Thursday, October 06, 2011

Re-visiting Modern Accounting Standards

Should acquisition cost of an asset depend on how it is financed?
To my mind, and to most non-accountants, the simple answer seems to be No. But that is not how modern accountants see it. Costs incurred (including interest) till the time an asset is ready for use is treated as part of the cost of the asset. Whatever compulsions may have been behind adoption of such a treatment as standard, it tends to militate against simplicity, and creates needless (in my view) complexity.
Can a company have Net Profit After Tax equal to double its turnover for a quarter?
Common sense tells us that this is impossible. How can profits exceed turnover, that too profits after tax? However, modern accounting is not all common sense. Or maybe, it is such highly developed common sense that it takes truly uncommon levels of sense to understand why this can happen. As it happens, there are several reasons why this can happen. Deferred Taxation Accounting (DTA) is one of the reasons. DTA is one more area where accounting has been made dreadfully complex. So much so that it creates situations occasionally as the one described in the question above, where quarterly Net Profits After Tax of some companies exceed even quarterly revenues! How can accountants explain to laymen this paradox – where, say, the quarterly turnover of a manufacturing company is Rs.50 crores and its NPAT is Rs.90+ crores? Most accountants trying to explain this situation will end up tying themselves and their listeners in knots. This happens in the relatively rare instance when a company has just turned the corner after several years of losses. One argument in favour of the currently favoured treatment of deferred taxes is that it makes clear the differences in expected tax provision on reported profits, and the actual tax provision. However, we lose sight of the fact that the net result of the income statement becomes almost impossible to understand, even to reasonably financially literate individuals. Surely, this could not have been the intent of introducing such accounting treatment!
Is it a bad thing to allow retired employees medical treatment for life in hospitals run by the company?
Certainly, one cannot fault managers in Tata Steel if they begin to think like this. Accounting for Employee Benefits is another area where accounting complexity has reached ridiculous levels (in my view). Tata Steel used to routinely allow their retired employees and their families to be treated in the wonderful hospital they have built in Jamshedpur; and absorb and meet the net losses or cash shortfalls of that hospital quite routinely, as part of its employee-friendly initiatives. Let us say their costs were Rs.30 crores per annum, give or take a few crores. When AS 15 was made mandatory, suddenly they realized that because they allowed their retired employees and their families to enjoy these facilities for life, they suddenly had to recognize the present value of all the costs they expected to incur over the next several years, as a cost in a single year. This resulted in a hit to their Income Statement to the tune of hundreds of crores in the year in which the new Standard was made mandatory (if I remember it right, it was over Rs.250 crores). Why? Could not well enough be left alone? Now, it has accountants and managers thinking closely about the impact of such facilities to its past employees on its current profits, way beyond the actual cash expenses of offering such facilities. Simplicity flies out of the door, to be replaced by dreadful complexity. What I wonder is, what purpose is served by such complexity?
Why did Warren Buffett call derivatives "weapons of financial mass destruction'?
Buffett should have included "securitised, structured products" which are a class of "innovative" derivatives, by the same appellation. We know now that derivatives and securitisation have made financial life, and accounting for the new-fangled "innovations" they spawned infinitely more complex. Banks in the developed world are still facing the consequences of the complex accounting legacy of the millions of securitised structured note transactions it entered into almost without thinking in better times. They are now realising the impact of all that complex accounting – it only passed the parcel of risk onto others. It did not eliminate risk. Ultimately, every bank in the developed world was left holding such risk parcels to varying degrees. But they did not simply pass on risk to others. Some structured products passed on risks to a distant tomorrow.
We have yet to see the complete impact of such contracts that, in addition to passing the risk around to different people, also passed the risk to a future date. There are several apparently innocuous deals and assets sitting on the books of several companies (not just banks) which represent accounting legerdemain of pushing losses off to a point of time in the distant future, so that the current management came out smelling like roses though their results should have had the faecal matter hitting the overhead rotating cooling device. They are the financial equivalent of mines in modern warfare. They will go off and claim the lives of innocents at any time in future, without warning. This is because several best-selling "structured products" designed by mathematical geniueses sitting at investment banks the world over, were designed to hide losses from shareholders, future management and regulators alike. We have yet to see the full impact of such deals. Liabilities under such contracts will crawl out of nowhere, as it were, and trouble future managers and bankers alike. This is the long-term legacy of allowing untramelled financial innovation. AS 30, 31 and 32 (collectively dealing with accounting and reporting of derivatives) is something that almost 90% of practising Chartered Accountants – those charged with implementing them and checking their implementation incompanies, will privately admit to not being comfortable with. I think these Accounting Standards is a gigantic case of GroupThink – the management phenomenon where even a unanimous decision taken by a Group is completely at variance with what almost all of those participating in taking the decision privately think and opine. We need the small boy who points out shrilly that the Empe3ror is not really wearing clothes!
Why should we bother about all these complexities?
Almost all the modern accounting standards that have contributed their bit to making accounting more complex and less understandable have behind them the objective of making a company's Balance Sheet more "realistic". What they have actually succeeded in doing is to make the Income Statement almost impossible to understand or predict. Why should one prefer Balance Sheet accuracy to Income Statement accuracy? I think that the Balance Sheet showing assets at unrealistic low values based on historical cost is a form of desirable conservatism in accounting. We have succeeded in making the Income Statement, which is a good indicator of how well a company is being run, almost too volatile to be of any use – whether to compare results with past years, or to compare results with those of peers. Therefore, what I make above is a case for a complete re-thinking of the basis of modern, fair-value based accounting, and slowly going back to the traditional historical cost based accounting.

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