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Pitfalls aplenty

R. Srinivasan

FOR TOO long, the annual report was the only medium of communication between a company and its stakeholders. And, traditionally, annual reports have tended to be monotonous and off the beaten track, as companies have been averse to giving much information for fear of giving competitors an advantage. Thus, other than the audited accounts and the directors' reports, which would only be of historical interest by the time they get to the hands of the shareholders, these annual reports serve more as status reports than as indicators of the companies' future prospects and plans.

In the past few years, following the pattern of the Securities Exchange Commission (SEC)-listed companies in the US, quarterly reporting of results by listed companies is now mandatory in India as per the listing agreement with the stock exchanges. This has been a welcome development, as even in the US, although quarterly reporting has now been in existence for almost a quarter of a century, its introduction was preceded by a tough battle between the companies, the SEC and the New York Stock Exchange.

However, despite its long existence, the US practice still has serious problems arising from errors and inaccuracies that tend to creep into the reports owing to the volume and the speed of the information provided. This has its effect on the fourth quarter, known widely as the `dump' quarter, bearing the brunt of the adjustment of all the errors of the earlier quarters, so as to bring the results in line with the full annual audited results.

The existing regulations in India require the publication of quarterly results in at least one newspaper with an indication of special factors, if any, that may have influenced the results and with figures for the corresponding period of the preceding financial year.

The quarterly results can, at best, only be considered as indicative and not absolute, as a good deal of estimation is needed in order to arrive at these results. These estimates are usually in the nature of provisions for income-tax, the extent of profit accruing on incomplete or long-term contract work in progress and the allocation of discretionary expenditure such as VRS and other deferred revenue expenditure.

While there can be no doubt that the publication of quarterly results is a major step in the evolution of good corporate discipline in India, it cannot be said that this measure is free from manipulative practices. Some of the pitfalls that quarterly reporting entail are:

* Where an open offer to the shareholders is being contemplated with a view to acquiring an increase in stake, quarterly results could be depressed so as to trigger selling of the company's shares in the market with the consequent fall in the price. If the results are kept depressed for a couple of quarters, the resultant consistent fall in the share price will facilitate the fixing of a lower average price for the open offer than would otherwise have been necessary. This could easily be achieved by a higher provision for tax and other expenditure, a higher charge for discretionary expenditure or by taking a lower credit for income such as for profit accruing from incomplete contract works.

* Artificially increasing revenues by transferring and invoicing stocks as sales to unlisted associate companies.

* Booking revenues that have yet been realised, with a view to inducing buying interest in the company's shares in the market and propping up the share price in the process. An interesting example of such a manipulation was brought to light in the US recently in a fraud that took place at Indus International Inc., a software firm in the Silicon Valley. Government regulators recently slapped criminal and civil charges on two executives of this firm for fraudulently inflating the results of a quarter two years ago.

The facts of the case are that the company feared that its internal forecast of profit for the third quarter of 1999 would fall short of analysts' expectations. Indus was close to selling software worth $1.7 million to an engineering firm, Holmes and Narver Inc., that had bought the same, contingent upon a contract materialising from the National Science Foundation. The latter's contract was delayed till the December quarter while Indus had booked the sale in the September quarter itself, showing the contingency aspect of the contract as a separate letter exchanged with Holmes and Narver, which was not disclosed to its accounting department. This letter agreed with Holmes and Narver that the sale by Indus to them would be cancelled if Holmes and Narver failed to get the contract from National Science Foundation. Holmes and Narver, in fact, did not get the contract and returned the software to Indus.

The whole matter came to light when Indus' accounting department reminded Holmes and Narver for the payment of the invoice and the latter refused to pay. The charges included another similar deal by Indus with another customer allowing Indus to book an additional $2 million in revenue in the same quarter that would not materialise at all, as the deal was a fictitious one. If this is the case with a country where quarterly reporting has been in operation for close to 25 years, our own regulators should be ever vigilant for perpetrators of similar frauds.

* As mutual funds are now required to disclose their portfolio at the end of each quarter, the chances of funds trying to spruce up their portfolios with reshuffling of securities in the last few days of the quarter cannot be ruled out.

As a safeguard against these pitfalls, the quarterly accounts should be subjected to a mandatory review before they are published, by the company's auditors who would confirm that these have been reviewed by them and that these are broadly in accordance with the accounting policies consistently followed by the company.

Any deviation found and reported by them should be published by the company as a part of the quarterly results. A review by the statutory auditors would act as a deterrent against these manipulations and would, apart from instilling confidence in the minds of the investors, also help remove any reservations that they may have on the credibility of the figures published.

Quarterly review of the accounts by the auditors will also help hasten the audit process at the year-end, facilitating the declaration of annual results with expediency.