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Sunday, May 05, 2002

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Investors, arm yourself against smoothing

Aarati Krishnan

In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation... . Integrity may be losing out to illusion. Arthur Levitt, former Chairman, US S ecurities Exchange Commission.

ADMITTEDLY, companies use accounting flexibility to ensure a more consistent performance and better stock valuation. But what's wrong with it, you may ask?

Plenty. For one, the use of creative accounting to present a desired picture of earnings, destroys the very purpose of having a system of quarterly or yearly disclosure of the financial performance of companies.

Towards the end of last year, Mr Arthur Levitt, the then Chairman of the US Securities Exchange Commission, lashed out at what he called a "game of nods and winks" that had come to characterise the relationship between auditors and companies.

Mr Charles Neiemer, Chief Accountant, SEC, later pointed out three disastrous consequences of smoothing.

  • Once a company starts smoothing earnings, it is almost impossible to stop. The inflated earnings become the floor for measuring future performance, and the gap between reality and what is presented keeps widening until it is unbridgeable.

  • Smoothing allows a company to paper over an operational problem when there is really a need to address it. This may allow a problem to balloon beyond proportion when it becomes too big to camouflage.

  • The loss of credibility that occurs when a company's financials are revealed for what they are could be disastrous and far outweigh any positive impact from smoothing.

    Some of the methods by which companies can smooth earnings can certainly be plugged, by a tightening of accounting standards.

    In the US, the Financial Accounting Standards Board has issued a string of new guidelines pertaining to areas such as mergers, restructuring costs, and accounting for goodwill, which are most prone to smoothing.

    In India, the Institute of Chartered Accountants of India too has promulgated a few new accounting standards that reduce the scope for smoothing.

    The new Accounting Standard 25 on Interim Financial Reporting, for instance, prevents companies from allocating expenses to the quarterly accounts on the basis of an estimated proportion of the full year's charges.

    This has had far-reaching implications for the quarterly financial announcements, forcing HLL to take restructuring charges, and MICO depreciation charges, to their quarterly accounts on the basis of actuals rather than discretionary estimates.

    But despite a more stringent accounting framework, it would be quite difficult to deter companies that are completely determined to smooth their earnings performance.

    Therefore, investors need to be armed with knowledge — of the prevalent methods of smoothing and of how to see beyond them — in order to make better investment decisions. Investors may bear the following pointers in mind while evaluating earnings performance:

  • Focus on the top line: While it may be relatively easy to tinker with the profit figure by changing the accounting treatment for some item of expense or by taking a discretionary charge, it is much more difficult to either bolster or underplay the net sales figure.

    True, companies have been known to resort to bill-and-hold transactions (where sales are invoiced but not actually shipped) or to push sales to dealers at the end of an accounting period, to present a better sales performance. But such adjustments can only be temporary and are bound to show up in the next accounting period. Further, they can make only a marginal difference to the overall picture.

  • Check out the operating profits before interest, depreciation and amortisation. Given that much of the discretion in accounting comes from charges for deferring expenditure, amortisation, and the methods of charging depreciation, it is much more difficult to tinker with operating profits than with the net profits.

  • Read the Notes carefully. Significant changes in accounting policy and details of exceptional items are often to be found in the notes.

  • Work out percentages and ratios to spot very sharp deviations.

    A sharp dip in "other expenditure" as a proportion of sales could indicate cost savings, or some unusual income, which has been tucked under the `other expenditure' figure.

    A sharp drop in raw material costs as a proportion of sales could indicate lower input prices, or the fact that the company has produced less and is liquidating stocks built up in the previous period.

  • Keep your eyes open for large write-offs and one-time restructuring charges. Large write-offs or "big-bath charges" (as Mr Levitt likes to call them) are often read as positive signals by investors, a sign that the company is cleaning up the balance sheet and putting its "sins" behind it. But write offs could also hide some important negative signals about business.

    For instance, a company's decision to write off a large chunk of deferred marketing expenses in a single year could mean that it does not expect any future benefits to materialise from that expense.

    A large "asset impairment charge" could mean that a company is scrapping a key division. Finally, do not read too much into the sketchy financial information provided in the quarterly results announcements. The cash flow statement, the balance sheet and the schedules to the profit and loss account are crucial for evaluating a company's true financial position in its entirety.

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