How companies play with accounting

policies to their advantage

Anand Adhikari

September 8, 2011

In late 2010, the directors of Mumbai-based Bajaj Corp, part of the Shishir Bajaj Group,
were pleased. Their company's Rs 297-crore initial public offering, or IPO, had done well,
and the board was eager to tackle bigger challenges, such as acquisition opportunities, that
were among the objectives of the IPO. But first, they had to decide how to treat IPO
expenses - a tidy Rs 20 crore - in the account books. The decision was important, as it
would affect profitability.
Bajaj Corp, a mid-sized hair oil company, had three options. The first was to charge the
expenses to the share premium account, where almost Rs 294 crore lay idle, in the balance
sheet. This would have no effect on profitability. The second was to amortise them equally
over five years, which would marginally affect the bottom line. And the third - setting off the
expenses against the current year's profits - would wipe out more than 20 per cent of the
profits for 2010/11. Given the slowdown in the domestic economy and the sluggish stock
market, the first option seemed the best. Bajaj Corp's stock, which debuted in August 2010
at Rs 800 per share - the offer price was Rs 665 - was already showing signs of weakness.
But Chairman Kushagra Nayan Bajaj voted for the third option. One of the directors voiced
concern about how investors might react. Dilip Maloo, Chief Financial Officer and Vice
President, Finance, explained that the third option would save on taxes and improve
liquidity within the company. Amortisation would yield similar results, but over five years, he
said. The directors unanimously agreed to Bajaj's proposal. Sure enough, investors were
underwhelmed: by January 2011, Bajaj Corp's stock had dipped to around Rs 500, down
almost 40 per cent from its debut. The Sensex actually gained two per cent in the same
period. Had Bajaj charged its IPO expenses to the share premium account, profits for
2010/11 would have crossed Rs 100 crore, and the stock would almost certainly have
outperformed the Sensex.
The decision was a bold move, as many companies crank out quarter-to-quarter profits with
an eye on the short-term reaction of the stock market, unmindful of the cost of playing to the
gallery. The proposal of the 34-year-old chairman was thus remarkable for its restraint and
conservative approach.
Contrast this with the approach of Indosolar, a Delhi-based solar cell manufacturer, which
had a Rs 357-crore IPO about a month after Bajaj Corp's issue. Indosolar already had a
policy in place to amortise preliminary expenses, of which a few crore rupees were still
outstanding at the time of the IPO. But it suddenly changed the policy when accounting for
the IPO expenses of Rs 33.58 crore: it decided to charge them to its share premium

account.
That meant the total outstanding expenses, some Rs 36.27 crore, would be set off on the
balance sheet, and not in the profit-and-loss account, for 2010/11. The company was neckdeep in losses (Rs 57 crore in March 2011). The decision to charge IPO expenses to the
share premium account prevented losses of a few more crores from going on the books.
Indosolar refused to comment when BT asked about the change in its accounting policy.
Indosolar is a classic example of how companies play with accounting policies to their
advantage. Chameleon-like policies make a company's accounts harder to understand,
and confuse investors and shareholders.
Wrong message to investors
In July this year, Veritas, a Toronto-based equity research firm, launched a scathing attack
on mobile phone services provider Reliance Communications, in a report that said: "The
company has inflated its EBITDA, EPS and book equity." It added that year-onyear
comparability in most instances was compromised because of "whimsical accounting policy
changes". Such accounting practices, if true, send the wrong message to global investors.
India will soon comply with International Financial Reporting Standards, or IFRS. This
means companies here will adhere to the same accounting standards that much of the
world follows. It will bring uniformity and greater transparency to Indian accounting, help
attract investment into India and also help Indian companies raise money overseas. "Global
investors look for reliable information that will only come from using the best accounting
standards," says Dolphy D'Souza, Partner at Ernst & Young India, or E&Y. "Local investors,
too, want more reliable and transparent information."
The rising number of auditors' qualifications in accounts statements indicates the
deteriorating state of Indian accounting standards. In good times, high profits keep all
stakeholders happy, and in bad times, accounting policy tweaks come to the rescue.
Today's business environment is uncertain, because input prices are high, interest costs are
ballooning and demand is slowing. Keeping profitability intact, then, is a challenge. Some
companies are responding by passing up the best practices in favour of more convenient
options under India's Generally Accepted Accounting Principles, or GAAP. Strong corporate
lobbying against the IFRS has already pushed back India's April 2011 deadline for
convergence with global standards to an indefinite date.
The investing community is, of course, pushing for IFRS implementation. However, N.
Venkatram, Partner at Deloitte Haskins & Sells, points out that "many advanced nations,
such as the United States and Japan, have also not moved to IFRS". Some African
countries have not done so, either. But about 100 countries have adopted these standards,
and India can ignore them only at its peril. "If we delay, we will miss out on the economic
advantage," says D'Souza of E&Y.
India has decided to converge with IFRS, which means it will make some changes in the

