Accounting fib - The naked truth

"If private business should be supervised in the public interest, government when it assumes a business role, is in equal need of supervision." James A Fulton

The government of India runs 388 public sector undertakings, comprising 293 government companies, 89 deemed government companies and six corporations. These figures are on the website of the Comptroller & Audit General of India (CAG) (www.cag.nic.in), who received the financial statements and audited many of them for 2004-05.

As a result of supplementary audit and consequent corrections made in the accounts for the year, the profit in respect of many government companies was determined by the CAG to be overstated, and many had understated their losses.

The comments of the CAG in the Report No 11 of 2006 (Chapter 1) are also copious with instances of gross overstatement of assets and understatement of liabilities by these government-run companies. There is a separate section in that report for the Navaratna (literally means nine gems) companies, which have also been pulled up by the CAG for such malpractices. Among them stands tall one navaratna. The CAG Report says the impact of its comments on this company alone has resulted in its profits being overstated by as much as 23 per cent.

I will refer to this "gem" of a company as "Cat's Eye or Ketu" (the French call it Chatoyancy, which also means that by certain finishing work, something like even wood, can be made to look like a gem).

We will also learn as to what other statutory functionaries had to say on its 2005-06 financial statements. Ketu, which proudly displays its Navaratna status in its Annual Report for 2005-06, is a listed company in India and is also listed on the New York Stock Exchange. So it is one of the "real" gems.

Chapter 12 of CAG Report No.13 of 2006 deals with "Follow-up on Audit Reports", where it refers to an appendix with an inventory of 144 unique issues dating back to 1996 and onwards, where the recalcitrant companies have not bothered to submit Action Taken Notes (ATNs) on the audit observations.

The CAG laments that the final ATNs in respect of the 144 paragraphs detailed in that Appendix were awaited as of November 2005. And guess what? Many of them relate to Ketu.

Our gem of a Ketu has the dubious distinction of being crowned by the CAG as being at the top of the list of companies that have overstated their profits for 2004-05. Its latest audited financial statements, available on its website, are for 2005-06. (Unlike other company websites, earlier years' annual reports are missing on its website.)

The audit report for 2005-06 has as many as 30 major audit qualifications. There are also 13 other significant observations in the same report. The auditor has summarised the financial implications of his qualifications, as he is required to do, in a separate schedule, which conspicuously arrays the monumental mis-statements in the accounts.

While the directors of Ketu have declared a pre-tax profit of Rs 6,713 million, the auditor says this profit is overstated by Rs 4,508 million, in part because wrong revenue recognition methods are used by the company.

That is to say, the real pre-tax profit was only Rs 2,205 million, less than a third of what is stated. Like Sherlock Holmes, who said, "When you have eliminated the impossible, whatever remains, however improbable, must be the truth", the statutory auditor, while giving a true and fair view opinion, says that nine sacrosanct accounting standards (these are measurement rules) have been flouted.

Ketu's audit committee was then chaired by a retired professor of economics who, the company secretary says, did not attend the last annual general meeting of the company. He must have considered it prudent not to do so.

The story is not over. While the Indian public was presented with the window-dressed financials for 2005-06, Ketu had a different picture to paint in its filing with the Securities and Exchange Commission in the US (SEC). In Form 20-F filed with the SEC, it says: "Information contained in our website is not part of this annual report."

While this looks like a legal disclaimer, the fact is that the website has the Indian audited financial statements with the numerous qualifications and the schedule of over-statement of profits.

The US GAAP Financials, which are part of the Form 20F filing, had a clean audit report by an international firm but the pre-tax profit declared there is only Rs 1,576 million - less than a quarter of what the directors reported to Indian shareholders.

This difference is not entirely explained by differences in accounting norms in the two countries. The company chose not to follow Indian accounting standards on many issues, but decided to do so when presenting the numbers to SEC.

The notes in Form 20-F clearly refer to these material differences, significant among which are the revenue recognition matters that have been qualified by the Indian auditor.

This acknowledgement of lower profits in the SEC filing strengthens the Indian auditor's assertion that the profit published in the 2005-06 Annual Report for consumption by the Indian public is grossly over-stated, on top of which there is the unascertainable impact of non-quantifiable audit observations relating to many account balances not being reconciled, including bank accounts that have unmatched or unlinked entries running to millions.

This company says in Form 20F: "As of March 31, 2006, our disclosure controls and procedures were not effective due to material weaknesses related to our inadequate knowledge and experience in application of U.S. GAAP, commensurate with our financial reporting requirements … We will need to improve our internal controls over financial reporting and have consulted with our audit committee and board of directors, and are planning to undertake remedial measures to make improvements as soon as practicable."

As if to add insult to injury, the Directors' Report to the Indian public proudly says: "The company has internal control system commensurate with its size and nature of business".