The Hindu Business Line : Writing on the wall

OVER the past few weeks, the financial press has been tracking the accounting practices of the US-based telecom giant WorldCom Inc. While the initial reports were on the few cases of accounting errors, it has now come to light that the company was ostensibly trying to use `accounting' to manage the bottom line for the past couple of years. It is obvious that once profits are boosted, the share prices get manoeuvred with all the consequential effects. The issue has snowballed to the extent that the US President, Mr George Bush, himself called for a full-fledged investigation, referring to the accounting irregularities as "outrageous".

It is strange that the US, which boasts of one of the tightest accounting rules in its GAAP, has landed itself in a terrible accounting mess — starting with Enron and now WorldCom and Xerox. These are top names in the world of business and the news has taken the accounting fraternity by surprise. Perhaps, it is time to introspect whether the overall rules for accounting spelt out by various accounting standards across the globe have to be reviewed for better administration. This seems essential in the larger interests of investors, creditors, lenders and all users of financial statements.

Modus operandi

From news reports it is now clear that WorldCom had used a simple tactic of capitalising most of the expenditure rather than charging the same as `revenue' — not something new in the scheme of accounting worldwide.

This has been accepted in the world of accounting as `creative', as it boosts the reported profits to shareholders and improves the earnings per share. What is staggering is the size of the manipulation.

As per estimates, expenses running to a few billion dollars were improperly booked as `capital expenditure'. Essentially, WorldCom booked `line cost' expenses — needed basically for day-to-day operations — as capital expenditure. Telecom access and transport charges, which would normally be treated as business expenditure, were treated as capital expenditure.

WorldCom decided to capitalise this and deflate total expenditure booked in the accounts. As per the company's annual report filed with the Securities Exchange Commission (SEC) for 2001, access and transport charges, which represent `line cost', totalled $22.07 billion for 2001 and the first quarter of 2002. It is estimated that, of this, approximately $3.8 billion was booked under capital account and not charged as expenses. The potential loss for 2001 was converted into a net income of $1.38 billion purely by accounting jugglery. What WorldCom effectively did was violate the rules of accounting dictated by the US GAAP, which requires that such expenditure be charged off in the year in which it is incurred.

In the complaint filed by the SEC, it accused WorldCom of manipulating accounting and overstating `reported profits'.

The India factor

While the problems of WorldCom have their repercussions on India as well — through its dues to VSNL — one needs to examine corporate India's track record in accounting manipulations. History is replete with cases of Indian companies converting losses into profits purely by `managing' accounting. Precious time is spent more on trying to exploit accounting loopholes and managing bottom line to satisfy the interests of those concerned. The problem is compounded as accounting pronouncements and verdicts are not uniform across agencies that supervise the corporate sector. In the recent past, there has been a hue and cry in the matter of accounting standards and who should take charge of issuing them.

It is also well known that corporates' reported profits are different for different agencies — such as the Department of Company Affairs (DCA), the income-tax authorities, credit rating agencies, banks, financial institutions, and so on. There is still not a common platform to report profits in simple terms to all agencies and users of financial statements. What WorldCom did in 2001 and the first quarter of 2002 is a practice commonly adopted by Indian companies. There have been cases of accounting jugglery that have attracted the attention of the media as well as the public. Several accounting standards offer various alternatives in accounting treatment leaving companies to decide a particular accounting treatment that best suit them rather than conform to the criteria of what is described as `pure' accounting. A few areas where manipulations generally take place are: a) method of depreciation; b) method of stock valuation; c) capitalising a good portion of the expenditure which are revenue in nature; d) capitalising interest as part of fixed assets rather than treating it as revenue; e) camouflaging real liabilities under the head contingent liabilities, and so on; and f) converting sales tax deferrals as income.

There are several other practices that border `creative' accounting. Accounting decisions, for instances, are often driven by the taxation position. When book profits tax was in vogue, companies used the tactic of routing profit on sale of assets directly to capital reserve rather than booking it through the profit and loss (P&L) account. The idea was simply to avoid book profits tax on such profits, if they are reflected in the P&L account. Thus, accounting decisions are almost always a function of what the company seeks to achieve while reporting its bottom line to shareholders and also partly on what the company has to achieve in terms of managing its tax outflow.

Courts have spent hours on end debating whether the principles of accounting have to be considered in determining the tax liability of an assessee. But no clarity has emerged on this issue so far. Recently, a few companies booked certain types of losses, directly debiting reserves instead of charging the same to P&L account. With 28 Accounting Standards, plethora of guidance notes and statements, the corporate sector's record in finding solutions to disclosure requirements and accounting problems have left a lot to be desired. Of late, the Madras High Court has been put through the test of assimilating and interpreting ASs. The DCA and the Central Board of Direct Taxes have chalked out their own game plan in the field of ASs. At the end of it all, the users of financial statements are a confused lot and invariably end up missing `the wood for the trees'.

Remedy

There can be no readymade solutions to the vexatious problem of `creative' accounting. The solution cannot be mandated through legislation, but has to be driven by corporate self-governance. There is a very thin line of distinction between `pure' and `convenient' accounting. The pronouncements on accounting have at best added to the literature on the subject, but not provided solutions to problems facing specific industries. It is not as if that for every accounting problem, the solution has to come from the authority issuing the clarification.

However, the time has now come to thrash out solutions for conflicts relating to capital and revenue, deferred revenue and revenue, and so on, with clear and concrete examples, spelling out circumstances in which expenditure can be capitalised or treated as deferred revenue.

As can be seen from the WorldCom controversy, the reported profit was manipulated by accounting jugglery. WorldCom is a wakeup call for Indian corporates.

One need not hazard a guess to come to the conclusion that several companies have used this tactic to bolster their bottom lines.

In the emerging fields of telecommunications and infotech, expenditures for the development of software and related areas require clear accounting dictates. In the Indian context, precise answers on whether such amounts are to be capitalised, treated as deferred revenue or charged off are not available.

To add to the complexities, the revenue authorities have their own interpretation of such expenditure. WorldCom should make us sit up and redefine the game of accounting and, perhaps, rewrite the rules to provide clarity on major issues.

It is in everybody's interest that an Indian version of WorldCom does not surface.

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