Chapter 7

Impact of changes in Accounting Policies

A Game all accountants play
During the time of crisis, when there is a significant drop in
the market capitalisation, and the bad performance of the
company is expected to spoil the stock price further, even
blue chip companies follow some tricks. All these tricks are
perfectly legal in nature but ethically imperfect as these
tricks help the promoters to stabilise the share prices but
mislead the investor as the intrinsic value calculated based
on mere published numbers is not fair enough. Jan 2008 to
Dec. 2008 is the best period to learn all such tricks.

Thus the job of a fundamental analysts is not only

restricted to valuation part but they are also required to
look into the details of numbers on which the valuation is
based. This is possible once the analyst goes through the
root of every number published.
Depreciation : Depreciation is essentially a 'non-cash' expense,
which takes into account the reduction in value of an asset due to
obsolescence, wear & tear etc. It offers a range of tools through
which profit figure can be tampered with.

The basic reasons for the same are 1) The useful life of an asset
is determined by the company and 2) Shifting of method from
WDVM to SLM in the initial year and vice versa.
Valuation of fixed assets(capitalisation of interest) -- As per
Accounting Standard 10, the cost of interest on the funds
borrowed for acquiring fixed assets should be capitalised till the
date the assets are put to use.

In case of any discrepancy in policy, the auditor has to point it in

his report (capitalisation of interest even after the asset is put to
use).
Foreign Exchange Transactions: Treatment of differences
arising out of foreign exchange transactions is also an avenue
which offers scope for manipulation of accounts. AS11 deals with
mark-to-market provisioning in corporate profit and loss accounts
for foreign exchange-related gains and losses. The year 2008
which saw major change in the value of Indian currency forced
many of the leading companies to play the tricks in order to
maintain faith among the investor community.
For. ex. In 2007, Indian companies took advantage of lower
interest rates to raise foreign currency loans and foreign currency
convertible bonds (FCCBs). They were encouraged by three
positive factors: the rupee was appreciating, the stock market was
on a high aided by strong FII inflows, and most companies posted
good results. Many in India thought the rupee would appreciate to
Rs 38, and most companies did not cover their long-term forex
liabilities. They were caught on the wrong foot when FIIs withdrew
more than $14 billion from stock markets within a short span of
time in 2008.
The stock market crashed and the rupee depreciated to Rs 49-
level. As a consequence, not only the loan liability had to be re-
stated at a much higher figure due to the depreciation of the
rupee, but even the quasi- equity instruments like FCCBs were
also not any longer perceived to be convertible as the existing
market prices were abysmally lower compared to the agreed
conversion price.
In Dec quarter of 2008, the companies which have reported
forex losses include Ranbaxy, M&M, Essar Oil, Tata Motors,
JSW, GHCL, TCS, Maruti, Dr Reddy’s, Cipla, Suzlon, GMR,
NIIT and Mindtree.
Companies were reporting forex fluctuations when there
were making profits, but now that they are making losses,
they don't want to report them.
Based on legal opinion, several large companies do not
follow AS 11, but comply instead with Schedule VI of the
Companies Act which stipulates that as a result of
exchange rate fluctuation, any change in the repayment
needed to be added or deducted from the cost of fixed
assets. Thus Schedule VI allows such losses to be
capitalised.
Amortization of Preliminary and other miscellaneous
Expenses – There is no specific rule for amortization of
preliminary and other miscellaneous expenses. Income
tax act may have rules to the period in which the
companies are required to set-off these expenses. But
this is from the point of view of view of computation of
taxable income.

Thus companies are free to enhance or reduce the profit

through the set-off of these expenses
Research and development expenditure : AS-8
requires to allocate pure research (a part of continuing
operation) to Profit and loss account whereas the
deferred R&D costs on a systematic basis to future
accounting periods by reference either to the sale or use
of the product or process or to the time period over
which the product or process is expected to be used or
sold.
The discretion of classifying pure and deferred research
is with the company. Thus there is an ample scope for
manipulation of accounting result.
Valuation of Inventory - This has direct impact on
profitability. There are basically three methods of
valuing inventory, they are FIFO, LIFO and Average
Cost Method. Companies can switch over from one
method to the other. This affects the profit figure. For ex.
Incase of recessionary situation, companies can switch
over from FIFO to LIFO, although the ultimate profit for
the company (sum of profit for the year and consecutive
years) doesn’t change. It surely increases the profit for
the concerned year.
Treatment of Gratuity – Companies are required to
provide for Gratuity on actuarial basis. But many
companies follow cash basis for recording such
transactions. This leads to increase in the amount of
profit.

Revenue recognition – Recognition of revenue is totally

a subjective decision. Thus any minor change in the
policy of revenue recognition has an impact on profit
figure of the firm.
Accounting Standards

Accounting Standards are the statements of code of

practice of the regulatory accounting bodies that are to
be observed in the preparation and presentation of
financial statements.

To compare the financial statements of various

reporting enterprises poses some difficulties because of
the divergence in the methods and principles adopted by
these enterprises in preparing their financial statements.
In order to make these methods and principles uniform
and comparable to the extent possible – standards are
evolved
Sr. No. Particulars
1 Disclosure of Accounting Policies
2 Valuation of Inventories
3 Cash Flow Statements
4 Contingencies and Events Occurring After the Balance Sheet Date

5 Net Profit or Loss for the period, Prior period Items and Changes in
Accounting Policies.
6 Depreciation Accounting
7 Construction Contracts
8 Accounting for Research and Development (This standard has
been withdrawn w.e.f. 01.04.2004 for all levels of enterprises and
AS 26 is applicable)
9 Revenue recognition
10 Accounting for Fixed Assets
11 The Effect of Changes in Foreign Exchange Rates
12 Accounting for Government Grants
Sr. No. Particulars
13 Accounting for Investments
14 Accounting for Amalgamations
15 Accounting for Retirement Benefits in the Financial Statements of
Employers
16 Borrowing Costs
17 Segment Reporting

18 Related Party Disclosures

19 Leases

20 Earning Per Share

21 Consolidated Financial Statements

22 Accounting for Taxes on Income

 Sr. No. Particulars
23 Accounting for Investments in Associates in Consolidated
Financial Statements

24 Discontinuing Operations

25 Interim Financial Reporting

26 Intangible Assets

27 Financial Reporting of Interests in Joint Ventures

28 Impairment of Assets

29 Provisions, Contingent Liabilities and Contingent Asset

Apart from the above mentioned accounting standards, ICAI has also prescribed
AS30, AS31 and AS32 related to financial instruments, which are mandatory from 1-4-
2011.
According to the Securities and Exchange Board of India
norms, if there is any change in a method of accounting
and if there is a material effect on the results following
the change, companies must give reasons for it and
quantify the effect that such a change will have.

Investors need not worry if companies are making whole

and true disclosure of the facts. But of course, they need
to find out its effect on intrinsic value. More than the
results, investors should look forward to views from the
management on how the company is shaping up rather
than the current quarter performance.