How companies cook up profit!!!

Why do companies
misrepresent accounts? Mainly because of the stock markets. Some
companies paint a healthy picture to get higher valuations at the
bourses. Listed companies are under pressure to report higher growth
rates, and some resort to accounting jugglery.

These are mere guidelines and the auditing company can only mention the
same in its Auditor's Report (attached with the annual report). Lastly,
a company can seek a court approval and the legal judgment can
supersede the accounting standard. Investors should ideally re-adjust
for these changes to arrive at a fair picture. To learn more about
unfair accounting practices, read on.

Write off: A
popular way of inflating profit is to write off business expenses. By
this, research and development, employee separation, miscellaneous
business expenses and so on are written off from balance sheet reserves
like general reserve and share premium reserve. The right way to
provide for every business related expense is to charge it to the
profit and loss account.

Companies use
some innovative methods of write-offs. Madhu Dubhashi, CEO, Global Data
Services of India (GDSIL, a wholly owned subsidiary of Crisil) says
that when companies make an investment (in shares, for example), there
is an accounting standard that there should be a provision for
diminution in the value of the investment under certain circumstances.

This
should be provided in the P&L account as per Accounting Standard
13. But many companies write it off against reserve, "which is not
correct". Likewise, companies also write off the value of impairment in
assets' against reserves.

Impairment is
basically the reduction in value of a fixed asset. Says Tridib Pathak,
CIO, DBS Chola: "Impairment of fixed assets should be passed on through
the P&L account and not by writing off of reserve."

Through
these methods of write-offs, companies manage to report higher profits
to the extent of the value of the expense, impairment or diminution in
that particular year.

Booster dose:
Companies can also inflate profits by manipulating the value of their
inventories. The correct way, say experts, is to value the inventory at
cost or market value, whichever is lower.

During
the past few years, many loss-making companies have entered into
debt-restructuring deals with their lenders who waive the loan taken
and the interest payable. Some companies show this as an income in
their P&L account.

Ideally, only the
interest waiver (if it was accounted as an expense in the P&L
account in earlier years) should be shown separately as adjustment for
previous years and the loan waived should be shown as capital receipt.
By not doing so, these companies manage to show lower losses or, in
some cases, even a profit.

Revaluation game: There
are other ways of ticking off accounts. Explains Dubhashi: "Eveready
Industries created revaluation reserve by creating a brand value, which
is not permitted by accounting standards.

Against
this fictitious reserve, the company has written-off bad loans and
advances as well as receivables - a double whammy! Firstly, there was
no reserve at all. Then real expenses were written off through
fictitious reserves. In any case, it should have been routed through
P&L."

This practice helped the
company project higher profits. Likewise, some companies resort to
revaluing their assets, which strengthens their balance sheet and
improves their ability to raise resources.

Redemption premiums:
Borrowing money for business through various instruments like
debentures and bonds is nothing unusual for companies. When such
instruments are issued, the company agrees to pay a premium on
redemption.

This is nothing but
cumulative interest, which should find its way to the P&L account.
However, some companies write off such expenses against the share
premium reserve.

Certain other areas
too warrant a closer look. If accounting policies are changed
frequently (the method of depreciation, for instance), it needs an
examination.

"What's more disturbing is
that many companies have stopped giving production and sales data and
accounts of subsidiaries saying that they have applied to the
Department of Company Affairs for exemption," says a research analyst.

Experts
believe that these developments are not positive and investors should
demand such information. Some firms defer the write-off of revenues
expenses over 3-5 years instead of charging it in the year it was
incurred by arguing that its advantage would accrue beyond a year. It
only shows higher profits in the first year, while profits are lower in
subsequent years.

The exception here is
the FMCG sector, which does not carry forward advertising (brand
building) expenses to subsequent years. The ideal route is to write off
revenue expenses, including product development expenses in as short a
duration possible, even if their advantage goes beyond a year.

Analysing accounts.
The treatment of each item in the accounting statement means different
things to different people. For instance, providing for ESOP expenses
does not affect a lender but does impact the shareholder.

Likewise,
a deferred tax is important for the lender as the company's obligation
to pay the tax takes priority over the amount payable to the lender if
the company winds up.

These are some of
the popular methods of manipulating accounts. Personal judgment is
required while analysing the accounts, and we need to make a choice
while classifying these entries.

And
lastly, it is advisable to read the account statements in conjunction
with the auditors' report and notes to the accounts. These help in
demystifying the accounting practices of the company so that you can
see the true picture of its financial health before you put your money
on it.