In recent times, many companies have resorted to inflating their numbers in keeping with their reputations or to meet investor expectations. What started as a trickle is now a full-fledged practice. Fortunately, equity analysts have been quick to sift through annual reports and flag instances of creative accounting. Here are some of the more common fudges in corporate India's accounting standards.
Foreign exchange gains/losses
You can have a long-term debt in a foreign denominated currency, or on the asset side of the balance sheet, you can have an overseas investment exposure. Both situations can lead to notional gains or losses. Until recently, there was no uniform standard for recognising profits and losses in various situations in the profit-and-loss account.
Besides, the corporates that routinely use forex hedges (forwards and derivatives) to manage forex risks pose an additional problem of how to recognise the realised and unrealised gains and losses on these exposures. While some strict (and welcome) changes have been made in terms of accounting standards, there are still fears on hidden/undeclared forex losses of many listed companies.
FCCBs: Interest and redemption premium
For many years now, companies have raised money in foreign currencies via convertible bonds. Typically, these bonds carry a very low coupon rate such as 0% or 1% and are redeemable at a huge premium, so that the yield-to-maturity value for the bond holder works out to 6-7%. The company hopes that the redemption premium will never be incurred by it since the bond holder will opt for conversion to shares.
Meanwhile, in the stock market, conversion is often not sought since the conversion price is lower than the prevailing CMP (current market price). In such cases, the redemption premium paid is routed 'below the line' (by charging it to share premium account, instead of reporting it in the profit-and-loss account ).
While this is the prescribed practice, it's unfair that such a charge on borrowed funds should not be reported in the profit-and-loss account uniformly across the life of the bonds. Even if the bond conversion to shares takes place, the discount to CMP implies that such issuances should be expensed like stock options.
Advances and investments
One of the most important determinants of shareholder value creation is capital allocation, that is, how a company reinvests the cash it generates. Redeployment in productive assets, such as plant and machinery, especially if the incremental business can be executed at a similar or better profitability, can quickly lead to multi-bagger stock performance as profits compound. Obviously, such opportunities are not uniformly available across all businesses. Many companies routinely divert the cash surplus from a profitable business to a cash guzzler, only to kill their own shareholder value.
Typically, such (mis)allocations of capital can be found by scanning the investment schedule in their balance sheets. Since investors have figured this out, the more creative companies often resort to making unjustifiable advances to group entities, which show up in the loans and advances schedule under the broader category of 'current assets'. There is nothing remotely current about such assets, since they are invariably share capital advance money or apparently short-term loans given to (often undeserving) parties, who enjoy the benefits of such funds for extended periods of time.
Acceptances
A simple word like this in the current liabilities schedule can send shivers down the spine of investors, especially if a bloating is visible. Acceptances are short-term liabilities that the company accepts and promises to pay such claimants in the future. The danger is that these liabilities might extend beyond the normal scope of trade payables incurred in the normal course of business.
For example, a short-term loan availed of to retire long-term debt can theoretically fall under acceptances. This helps the balance sheet in many ways. Firstly, long-term debt is understated as a result of diverting the liability to the current liabilities head rather than the debt head. Hence, the total capital employed (net worth plus debt) in the balance sheet effectively falls and artificially improves return ratios such as RoCE or RoA.
Secondly, the increase in current liabilities reduces the net working capital (CA-CL), which improves the apparent cash flow from operations. Again, this is artificial, since in a few days after the balance sheet date, the company will probably resort to switching the acceptances with proper long-term debt.
Thirdly, under-reporting of debt has the effect of boosting fair market capitalisation, and hence, fair value per share, wherever analysts attempt to estimate fair EV (market cap plus debt) as a multiple of EBIDTA. All other factors remaining constant, the effect of under-reported debt will be to boost fair market cap. Hence, the target price of the stock (calculated by a less-than-diligent analyst) would rise with no sane rationale.
As the Indian accounting standards are set to approach global standards of checking fraudulent practices, especially with the IFRS (International Financial Reporting Standards) convergence, some of these malpractices will hopefully end. Moreover, Sebi needs to lay down strict laws to combat this menace.
Even the Indian accountants and analysts will have to continue to set the bar high for accounting standards in such a way that corporates find it increasingly difficult to get away with a less-than-fair disclosures of numbers to investors.
0 comments