Activist Analysts vs Aggressive Accounting!
We don't have activist investors in this country, yet. But, in recent months, a new breed of activist analysts have sprung up. To illustrate let me use 3 recent research reports that caused much anguish to the companies they covered.
Macquarie accused HDFC of adopting aggressive accounting practices by passing provisioning through reserves and also adjusting for zero-coupon bonds through reserves instead of the P&L account. Due to which it said earnings have been overstated by 38% in FY11 and 24% in FY12. In other words, earnings growth has been managed.
HDFC responded strongly saying, its accounts are as per Indian GAAP and consistent with its long term policy. HDFC also questioned the timing of the Macquarie report pointing to a May 7th report by the same firm that rated HDFC as outperform based on the same facts and figures.
Espirito Santo counted a third instance of aggressive accounting at Biocon. Biocon deferred revenue from a deal termination that Espirito thought should have been recognized as a one-off revenue item in that period itself. And though the report admits that accounting standards do give flexibility in recognizing such deferred revenue it also criticizes the company for aggressive accounting that will lead to consistent over-reporting of EPS to the tune of 20% every year during FY13 to 15.
Biocon responded saying ” the accounting method followed is in compliance with GAAP and appropriate disclosures have been provided. Auditors have drawn reference to this method of treatment ‘as matter of emphasis’.
And finally just this week a Credit Suisse report said JSW Steel had understated its debt by 119 billion rupees. Credit Suisse then revised its comment to say the “debt effectively higher”. JSW maintains its financial statements are in accordance with Indian GAAP and consistent with the practices being followed by the company for years.
All this brouhaha over accounting practices leads me to ask this week – are companies too aggressive or analysts too activist? What numbers should investors believe? To answer that I have with me veteran auditor PR Ramesh, Chairman of Deloitte India, Sai Venkateshwaran, Partner & IFRS Practice Leader, Grant Thornton and Chirag Talati, Analyst at Espirito Santo and author of the Biocon report.
Doshi: My first question goes to you- before that a caveat, I know that your firm is involved in both the HDFC audit as well as some audit aspects of JSW, there is some degree of conflict there, so I appreciate you may not comment directly on some of those issues but broadly speaking, based on what I have stated, what is this- a case of aggressive accounting by India Inc or a new breed of activist analysts that are finding things to pick at?
Ramesh: I think I would agree with you in the second part of it, perhaps we are seeing an emerging breed of activist analysts.
Doshi: Are you saying that in a complimentary fashion or are you saying that they are maybe taking it a bit too far?
Ramesh: Again complimentary or what is not complimentary depends on how it impacts me finally.
Doshi: You or the company?
Ramesh: No, as a professional.
Doshi: But as a senior auditor, you would be delighted that if something within audit practices is creating concern within the analyst community, they are at least today finding the voice to flag it.
Ramesh: True. Whilst I would always encourage different points of view but what is important is to distinguish between what is fact and what is opinion. I would always prefer that an analyst states the facts only because opinions would depend upon having full information. Particularly in accounting, when you have two accounting choices- let us say you have two or more, now the fact that one chose a method over the other is a matter of fact. So when an analyst presents, he could say that look if this accounting were done, this would be the picture and if this accounting were done, this would be the picture. It is not appropriate for an analyst to say this is conservative, this is aggressive because today we are not in a world of conservatism, we are in a world of fairness because if I am a shareholder today and if the accounting is conservative, why should I be impacted and somebody later benefit.
Doshi: Would you agree with that view and when you answer that question please also remember that in all three reports that I have cited, the analysts have said that these companies are following accounting practices but yet they have turned the accounting practice aggressive. So for instance let us take the Macquarie case, they have said that what HDFC is doing is not outside the accounting standard but then they have cited the comparison with LIC Housing Financing- it passes its provisioning through the P&L and not setting it off against reserves and thereby creating some peer group pressure, what do you make of this?