standards, rather than adopt them wholesale. Convergence will have a major impact on
many accounting standards, such as revenue recognition, capitalisation of expenses, fair
value and acquisition accounting. In particular, stringent revenue recognition norms could
give many mid-sized companies a headache. Under the Indian GAAP, revenue for the sale
of goods is recognised based on the company transferring significant risk to buyers. In other
words, a company only has to dispatch the goods to account for the revenue. But under
IFRS, revenue recognition is based on the actual delivery of goods to the customer. In the
case of construction contracts or large engineering goods, revenue is recognised based on
the stage of completion, which is marked by milestones. Companies adopt different
milestones for revenue recognition, depending on the nature of contract and the degree of
customisation.
Take the case of Suzlon Energy, Asia's third-largest wind turbine maker. For the financial
year 2010/11, Suzlon decided not to align the revenue recognition policy of its overseas
subsidiary, REpower, with its own, although it had been doing so earlier under the Indian
GAAP. Suzlon has been facing rough weather since 2008, because of the global recession
and concerns over the quality of its turbine blades. "REpower's revenues were earlier
computed by applying Suzlon's milestones for revenue recognition," says Suzlon's Chief
Financial Officer Robin Banerjee. The company says the nature and level of customisation
of the contracts of REpower and Suzlon are different, and maintains that there is no change
in the group's revenue recognition policy. "The change is in the process of consolidation of
revenues," explains Banerjee. The result of this consolidation is that Suzlon's revenue for
2010/11 is higher by Rs 974 crore, and net profit by Rs 109.57 crore. So Suzlon's first
glimmer of good news in a while came in 2010/11 - but with remarks from the auditors, SNK
& Co. and S.R. Batliboi & Co.
Under IFRS, companies will have to follow the same revenue recognition policy for the
parent and subsidiaries. Differential accounting treatment under the Indian GAAP leaves
substantial room for subjectivity, and gives companies the licence to twist accounting
policies to suit their convenience.
Another example of questionable accounting practices is the way in which some
pharmaceutical companies treat research expenses. Under both the Indian GAAP and
IFRS, research expenses are capitalised only after the company is certain that the new
drug is ready for the market, and after it applies for the approval of the drug regulatory
authority. And yet, many Indian companies capitalise research expenses even before
clinical trials are over. When capitalised, expenditure goes directly on the assets side of the
balance sheet, with no impact on the profit-and-loss account. If it is not capitalised, it
appears on the profit-and-loss account and lowers profits.
Biotechnology firm Panacea Biotec is a case in point. Auditors S.R. Batliboi have inserted a
qualification with regard to capitalisation of expenditure on clinical trials, which added up to
nearly Rs 60 crore for 2010/11. The management justifies it by saying it is confident that the
products in trials will be commercially viable.

