the relatively overlooked second rung companies is not difficult to imagine.
Reasons for the irregularities – Do we look inwards?
It is not difficult to find out the reasons why companies resort to such practices. Some of the explanations are:
· Accountability of auditors: There is an inherent contradiction in this system that the auditors are paid by the companies themselves and hence the auditors are reluctant to present the actual figures due to the fear of the loss of the long term contact with the company.
· Misplaced priorities: Stock markets lay too much emphasis on the short term parameters of performance like ‘sales’ and ‘net profit’ of any company without giving adequate importance to the measures taken by the company to improve long term profitability. So companies are tempted to be short sighted to present good figures for the current period putting at stake the long term profitability of the company.
· Personal gains for Managers: Most of the managers at top positions have an ESOP component to their salaries which means that they gain directly by an increase in the share price. So they are tempted to present better figures in the markets.
It is fair that any instance of malpractice by a company should be condemned in the harshest of words and penalized by punitive action. But the markets and investors should also look inwards and see their contribution to the present state of affairs. May be there is a case for giving more importance to the long term steps taken by the company to increase profitability even if these steps result in slightly poor results in the short run.
Possible solutions – Belling the cat
There is an urgent need to restore confidence amongst the investor community by taking immediate and strong actions to curb the use of unfair practices used by companies in reporting financial figures. Some of the areas for improvement and the possible solutions are:
· Improving the accountability of audits: This can be improved by implementing a system where the auditors are not paid by the companies but by the stock exchanges as they have larger interest in getting the credible figures from the companies. Another option to look for is to implement a system where no auditor is allowed to audit the same company again in the next 5 years so that the business considerations do not come into the picture for the auditors. Also there is a need to stop the consultancy services offered by the auditors as the companies use it as a carrot to make the auditors close their eyes.
· Reworking the standards: Indian accounting standards are based on the Companies Act 1956. There is a need for a complete overhaul of the accounting standards and making them binding on all audit firms. Best practices from all over the world should be studied and the act should be changed to enforce stricter laws. SEBI should also be a part of this ‘overhaul’ committee to include the interest of the investors.
· New regulator: The Institute of Chartered Accountants of India (ICAI) has failed miserably in its role as the regulator and there is a need to create a separate regulating body which could comprise members from the RBI, SEBI, Comptroller General of India and of course ICAI. This regulating body should be given adequate power and the authority to enforce the rules of the game.