Venkateshwaran: I think if you look at Indian GAAP, I think the way Indian GAAP today exists; it does give multiple alternatives in certain circumstances in certain areas. I think there is ambiguity in terms of what the guidance is So let us say if you take the example of one of the instances that has been quoted in the Macquarie report relating to the utilization of the securities premium account, now it is an accepted Indian practice and something that is in keeping with the Companies Act in terms of what you can use that securities premium account for. So the premium on redemption securities can definitely be…(Interrupted by Anchor)
Doshi: So you are saying this option is available to the company, the company has used it and therefore there is nothing wrong with it.
Venkateshwaran: Technically there is nothing wrong.
Doshi: But you are using the word technically. There is a caveat.
Venkateshwaran: Yes, so there are multiple choices available and another company could very well choose to go down a path of expensing all of that thoroughly.
Doshi: As an auditor, when you audit a company, leave aside HDFC, when you look at the company’s financials what do you check them for- whether they have technically abided with the accounting standards or whether they have done it in the true spirit of accounting standards?
Venkateshwaran: When we talk of true spirit, I think the spirit kind of differs from GAAP to GAAP. So if I am looking at it from an international perspective …(Interrupted by Anchor)
Doshi: We are talking Indian GAAP, we have not moved to anything else yet.
Venkateshwaran: Yes, so Indian GAAP I think these are two perfectly kind of …(Interrupted by Anchor)
Doshi: What do you look for, technical adherence or spirit?
Venkateshwaran: I would say that both of these are technically correct and I think the spirit – it is in line with the spirit of what is in the standard. So long as the disclosures are made, I think the intelligent reader should then make his analysis and say okay, if I adjust this to the interest cost, this is what the interest would look like but I don’t think there is anything wrong with what the company has done.
Doshi: You represent the new breed of activist analyst. There are many of them so more power to you- are you being too activist if there is anything like being too activist because here is Mr Ramesh saying if you have a different opinion than what the company has done and if both opinions are within what the standard provides, then just lay out your second opinion there as opposed to labeling practices as aggressive or not conservative whereas Mr Venkateshwaran is saying what is the harm if you pick one out of two or three options that the standard in fact does provide you, why would you call that wrong?
Talati: Our opinion is that when you look at accounting, firstly, from an analyst point of view and an investor point of view, there are no direct shades of black or white, there is always a grey matter involved and that is why an analyst or investor comes in. It is up to the judgment that we apply. When I say that it is being aggressive or it is being conservative, the fact is we are already laying out two different options because when we are saying earnings would have been overstated by 20%, it is saying that in scenario B, which we think should have been adopted by the company earnings would have been this. So indirectly we are already addressing the point.
Doshi: When you use words like overstatement or in the other instance there is the use of the word understatement which was eventually rolled back- the first private sector rollback I have seen- when you use words like that, you are flagging something to the investor. Now who is the investor supposed to believe- you and your opinion or the company and its auditors who seem to believe that what is being done is fair practice?
Talati: When we laid out our corporate governance report or when we flagged out this note on Biocon or Educomp or others, this has come out in response to investors’ request. It is not something that has come out of Espirito Santo wanting to write something radical or be radical. This has come out in response to a lot of foreign institutional investors coming up and saying, look this is a country that is dominated by promoters, we represent minority investors who are sitting 6,000 miles away not sure of what is going on in India. We need some handholding; we need some clue as to what is happening within the company. Now that is where the corporate governance score card comes into play but when we talk about accounting, when as analyst we try to say that in companies trying to be too aggressive, we have looked at the company from a point of view international peers or Indian peers and when somebody kind of tries to be out of the practice, then it is a point that needs to be raised for investor.
Doshi: That is an important point you have raised. I will open that up to everybody on the panel- in the case of HDFC, there was a comparison drawn to LIC Housing Finance, I am not saying LIC is the last word in how accounting should be done but nonetheless in the case of Biocon, you said that several domestic pharmaceutical companies do not account or do not use the same practice that Biocon has and therefore Biocon stands out in the option that it has chosen, right?
