FCMH (On-line)

Sessions to be conducted by SABYASACHI SENGUPTA (XLRI)

Module Number III
Number of Sessions in this Module FOUR (4)
Title of this Module “Financial Reporting Related Issues”

Scheduled Dates and Time Slots November & December 2020 – 08.00 PM Slots
(November 2020 – 29th)
(December 2020 – 1st, 6th, & 8th)

MODULE NUMBER III (Session Number 15)

CREATIVE ACCOUNTING PRACTICES

A whistle stop tour through the world of corporate cosmetics.

(It is being, hereby acknowledged that the following three examples have been quoted from an
article titled “Labyrinth” by Shishir Prasad and Avinash Celestine).

Defer revenue expenses and write them off against reserves in future.
Here’s what it means. Suppose you have entertained some friends at an expensive restaurant. The bill is huge.
You convince the restaurant owner that you’ll pay him next month. He knows you and agrees. Now is the tough
part. How do you explain the big splurge to your spouse?

You hit upon a new idea — let me not show the expense in this month’s household accounts. The next month
you dip into your savings to pay off the restaurant owner. Once again the monthly budget does not show the
effects of the grand party. But, it shows in your savings and it is likely that your spouse is not looking there. In
other words the Profit and Loss Account remains unaffected while the balance sheet takes a hit.

A renowned company in the Indian Automobile sector used this method a couple of years back. It wrote off Rs
1178 crores of deferred revenue expenses on its big dinner party, namely, the development cost on one of its
prime model car. Had this been written off against profits the company’s losses would have more than doubled
as compared to the reported results in the previous year. Instead the company ended with a modest book profit
of Rs 53 crores in the year such accounting treatment was made and this was publicized as the most spectacular
turnaround story of recent times.

Now, strictly speaking, such accounting treatment does not contradict the provisions laid down in the Indian
Accounting Standards. Even rating agencies did not object to the same and the above company managed to
obtain a good corporate bond rating in that year.

Go in for big bath accounting

It’s not that writing off expenses and debts against reserves is necessarily a bad thing. Or that writing it
off against the profits is necessarily a good thing. Let us explain. Suppose you do tell your spouse that
you gave that big party to your friends. The monthly expense statement would shoot up. The household
budget is in tatters. Domestic peace is threatened. But, bliss returns soon after and it’s time for the next
month’s expenses to be totted up. “See” you say, “We’ve got expenses dramatically down this month”.
The opposite party has forgotten why they had gone up last month and is actually quite impressed.

That’s what an Indian Financial Institution did a couple of years back. It wrote off Rs 813 crores of bad
loans against its profits. Profits fell by 55% as compared to the previous years. Now, as almost the
major chunk of bad loans was written off at one stroke in that financial year, next year did show a
marked increase or hike in profits, which actually appeared very impressive to the investors.

The huge write off was far in excess of the norms and guidelines specified by The Reserve bank of
India (RBI) in this respect. It may be noted that RBI guidelines on prudential norms only specify the
minimum amount to be written off and the organization is not precluded from going for higher write
offs depending on management judgement, which is a subjective parameter in general.

Book inter - divisional sales as revenues

There is an old puzzle in economics. Why is it that national output increases when you hire a cook or a
driver and falls when you marry her or him? There is no change in the economic situation, but since
the cook or the driver is now a part of the family unit, there is no payment for her or his work. Hence,
national output is deemed to have fallen.

Absurd, isn’t it? Companies take advantage of this absurdity to pump up their top line or total
revenues. The way this is done is by counting inter- divisional sales as revenues. One part of the
company sells it to another and books the revenue. So the wife pays the husband for driving and the
husband pays the wife for cooking. The total family income goes up. Which is quite convenient for a
couple seeking housing loan.

An Indian manufacturing company has been accused of increasing its sales this way in recent years.
One of it division sold capital equipment to another. This sale was accounted for as revenue. What’s
interesting is that this company has been doing this for at least last three years or so. The percentage of
such inter divisional sales had been going up over the years and when it came to light, such sales
accounted for 25% of total sales.

In a press release the company management had commented that the inter-divisional sales represents
the direct cost of material, labour and overheads only and no profit element had been loaded and thus,
the bottom line had not been affected.

Creative Accounting
Reasons & Repercussions)
The most obvious reason for indulging in creative accounting practices is to maintain the stock prices. It would
not be an exaggeration to comment that the need to meet expectations of stock markets is promoting creative
accounting practices all over the globe. Secondly, there are incentives for meeting expectations. In other words,
it translates into senior management and CBO compensation. Thirdly, robust earnings ensure that credit ratings
are high and borrowing costs are low. Finally, a company is planning share issue (IPO or otherwise) good
earnings may ensure commanding a high sometimes, undue premiums.

Essentially, for the above noted reasons, companies gently cook their books. However, whether the books of
accounts are gently cooked or roasted, it’s always the investors who get burnt in the process.

Accounting Screens
(Useful tool in identifying creative accounting practices)
Analysts at Clear Capital – a part of the UK based Noble Group, developed a set of accounting screens that they
used in a report of September 2008 to assess possible uses of creative accounting. An article published in the
Business World, titled ghosts in the Balance Sheet” (2 nd Feb 2009) bad used these five metrics model to
identify cases of possible earnings management in the Indian context.

The Five Metrics Model

Are a Company’s percentage growths in cash flows from operations increasing as
Booking Revenues in fast as its percentage growth in EBITDA? If there are significant differences
Advance between the two, there are possibilities that the company is booking revenues
without corresponding cash flows.

Are the other incomes as a percentage of investments showing consistent results

Shoring Up Operating over the years? In case the percentage of other income on investments are
Revenues showing significant drop there are chances that the company is diverting non-
core revenues to its top line revenues.

Reimbursement of Loans As a general thumb rule, if more than 1% of company’s loans and advances
to related parties account for loans given to related parties it might indicate that cash is being
pulled out of the firm by promoters with some ulterior motive.
Shifting expenses away Already discussed in depth in our PPT on Creative Accounting Practices. Please
from the current period refer the PPT for details.
Mismatch between Material mismatches in terms of the Revenues, Profits & Cash Flows between the
quarterly un-audited un-audited quarterly results and audited annual results should logically raise a
results and annual red flag and may make a case for probing or digging deeper into the financials of
audited results the company.