A dozen ways of inflating profits, valuations

A dozen ways of inflating profits, valuations
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First Published: Sun, Jan 25 2009. 11 50 PM IST

Updated: Sun, Jan 25 2009. 11 50 PM IST
Mumbai: The spotlight remains firmly on corporate governance issues two weeks after the founder of Satyam Computer Services Ltd, B. Ramalinga Raju, confessed to doctoring the company’s books to the tune of Rs7,136 crore in India’s biggest accounting scandal.
While investigating agencies try to unravel the fraud, Crisil Research, an arm of credit rating agency Crisil Ltd, the Indian associate of Standard and Poor’s, found there are at least a dozen ways a company can creatively cook the books.
Also See Accounting Issues (Graphic)
Crisil Research came across these loopholes by studying the notes to account and footnotes in the annual reports of companies. While most of them would probably not amount to a violation of the law in letter, at least some are breaches of the law in spirit.
“To call them malpractices would be harsh. The companies are just exploiting the loopholes that exist in the law,” said a partner at a Mumbai-based firm of chartered accountants, who didn’t want to be identified.
Listed below are the ways companies exploit these loopholes, collated after discussions with Crisil Research and at least two company secretaries of Mumbai-based firms:
Write-off expenses from reserves: Expenses towards research and development or money paid to employees or provision for taxes as part of a voluntary retirement scheme must reflect in the profit and loss (P&L) statement. Companies can show it as a one-time expense or amortize it over several quarters. In practice, many Indian firms take the easy way out by writing these off or deducting this amount from the reserves. This means expenses are understated in the P&L account and consequently, current profits look rosier than they are.
Show previous year’s expenses as this year’s income: By writing off a one-time expense against reserves, a firm can inflate its profits. If for some reason, the company doesn’t have to incur the expense (in case of tax provisions), it writes this expense back into the books. But instead of adding it to the reserves from where this amount was originally deducted, the company can show it as income in the P&L account, thus increasing profit.
In good time, firms can suppress profits by setting aside money for unforseeable expenses such as doubtful debts and possible liabilities on pending legal claims (court orders expected against the company) all of which have a high probability of happening. Hence, the amount is shifted from the P&L account to the balance sheet. When the company faces turbulent times, the same provision is written back by reversing the entry and is recognized as income.
Essentially, this amounts to transferring income from one year to another. This could also result in tax planning by deferring taxes as the rate of tax in subsequent years could be lower.
Revalue assets to write off losses/expenses: This works if a company has enough reserves in its balance sheet. If it doesn’t, it can “create” some reserves either through brand valuations (using professional valuers) or by “revaluing” their existing assets to inflate the reserves. So now, the company not only has an inflated profit and loss, it also has an inflated balance sheet without spending any money.
Revalue assets to write off transfer value: Imagine a company called Veritas, which has an associate or subsidiary called Satirev. Now, Veritas has three machines (assets) and wants to transfer one to Satirev without accepting any payment. In other words, it wants to gift away an asset. How does it do it? After transferring one machine, Veritas will revalue the remaining two machines (increasing their value by 50% each) so that the balance sheet remains balanced. Alternatively, Veritas will revalue its holding in Satirev to make up for the value of the asset it transferred.
Show loan waiver as income: One should look for this, especially in the books of companies that have accumulated losses and have got their outstanding debt restructured. Very often, as part of this restructuring, debtors waive a part of the outstanding loans to help the company turn around sooner. Instead of showing this as part of the balance sheet, some companies book it as income for the year.
Transfer loans to associates: Sometimes, companies transfer outstanding loans to associate companies. This helps them lower the debt-equity ratio—a measure of how leveraged a firm is.
A lower debt equity ratio helps firms borrow more. Still, since they have to repay the original loan, it is shown as a “contingent liability”, which is defined as an obligation that must be met, but where the probability of payment is minimal.
Transfer fixed assets to current assets: Yet another way of revaluing assets. A corporate balance sheet typically has fixed assets (such as land, machinery) and current assets (cash, bank balances, receivables). Under the pretext of selling a piece of machinery, a company might transfer a portion of its fixed assets to current assets. Now, fixed assets are often valued at book value or the price at which they were bought. When they are transferred to current assets, they can be done at market price. If market prices are more than the book value, the difference could be shown as income, which again boosts profit.
Continue with dead projects: When a company starts a new project such as building a factory, it is allowed to capitalize expenses, which means whatever it spends on the project is shown as investment in the balance sheet.
During times of slowdown, the project may become unviable, yet the company might continue to show it “under implementation” so as not to add to the expenses in its P&L account.
Inventory valuation: Often, the closing stock of goods for a manufacturing firm is valued at higher than the selling price. This is against the law, both in letter and spirit. Firms desperate to show profits resort to such a practice, say experts.
Inflate sales: Higher sales growth results in higher profits. This also eases working capital financing from banks. At the end of each accounting period, the inflated sales are reversed as sales returned and rebooked with a lapse in time as sales to a different client and at revised prices, thereby further inflating the value of sales in subsequent years.
Sale/lease back of assets: Firms sell utility assets such as diesel generator sets, boilers and office buildings to leasing and finance companies and get cash up front. The same asset is then leased back to the company which pays a monthly lease rental. The company benefits as such rental is a deductable expense for tax calculations.
Change depreciation policies: This is done to postpone or advance taxes/profits as depreciation is an expense which is non-cash in nature and does not impact cash balance available for business operations but saves tax outflow.
The objectives behind all accounting adjustments range from boosting profits after tax to raising valuations, suppressing revenues for tax purposes and even getting higher bank financing.
Graphics by Sandeep Bhatnagar / Mint
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First Published: Sun, Jan 25 2009. 11 50 PM IST