Doshi: What do you make of this then the fact that peer group companies are doing it differently?
Ramesh: No, that is again what is peer group doing? I am not getting into specifics again but if the industry leader treats a matter in a particular way and an entity which is a smaller entity within the same industry does it differently, do you say the industry leader should follow the smaller entity or the smaller entity should follow the industry leader, what was industry …(Interrupted by Anchor)
Doshi: I don’t know, actually I don’t think it is necessary that industry leader in size or in customer acquisition is necessary the industry leader and best governance practices either, right?
Ramesh: Exactly. He used shades of grey, black, white- it is almost like implying that you shouldn’t dye your hair and look younger, it is wrong just because ten other people dye hair, why is it wrong?
Doshi: Okay, answer this question for me, on the Biocon matter his report says that we are not saying this is against accounting standards right?
Doshi: And yet, they point out to the fact that the auditors of Biocon have drawn an emphasis of matter or matter of emphasis however it said in accounting language, right? So that is a flag that the auditor itself is raising. It is not as bigger flag as a qualification but it is a flag nonetheless. Ordinary investor may not understand what this means, is the auditor saying this is a good practice, it is a bad practice, it is an objectionable practice, so they are doing the service for the investor to try and clarify what it means?
Ramesh: Let me clarify. In general, an auditor makes an emphasis on a matter of paragraph. It is not a flag. His first point is he is saying it is not a qualification- that means he concurs with the accounting treatment. However, he also says here is an important accounting; you need to be aware of this important accounting in the context of the financial results. So in a way you are laying down the facts, you don’t need to sit in judgment there because if it is in compliance with accounting standards of the law why should an auditor sit in judgment and say this is aggressive, this is conservative?
Talati: We say that we are here to provide that judgment for investors to help them say whether it is aggressive or conservative because finally it is their money involved.
Ramesh: You could have a situation as an analyst aggressive and other would say it is conservative- do you mean to therefore say, a company should take an opinion poll and then do accounting? It is not practical. If a company changes its accounting policy then one can look at and say there is a motive for change but when the accounting policy is consistently followed and within the accounting choices irrespective of which year it is and what the results look like then why should somebody say it is aggressive or conservative?
Doshi: Let me ask another question- this may come from accounting ignorance, but is it that our standards provide too many options that companies can pick from, therefore there is a great deal of discretion at the hands of companies and their auditors and therefore it doesn’t allow for comparables across companies, across the world in that sense. Could it be that or could it be that international standards are stricter when they view things like these or transactions of this nature or require further disclosures, which if applied in the instance of several of these companies, we wouldn’t have been at this table discussing this anyways?
Venkateshwaran: Absolutely, I fully agree with that. I think the fact is that Indian standards, the way they are today, I think in a lot of areas there are shades of grey, there are multiple choices available, there are guidance setting with these standard and probably another guidance setting within let us say the companies are concerned …(Interrupted by Anchor)
Doshi: You are the IFRS Practice Leader of Grant Thornton; does that offer you an equal number of options?
Venkateshwaran: I think in IFRS I think its more application of …(Interrupted by Anchor)
Doshi: How would these three companies have accounted for, what they have accounted for, however, objectionable it was to the analyst under IFRS?
Venkateshwaran: Probably in some cases it might have been somewhat different and again I think …(Interrupted by Anchor)
Doshi: So did even closer to what the analysts had expected?
Venkateshwaran: Not necessarily, but what has happened is that under IFRS I think there is a lot more of application of judgment and every significant judgment requires a detailed disclosure in the financial statements to enable users to clearly understand how a transaction has been accounted and what are the key areas of judgment behind that and what’s the reason why management has accounted for a particular transaction in a particular way. Indian GAAP hasn’t evolved to that level where it has all those disclosures and you also have several of these multiple choices that are available. So, a company chooses some of those alternatives and it is not backed by adequate level of disclosure because it is not mandated.
