Policymakers must tighten rules on expense accounting

Macquarie Capital Securities India (Pvt.) Ltd’s latest report on Housing Development Finance Corp. Ltd (HDFC) raises some important issues related to accounting treatment of certain expenses.

Macquarie analysts Suresh Ganapathy and Parag Jariwala said HDFC adopted aggressive accounting practices in the last two years, resulting in inflated earnings and return ratios. This was done by passing certain loan provisioning through its reserves and adjusting the interest cost for its zero-coupon bonds through reserves rather than showing them in the profit and loss statement.

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A report on mortgage lender HDFC says it used aggressive accounting methods over the last two years. Mint’s Mobis Philipose says the government will need to tighten rules to tackle this problem.

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HDFC isn’t the first company to offset expenses against reserves. There have been several other examples in the past. In HDFC’s case, it used the provisions of section 78 of the Companies Act, which allow companies to “write-off the premium payable on the redemption of any redeemable preference shares or of any debentures of the company against the securities premium account”.

When this is applied to a zero-coupon or a deep-discount bond, it enables a company to avoid passing its entire interest cost on a loan through the profit and loss statement. HDFC’s argument is that funds raised from the bonds were used to invest in subsidiary companies and that its share of profits in these companies isn’t fully reflected in its reported profit either.

But it’s quite likely that investors value these subsidiaries on a stand-alone basis and add this to the company’s sum-of-parts value, or consider consolidated profit, which takes into account the share of a subsidiary’s profit.

Similarly, when the National Housing Bank increased provisioning norms for certain loans, HDFC adjusted it against additional reserves. Prudence demands that any expense incurred by a company must get reflected in the profit and loss account. Even if the expense is capitalized, it must get reflected by means of depreciation, amortization or write-offs.

As pointed out earlier, HDFC isn’t the first company to keep some expenses out of its profit and loss statement. In the past, Tata Motors Ltd offset accumulated product development expenses against reserves, instead of amortizing them and passing them through the profit and loss statement through the useful life of the underlying asset. Similarly, Tata Steel Ltd offset its accumulated voluntary retirement scheme expenses against reserves.

More recently, Hindalco Industries Ltd routed the impairment in the value of its investment in Novelis Inc. through its reserves, rather than taking a hit on the profit and loss statement. Not that these are the only companies doing so, but these are among the biggest examples in terms of the amounts involved.

In each of these cases, the companies relied on the courts to approve their scheme of capital restructuring and reduction, presumably because they couldn’t do so under existing laws and regulations. The observation of the Bombay high court in the Hindalco case is instructive. “The court cannot interfere with the discretion and commercial wisdom of the stakeholders and the board of directors,” it said.

Since Indian companies have shown they can get aggressive when they want to with accounting treatments, this matter must be decided by policymakers, including the ministry of corporate affairs and the markets regulator Securities and Exchange Board of India.

Section 211 3(A) of the Companies Act states that every profit and loss statement and balance sheet must comply with accounting standards. That should go without saying, but it appears that sub-section 3(B) provides a way out, stating, “Where the profit and loss account and the balance sheet of the company do not comply with the accounting standards, such companies shall disclose in its profit and loss account and balance-sheet the following, namely: the deviation from the accounting standards; the reasons for such deviation; and the financial effect, if any, arising due to such deviation.”

Chartered accountant Jayant Thakur says even the listing agreement must be more tightly worded to ensure that right disclosures happen, if accounting standards have not been complied with by resorting to court-approved schemes. The disclosures should have enough details to bring out the exact financial implications year after year.

But he adds such disclosures are the second best option, and that in an ideal scenario, no deviations should be permitted.