State of alert on window-dressing

“Everyone talks about the weather but nobody does anything about it”, said Charles Dudley Warner. Reports on companies by rating and research agencies were often equated with weather reports — the weatherman’s predictions and reality are a study in contrasts.

The question as to why the global rating agencies did not raise an alarm on Lehman Brothers’ lopsided balance sheet — a document that is believed to have precipitated the economic crisis — remains unanswered.

The Canadian research firm Veritas was probably the first to try and shake off the weatherman tag by grounding Kingfisher as a company long before the airline grounded its aircraft. Similar reports reportedly emerged on some Reliance group companies.

Macquarie questioned HDFC Bank’s accounting practices in what was an about-turn from their stand on the same company weeks before their report. The latest to join this list is Credit Suisse which has taken on JSW Steel. The company’s debt was understated on three counts: acceptances of Rs 7,500 crore are, in effect, debt; securitised receivables of Rs 3,100 crore are also debt; and Rs 1,200 crore from the fall in the rupee adds to the debt.

Research reports, initially focused on predictions of an entity’s share price, are now talking about accounting practices, corporate governance and risk mitigation strategies.

Standard response

Companies prepare a standard reply to questions on such reports — “the company prepares its annual financial statements in accordance with Indian generally accepted accounting principles. It presented its balance sheet for the year ended March 31 in conformity with the revised Schedule VI of the Companies Act, 1956. The classification of assets and liabilities and recognition of income and expenses in its financial statements was in compliance with accounting regulations and consistent with the practice followed by the company. The company strongly objects to these misleading statements. These financial statements have been audited by a reputed firm of chartered accountants”.

This leaves the shareholder befuddled — does he sell his holding based on the report of the rating agency, or does he back the company that has doled out decent dividends in the past? Between the agency and the company, who is right? Or are both partially right?

Differing standards

The first issue on which the shareholder needs to feel assured is that there is no blatant violation of accounting policies by the company. The confusion seems to arise because of an alternative set of accounting standards — International Financial Reporting Standards (IFRS), which are not mandatory in India.

In the case of HDFC, for example, consolidation of subsidiaries is not mandated by Indian accounting standards, but by IFRS. It is possible that the company was looking at the financial statements with India-GAAP eyes but the agency was using IFRS-eyes.

Accountants would know that acceptances, endorsements and obligations form a contra entry in the balance-sheet of a bank — they appear on both sides of the balance-sheet, thereby having no monetary impact. If the reporting of the bank on JSW Steel is accepted and acceptances are shown as debt, would the counterparty to the transaction show this as a loan receivable? An answer to this question would solve the mystery.

The Companies Accounting Standards Rules has always taken a different path from Accounting Standard 11 on foreign exchange gains and losses — while the former permits capitalisation of gains/losses till 2020 (the rationale for which remains a puzzle), the latter mandates routing these through the profit and loss account.

The difference of opinion seems to arise because of interpretations of accounting standards. Both, the rating agency and the company could help here by being more explicit and detailed in their comments and replies, respectively. With auditors getting more and more careful and conservative, chances of a gross violation of accounting standards not being reported would be remote, unless the auditor in question has decided to throw both caution and career to the winds.

The Ministry of Corporate Affairs could help by ensuring that the road-map to transition to IFRS doesn’t remain a road-map for ever.

In an era wherein even the till-now sacrosanct Libor has been found to have been managed, it is natural to expect research agencies to red-flag even an interpretation difference.

Investors and shareholders should consider research reports as a ready reckoner on what they could have missed while analysing their investment. However, they would be well-advised to do their own research on the comments before deciding on their investment.

(The author is a Bangalore-based chartered accountant)

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