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| The quarterly corporate results season is now over, and many investors have taken the decision to invest or get out of a stock based on a company's performance in the last quarter.
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| If results exceed expectations, investors buy more of the stock, and if they miss earnings expectations, they dump it.
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| Very often, though, investors base their decisions on little more than the headline earnings numbers.
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| How correct are these numbers? Does it make sense to invest on the basis of the published net profit and earnings figures alone? Are annual published accounts really a statement of accounts or a presentation of analysis?
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| These questions have recently been examined by Global Data Services of India Ltd (GDSIL), a corporate data-crunching subsidiary of rating agency Crisil.
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| GDSIL has brought out a three-volume work on "Accounting & Analysis - the Indian experience"*, that attempts to answer such questions.
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| GDS' analysis points out that accounting for ESOPs, deferred tax liabilities, valuation of goodwill, valuation of impaired assets and the treatment of contingent liabilities, while being perfectly legal and according to the accounting standards, may be more of a statement of opinion than of fact.
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| Changes in the accounting treatment of these issues could result in profits being very different from the published figures, in spite of the fact that there's no difference in the amount of cash flowing in or out of a company.
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| For example, consider contingent liabilities, which few investors take into account. Yet GDSIL shows that several companies' contingent liabilities form a very high proportion of their net worth.
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| Similarly, guarantees given on behalf of subsidiaries and affiliate companies can be substantial, as shown in Table 2.
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| Also, a number of companies assign their own debt to others, although they remain liable to pay these debts.
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| For instance, L&T has, over the years assigned its debt to a subsidiary, and the difference between the outstanding loan amount and the transfer value has been shown as income for the year in L&T's books. GDSIL has computed L&T's profits in FY 2001 and 2002 to be Rs 50 crore and Rs 40 crore higher on account of the loan assignment.
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| Deferred tax assets are yet another area where the management's perception of future profitability can be used to alter the bottomline.
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| A number of loss-making companies have been able to lower losses for FY 2002 or even show profits instead of losses because of provisioning for deferred assets. (Deferred tax assets could arise due to items such unabsorbed losses, unabsorbed depreciation etc.).
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| GDSIL has pointed out that a number of loss-making companies are actually able to lower losses for the year or even show profits because of provisioning for deferred assets.
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| Most investors know that "other income" or non-core income should be taken out of earnings to indicate the quality of earnings.
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| GDSIL estimates that in FY 2002, as many as 54 companies would have incurred losses without the contribution of non-operating income. Table 4 is an illustrative list of such companies.
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| In FY 2002, well-known companies such as Telco (now Tata Motors), M&M and Bombay Dyeing adopted the practice of writing off large amounts of miscellaneous expenditure and other deferred expenditure directly through the share premium account.
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| Consequently, annual write-offs in the P&L account have been eliminated and the profits of subsequent years will, therefore, show an increase. The point is that such practices make comparison of the headline earnings figures difficult.
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| GDSIL's report also points to several other areas where their interpretation of accounts is different from the published figures, after taking into consideration adjustments for diminution in value of investments, capitalisation of interest and other intangible expenses, exposure to subsidiaries and many other issues.
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| They have then re-calculated profits after making these adjustments, and have found that there was a difference of 15 per cent or more in the profits of 70 companies.
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| The key takeaway from the GDSIL study is that there's no alternative to go deep behind the published net profit figures if the investor wants to make an informed decision.
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| Alternatively, he could discard profit and concentrate on cash generated. As they say, "Cash is fact. Everything else is an opinion."
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| *Global Data Services of India Ltd: Accounting & Analysis, The Indian Experience (3 volumes) |
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