Analysts uneasy
Besides investors, analysts, too, are concerned. In May this year, analysts grilled the top
management of Delhibased infrastructure and energy conglomerate Punj Lloyd, including
Chairman Atul Punj, because there have been auditors' qualifications in its accounts every
year since its December 2005 IPO. One analyst asks: "Why don't we see similar auditors'
qualifications in the annual reports of Larsen & Toubro, Gammon India, Hindustan
Construction or IVRCL? Is the company's accounting treatment too aggressive?" Punj Lloyd
defends itself by saying it has a good track record of receiving disputed claims through
arbitration. "We have never lost a case, barring maybe a couple of cases related to tax,"
said Luv Chhabra, Director, Corporate Affairs, Punj Lloyd. He cites the example of a case
pertaining to Pipavav Shipyard, in which the auditors' qualification was dropped.
The Pros and Cons of IFRS
India was supposed to implement International Financial Reporting Standards, or IFRS, by April 2011. It
has deferred this indefinitely, and insisted on many modifications to the standards - accounting boffins
call them 'carve-outs' - as they relate to areas such as agriculture, real estate, financial instruments and
goodwill. It makes sense to adapt IFRS to the realities of a particular country, but a large number of
carveouts defeats the purpose of global standards.
An example of necessary tweaking is China's decision to modify the IFRS on 'related party transactions' to
reflect state ownership of many companies on the mainland. The 'related party' clause will not necessarily
apply to Chinese companies. But in India's case, the European Commission, an executive body of the
European Union, has warned that the country risks "creating a country-specific version of the IFRS that
differs from those used worldwide".
Among those who defend India's right to choose its own accounting standards is N. Venkatram, Partner at
Deloitte Haskins & Sells, a global consulting firm. "Every government has a responsibility towards its own
economy," he says. He cites the example of India's conservative standards for banking, saying they
ensured the sector was rock-steady when the global downturn traumatised the industry worldwide.
Dolphy D'Souza, Partner, Ernst & Young India, has a different view. "The initial modification may be a
starting point, but ultimately, the market reality will bind India to adopt IFRS in totality," he says. Many
accountants and analysts agree that the main concern that global standards seek to address is clarity in
accounting, so that companies do not take investors for a ride. Where there is scope for differing
interpretations, they say, the standards tend to be principle-based. IFRS may not be able to put a
definitive end to accounting jugglery and auditors' qualifications. However, D'Souza says: "Given that
many countries have already adopted IFRS, ambiguity and the scope for multiple interpretations are
substantially reduced."

Repeated auditors' qualifications point to the larger issue of corporate governance, and the
sustainability of the business in the long term. But is it fair to fault accounting standards?
"Existing Indian standards are robust, and have served us well over the years," says
Deloitte's Venkatram. The laxity of independent directors can also enable creative
accounting. Consider the case of Kolkata-based Dhunseri Petrochem & Tea. In March this
year, a fire broke out at the raw material storage facility at the company's plant in Haldia,
West Bengal, disrupting operations, and causing the loss of inventory, fixed assets and
production. Dhunseri filed an insurance claim for Rs 65 crore, and wanted to include this
amount under 'other income' for the financial year ending March 31, 2011.
Dhunseri's auditors Lovelock & Lewes insisted on a qualification, because the amount that
would be approved by the insurance company was not received. The claim remained
unsettled beyond the end of the financial year. But Dhunseri's audit committee, which

included the independent directors and Executive Chairman C.K. Dhanuka, insisted the
money be shown as other income for 2010/11, on the grounds that other companies had
done similar things before. Another reason given was that if the insurance claim were not
shown as income, profits for 2010/11 wouldbe depressed, and the next year's profits would
be inflated. By accounting for the unrealised claim in 2010/11, Dhunseri increased its other
income from Rs 81 crore to Rs 146 crore, and its profits, from Rs 76 crore to Rs 127 crore.
With regard to insurance claims, there is again an element of subjectivity under both the
Indian GAAP and IFRS. In a case like Dhunseri's, if certainty levels are high, the insurance
claim should be immediately recognised. If they are not high, it should not be recognised.
Global implications
In an age when Indian corporations run global companies, accounting practices should be
conservative rather than aggressive when there is an element of uncertainty. Bharti Airtel,
Infosys and Wipro are among the few Indian companies which voluntarily follow global
financial reporting standards.
"Nothing stops Indian companies from adopting IFRS on their consolidated accounts," says
D'Souza of E&Y. The Securities and Exchange Board of India, or SEBI, allows listed
companies with subsidiaries to publish consolidated financial results in accordance with
IFRS. But apart from information technology companies, few others do so. "IFRS is more
relevant to companies which have international operations, or who wish to raise capital
overseas," says Venkatram of Deloitte. There is no dearth of such companies in India.
A bad accounting policy can devastate a company, as the cases of Enron, WorldCom, Tyco
International and AIG have shown. Regulators are becoming more proactive. For example,
SEBI quietly did investors a favour last month by making it mandatory for listed companies
to announce fourth quarter results along with audited annual results. Some companies had
been conveniently filing only annual results, and not fourth quarter results - an unhealthy
practice that makes it harder for investors to gauge quarter-to-quarter performance.
Accounting standards are like signs on a long highway - the driver has to make the right
judgment.
Venkatram argues for maturity in disclosure standards. "We need better enforcement," he
says. Independent directors, market regulators and other stakeholders - especially domestic
and foreign institutional investors - need to be vigilant and challenge promoters if they stray
from the road. Satyam Computers became India's first information technology company to
adopt IFRS, way back in 2008. History has shown that it was not enough.