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Sunday, May 05, 2002

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Accounting for a better earnings picture

Aarati Krishnan

IN THE uncertain world of stocks, consistency is a prized attribute. Consistent growth in reported earnings is one reason why a Hindustan Lever or a Nestle India is bestowed a price earnings multiple (PEM) of around 30 times earnings, while the more volatile Marico or Nirma have to be content with a single-digit PEM.

But this does not necessarily mean that Hindustan Lever or Nestle India operate in a less cyclical or economically sensitive business than Marico or Nirma. In fact, the sluggish, or even shrinking, market for some categories of fast moving consumer goods has put immense pressure on the larger companies, forcing them to report single-digit or even declining sales growth over the past two years. Yet, both Hindustan Lever and Nestle India continue to enjoy an unimpeachable track record of double-digit profit growth.

Both companies owe much of their smooth earnings trajectory to a slew of cost-saving and supply chain initiatives, which have kept profit margins rising at a higher rate than sales. But that is only part of the story. If HLL and Nestle India have seen their earnings rising steadily quarter after quarter, this is also partly due to their accounting policies. For both companies, discretionary charges have played a role in ironing out sharp jumps in earnings from quarter to quarter.

There are a host of instances of other companies which owe their consistent or flattering earnings performance not to their operations but to their accounting treatment of it.

Playing it

too safe?

Take Nestle India, for instance. Every year, the company sets aside a significant portion of its earnings as "provision for contingencies" for "matters arising out of litigation or management discretion". The provision varies significantly from year to year and, indeed, from quarter to quarter. Over the past three years, Nestle India has drawn very little from this provision, yet it has supplemented it liberally each year.

In 1999, 2000, and 2001, Nestle India set aside Rs.14.9 crore, Rs.30.77 crore and Rs 27.92 crore towards the contingency provision. But it drew just Rs 70 lakh, Rs 1.31 crore and Rs 9.83 crore from it in those years. Between December 1998 and December 2001, this provision swelled from Rs 42.08 crore to Rs 103.80 crore, and accounts for around 12 per cent of Nestle's total assets.

It remains to be seen whether Nestle finds a use for this provision some time in the future. But it has certainly helped the company in one respect. But for this provision, Nestle India would have had far more volatile earnings than it has had otherwise.

To illustrate, in the four quarters of 2001, Nestle India reported growth figures of 45 per cent, 18 per cent, 21 per cent and 37 per cent in its profits before taxes, after charging off a provision for contingency in each quarter. Without this discretionary provision, the growth in Nestle's profits before taxes for the corresponding period would have been at 63 per cent, 15 per cent, 10 per cent and 3 per cent respectively in these quarters.

Restructuring for a smooth ride

With a slew of mergers and disposals evenly spread out across quarters, a steady stream of exceptional incomes have kept HLL's bottomline robust, over the past year. But what has added to the discretionary element in HLL's financials is the "restructuring charge" which it takes to its accounts. HLL has regularly taken a charge for restructuring costs in each quarter. But until recently, this charge was not the actual restructuring costs incurred by HLL for the quarter. Rather, HLL prepared quarterly accounts after taking a "proportionate restructuring charge" based on "estimated" restructuring charges for the full year.

This has helped HLL report more consistent quarterly earnings. After the restructuring charge, HLL's profits before tax for the four quarters of 2001, grew by 18 per cent, 16 per cent, 15 per cent and 17 per cent respectively. Without the charge, the growth rates would have been 13 per cent, 11 per cent, 9 per cent and 14 per cent for the same periods.

Typically, in the closing quarter of the year, HLL finds that the actual restructuring costs have been much lower than estimates. This leaves HLL with a relatively small restructuring charge in the closing quarter, magnifying its profits. In the first quarter of 2002, thanks to a new accounting standard on interim financial reporting, HLL has put an end to this practice, charging restructuring costs to the quarterly accounts on the basis of actuals rather than estimates.

