Accounting requirements for Indian companies are primarily governed by accounting standards notified under Companies Act, 1956. Additionally, the Institute of Chartered Accountants of India provides guidance notes and there are opinions from the Expert Advisory Committee. Other provisions of the Companies Act and guidelines from the Securities and Exchange Board of India also apply in certain areas. These requirements, together, are commonly referred to as Indian GAAP (Generally Accepted Accounting Principles).

While GAAP evolved over time, its application is inconsistent for various reasons. Thus, in several cases, though GAAP may have technically been followed, there is a question whether the practices result in a fair reflection of the financial results and position.

Losses adjusted through reserves: Several companies have used court-approved merger schemes to follow practices that would otherwise not be permitted by GAAP. For example, as a part of court-approved schemes, companies routinely write off goodwill or other assets; or create reserves to absorb future expenses and losses. Such adjustments through the balance sheet and reserves overstate current and future profitability. In fact, due to this practice, SEBI amended the listing agreement for listed companies, calling for an auditor’s certificate that the accounting prescribed in the scheme complies with accounting standards. However, several companies continue to carry large reserves from previous schemes to absorb expenses and losses.

Capital reduction schemes, permitted under specific provisions of the Companies Act, are another area where losses due to write-down of assets are adjusted against reserves.

Understatement of interest costs: Several companies elect to adjust redemption premium or discount on issue of debt through reserves, and not through earnings. Here, the true cost of debt is not reflected in earnings. Diversity also exists in the timing for recognition of redemption premium on convertible debt, with some companies opting to recognise it only on actual redemption. These companies view the redemption premium as a contingent liability, as the holder may elect to convert the debt instead of seeking redemption.

Capitalisation of foreign exchange differences: Several companies elect to capitalise foreign exchange differences on borrowings related to acquisition of fixed assets. Similarly, exchange differences on other long-term borrowings are not recognised immediately but deferred over the borrowing term. In both cases, exchange gains and losses are not immediately recorded in earnings.

Depreciation: Many companies depreciate their assets using the minimum statutory rates without properly assessing the useful life of the assets. This may result in assets being recorded in the balance sheet even when they may not be in active use.

Mark-to-market on derivatives: In the absence of specific guidance, many companies do not fully record the mark-to-market losses on non-FX (foreign exchange) derivatives. Further, while some companies record mark-to-market gains and losses on FX derivatives through earnings, others may opt for reserves using the principles of ‘hedge accounting’. Practice also varies on the quality of documentation to support such ‘hedge accounting’.

Sale of receivables with recourse: There are instances where companies remove ‘sold/discounted’ receivables from the balance sheet even though they may have provided recourse to the ‘buyer’ of the receivables. In substance, these are financing transactions, as the financier has recourse to the company in the event of a default by the debtor.

Treasury shares: Some companies have created ‘treasury shares’ through merger schemes and reflect them as investments in the balance sheet. There have been some instances of companies recording ‘gains’ when such treasury shares are subsequently sold. International practice is to treat such transactions as buyback of equity with the resultant cost treated as a reduction of reserves. Any subsequent sale is treated as fresh issue of capital.

Consolidated financial statements: As consolidated financial statements are not mandatory on a quarterly basis, many companies report only standalone results. This may not reflect the financial results for the group as, amongst other things, inter-group transactions are not eliminated.

Exceptional items: It is common for companies to reflect non-recurring or unusual items as exceptional. While at one level this could result in better reporting of recurring results, companies sometimes elect to regularly classify items as ‘exceptional’, thereby smoothening earnings.

The practices discussed above have resulted in a situation where financial statements prepared in accordance with GAAP may not correctly reflect the financial results and position. In recent times, several analysts and the media have highlighted this issue. Timely action by regulators would benefit the investor community and infuse transparency into financial reporting.

Jamil Khatri is Global Head of Accounting Advisory Services, KPMG in India

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