Hustling up by rustling up

By the turn of the 20th Century, corporate giants began hustling up the corporate performance by rustling up some innovative methods in presenting financial figures. “Book cooking” is a phrase often used to describe numerous activities that corporates engage in with the intention to minimise taxes and maximise profits. When a company knowingly manipulates its income and expenses to show better earnings, it is said to have cooked it books. Methods that look seemingly legal are put in place to avoid tax or evade tax and launder money. Invariably such activities are fraudulent in nature.

Corporate scams

Leading the (in) famous path was the energy giant Enron. Another corporate – WorldCom, the telecommunications company both leaders in their respective spaces are believed to have cooked their books to show inflated financial figures. It was done continuously and so well that they began crumbling under their own weight and ended up filing for bankruptcy in the early 2000’s. In both cases the Board and the Auditors got hammered for looking the other way and not raising flag when required. Back home, the Satyam saga unfolded by the close of the decade. The founder had confessed to a staggering Rs. 7,000 crore accounting botch up. Jolted out of slumber the government and the public / investors had come down hard on Satyam’s Board. A few years later majority of promoters, a few board members and the auditors were found guilty and convicted. In fact, in January, 2018 the auditors were slapped with a 2 year ban on auditing in India. The repercussion felt long after the promoters got arrested and released on bail.

Camouflaged presentation

It takes very educated and conniving minds to camouflage financial performance of the company. That coupled with circumventing (not brazenly flouting) laws was sure shot recipe of success.  A bird’s eye view of the same:

1. Companies often report profits by including figures of future profits which are only estimates. They report profits at the commencement of the deal itself instead of reporting as and when received during the course of deal. Enron was believed to have used a method called “Mark to Market” wherein projected earnings would be reported as current income.
2. Similarly, credit sales are shown as actual sales income. Even if a company sold and gave credit to its vendors, it would book the amount as actual realised income from sale.
3. The manufacturing industry resorts to practices such a shipping products to distributors ahead of their demand or being placed an order. They are then recorded as sale.
4. Non recurring expenses are one-time expenses that occur rarely. When such non recurring expenses are reported every year, it is a glaring misuse of accounting systems.
5. Buy back of stocks from vendors /distributors by taking debt to pay such buy back actually decreases the earnings per share. This is because debt eats into the company’s earnings.
6. A universally practice is to create separate entity and book liabilities and or expenses in that entity. This way, the parent entity’s balance sheet will have lesser liabilities and look healthier.
7. Synthetic lease is another popular method. When a building or factory premises is taken on lease, the lease amount is to be paid upfront. However, companies keep away from reporting the amounts until the conclusion of the lease. It is a liability, yet is recorded as an expense.
8. In the course of amalgamation or merger, the company that is selling its stakes to another will endeavour to pay off as much as its expenses and liabilities as possible. Consequent to such amalgamation, the earnings per share of such merged / amalgamated entity will look big.
9. Promoters of companies give loans or even announce dividends from its accumulated reserves. While it is logical to treat loan as an income and pay dividend distribution tax while declaring dividend, companies often try to merge or amalgamate with lesser entities to circumvent payment of tax.
10. Formation of trusts is one of the biggest and most widely followed method of tax avoidance and routing funds. Especially true with respect to the bigger corporates, they form or patronise charitable trusts which are not subject to tax on major expenses or income.

Government strategy to plug the lacunae

The budget 2018 offers more than it meets the eye. The government has announced measures to plug the loopholes in law. It has made it expressly clear that from 2018-19, any payments made post amalgamation of entities shall be taxed, irrespective of the reserves of the profitable company. This will ensure that any dividend declared consequent to the amalgamation will very much be taxed. Similarly the government has announced that all companies which incur tax liability will have to pay up or face the heat. Hitherto, all companies which had less than Rs. 3,000 tax liability were not prosecuted, even if they did not pay tax. All these, coupled with the government’s head on collision with shell companies and black money is to ensure that corporates do not side step the tax liability and have to pay up. Amidst alleged fund diversion by a corporate hospital- listed company to third parties, in the second week of February, 2018 SEBI announced its intention to take to task those companies in which it’s noticed falsified or incorrect financial reporting. The regulator has in no uncertain terms stated that it will pull up all involved – Management and professionals alike.

Play vigilante

It is not the sole responsibility of the government to detect corporate accounting policies that tweak tax liabilities in their favour. Irrespective of the size of the Company, a vigilante Board and ethical professionals are the major players who can protect stakeholder interest. They have to places investor / public interest ahead of their own individual interests. Professionals shall ensure effective internal controls and periodic audits and raise the flag and intimate the Board at early stages itself. Similarly the Board, individually and collectively should refrain from self-indulgence and work for the betterment of all stake holders concerned. Don’t cook the books. Cook by the Book!