To defer or not to defer

If there is one area where companies have considerable room for tinkering, it is in accounting for advertising and promotional expenses. Such expenses are usually spread out over the estimated period during which benefits from the expense are expected to accrue.

In consumer-centric businesses, advertising and promotional expenses typically account for 8-10 per cent of sales, and the way in which these expenses are charged to the accounts can make the difference between a profit and a loss. But how the company accounts for its advertising and sales promotion expenses is largely left to its discretion.

If awash in profits, a company can choose to set off its entire brand-building expense in the year in which it is incurred (which is what the FMCG bigwigs do). Or it can defer the expenses to a later period when the profits are in a position to absorb the charge.

Henkel SPIC, which is on the verge of a turnaround, has recently changed its accounting policy to charge off brand-building expenses in the year in which they are incurred. The balance sheet, however, carries deferred revenue expenditure (mainly relating to accumulated marketing spends of previous years) of around Rs 65 crore.

If amortised, these expenses would certainly push the company into the red. In 2001, Henkel SPIC's net profits amounted to Rs 5.83 crore. The company reported its net profits before amortising Rs 19.54 crore pertaining to marketing spends of the earlier years. The company is now considering a proposal to set off the accumulated expenses against its share premium account, in which event Henkel SPIC's profits will be freed of the burden of amortisation in future.

Henkel SPIC has a precedent in Tata Engineering, which recently charged off a total of Rs 1,180 crore in deferred revenue expenditure and erosion in the value of investments, against its share premium reserves. The whopping write-off certainly helped purge Telco's balance sheet of some of the deadweight. But it also helped boost Telco's future profits, which would otherwise have had to bear the burden of amortisation for some years to come.

Charging off for a rainy day?

If companies have the flexibility to charge off or defer brand-building expenses at their discretion, similar is the case with expenses on research and development.

Indian pharma majors Dr. Reddy's Labs and Ranbaxy Labs have seen a quantum jump in their earnings in the past few quarters, as they made significant a break-through in the export markets for generic drugs.

Over the past quarter, both companies promptly announced changes in their accounting policy for research, registration and product development expenses. Instead of deferring these expenses over the estimated period of benefit (as they have done so far), the companies now propose to charge off these expenses in the period in which it was incurred. This move may only marginally tone down the heady profit growth for these companies in the current period, but the lower R&D charge will definitely help bolster profits when profit growth slips to a lower trajectory.

In its March 2002 quarterly results, MICO states that it was hitherto charging depreciation to its quarterly financials on a pro rata basis considering "planned additions to assets for the full year". That is, it was charging off depreciation on assets it did not yet own! But thanks to the recently promulgated Accounting Standard on Interim Financial Reporting, MICO has now switched over to a system of charging depreciation based on actuals.

Stashing income in "other expenditure"

If anything, the above represent the more acceptable cases of earnings smoothing, where accounting flexibility has been used to project a more conservative picture of earnings. But there are other one-off instances where creative accounting has helped project a flattering picture of earnings performance for a quarter.

Despite sluggish sales growth and a limited product basket, P&G hygiene and healthcare has had an enviable track record of consistent earnings growth. But profit growth suffered a sharp blip in the just-concluded March 2002 quarter, as profits after tax slid by 42 per cent. The company was quick to point out that the corresponding quarter of 2001 carried a exceptional income of Rs 10.05 crore, without which net profits would actually have grown 12 per cent. However, the company certainly omitted to mention this fact in the March 2001 quarter.

In an unusual accounting treatment, P&G actually reduced the exceptional income (from a write-back of provision) from its expenditure for the March 2001 quarter, in the process ramping up its operating profit margins. P&G' s accounts for the quarter did not disclose the fact, leaving analysts rhapsodising about the quantum jump in its operating profit margins in that period.

Clearly, companies have a host of accounting weapons, which can make the quarterly earnings ritual seem like a bit of a farce. How does an investor arm himself against being misled? Read the accompanying story.

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