Doshi: Is that the problem here? Mr Talati, is it that the standards offer you too much choice or is that the companies are picking the wrong choices or is it that if they were picking these choices, but were accompanying them with extensive disclosures, then you would not feel that aggrieved and would not term their accounting practices as aggressive?
Talati: I think it’s a combination of all these factors. The fact that Indian GAAP has lot of differences compared to IFRS, you cannot directly compare it with international peers. At the same time, in all the three cases or in our case as well what we are saying is that the application could have been different and the numbers could have been different and that’s what investors should look at.
Ramesh: What is wrong? Let me give you an illustration. Depreciation on assets, if an asset cost is Rs 100 it has to be depreciated over its life, say if the life is 10 years. There are two or more ways of doing it, one is to charge Rs 10 each year, over 10 years. The other has to do in a written down value method where you will have higher depreciation in earlier years, lower deposit. Now at some point in time an analyst may say that is aggressive or that is conservative, but those are two choices and if you look at industry practices it will vary. So if you get into accounting and its choices and its application and sit in judgment on its application, I think it would be completely inappropriate.
Venkateshwaran: In the case of one of these reports, one, we are trying to compare GAAP numbers with non-GAAP numbers. So for instance acceptances if you look at the revised Schedule VI, revised Schedule VI by definition requires that to be classified under trade payable, so it is what the company has done and every peer company in India …(Interrupted by Anchor)
Doshi: So you are saying that the research report was misguided in believing that it should have been accounted for its debt, to put it simply?
Venkateshwaran: Yes, now if you look at international practice and maybe from an international trader’s perspective when he sees acceptances, he says we need to look beyond that because acceptances could take the color of trade payables; it could take the color of borrowings depending on the facts and circumstances. In some circumstances that could …(Interrupted by Anchor)
Doshi: There are trade payables and then some of them borrowing?
Venkateshwaran: Yes, so here I think somebody needs to actually look at the underlying fact patterns. But the fact is when you have, let’s say a revised Schedule VI, which lays down a format in which the GAAP information needs to be presented in financial statements and when a company has done that I think to put out a analyst report saying that this is not in line with accounting principles seems to be somewhat misguiding.
Doshi: Mr Ramesh, accounting is not a science, its an art- is that the claim that you are making and if that is that case then the picture you all are painting doesn’t appeal to Mr Talati and his colleagues. Let me put it that way. How do you reconcile this from an investor’s point of view?
Ramesh: Accounting is neither a science nor an art; it is the language of business. Accounting does have choices, so one needs to reach a situation where there are very limited or perhaps no choices and a single accounting language across the world - that’s the panacea.
Doshi: Till we don’t get there, since we haven’t even gotten close to IFRS at this point, what do you make of what firms like Espirito Santo, a Macquarie or Veritas are doing in terms of raising flags for investors even if you don’t like the terminology “aggressive”?
Ramesh: Yes, I definitely don’t like the terminology “aggressive” as I repeat they should just lay down the facts.
Doshi: You agree with that Mr Venkateshwaran?
Venkateshwaran: I think ultimately we all need to because in a principles-based kind of environment that we are in a way living in, I think key judgments that are taken by management need to be appropriately disclosed and an analysis of that judgment which is to be made by the research analyst and document the result report, I think should just lay down the facts and say okay these are the …(Interrupted by Anchor)
Doshi: So you are saying the same thing as Mr Ramesh. But let us admit it Mr Talati, when you add aggressive accounting to your report or you say understating debt, that is what captures attention, is that why research firms are doing this?
Talati: To be fair there is a lot of media attention as well that these reports get and a lot of these reports get quoted out of context because media does not necessarily go into a fourteen pages report on accounting. But if I were to agree with these two gentlemen saying that we should just lay out facts, then fact would be that we should just lay out facts not write a buy or sell, we are out of jobs. We are here to make judgments about a value of a company or what the company is doing and at the end of the day that is what we are doing over here.
Doshi: So I will close by saying maybe the language can be toned down but I am just glad that more vigilant analysts make for more vigilant investors.