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Can accounting adjustment impact co. financials?

Jun 26, 2012

There has been a lot of brouhaha over the latest allegations of profit inflation by housing finance lender, HDFC. Brokerage firm, Macquarie Research has accused HDFC of following aggressive accounting policies that enabled it to inflate earnings by an average of 32% in the last two years. The research report by the brokerage firm states that HDFC set off provisioning and interest cost on bonds against reserves instead of routing it through profit and loss (P&L) account in the last two years.

HDFC has defended its accounting adjustment as being in line with the Indian 'Generally Accepted Accounting Principals' (GAAP). Apart from housing finance, HDFC has presence in banking, life insurance, general insurance, venture capital and asset management businesses through its subsidiaries. But as the standalone accounts do not include the share of profit from these subsidiaries, the mortgage major has excluded expenses pertaining to these subsidiaries from the revenue account and has chosen to set it off against the company's 'Reserves'.

How far is this contention right? At the face value, such an adjustment appears fairly harmless. One may observe that it hardly makes a difference if the expenses are debited to the P&L account or adjusted with the capital account as the end reserve position in both cases remains the same. While this is true, it still makes a huge impact on the company's profitability and shareholder's returns. Let us understand this with the help of an example. A company has an annual turnover of S and earnings of P. At the end of the year, its reserve position increases from R to R+ (P-D) assuming the company distributed some earnings as dividend D.

Sceanario I

Profit Margin (%) = (P/S)*100

RONW (%) = [P/{R+ (P-D)]*100

Let us now consider a scenario, where the company decides to adjust one of the expenses X against reserves. In this case, profits will get inflated by X while reserves will fall by the same amount.

Scenario II

Profit Margin (%) = {(P+X)/S}*100

RONW (%) = [(P+X)/{R-X+(P+X-D)}]*100

RONW (%) = [(P+X)/{R+ (P-D)}]*100

Therefore, this one adjustment provides the dual benefit of hiking the company's profit margin as well as the shareholder's return. This is one of the window-dressing techniques employed by companies to overstate profits and improve return ratios.

When a company resorts to this adjustment, auditors are required to raise qualification in their 'Auditors Report' that is annexed with the Annual Report. But it goes un-noticed unless investors delve deeper into the Balance Sheet. Several Indian companies have been merrily dipping into their reserves to conceal expenses that would have otherwise would have shown up in their P&L account.

Madhu Gupta

Madhu Gupta (Research Analyst), ValuePro has a post graduate degree in both physics and finance. Having worked with India's leading economic research agency, she has a natural flair for numbers and analytics. She brings with her a near-decade long rich experience in the field of finance. A firm believer of the principles of value investing, she looks for robust businesses with durable competitive advantages.

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