Profit and loss can be manipulated, market price gives a better picture of cos’ financial position

The Comptroller and Auditor General’s ( CAG) estimates of government losses and corporate gains have stirred much controversy. Supreme Court Chief Justice S H Kapadia attempted to elucidate valuation principles in a recent speech. He reportedly said, “Today, a number of controversies on valuation are discussed but the basic principle of valuation is that loss is a matter of fact and profit or gain is a matter of opinion. Please apply this test to the controversies going on. I do not want to discuss anything further. Loss is a matter of fact and profit and gain is a matter of opinion. So, if you understand these principles, we will be able to judge.”

I cannot make sense of this. I know of no principle in economics or audit that says losses are real but profits are not. One principle actually enunciated widely is “cash is a fact, but profit and loss are opinions”. That’s very different from the Chief Justice’s claim.

In 1975, the Press Club asked me to explain a puzzle. Its accounts showed a profit, but it had no money in the bank. Where had the profit gone? I soon found the answer. The accounts showed all receivables as ‘income’. But many members had not paid their bills, so the receivables had not been received! There was a paper profit, but a cash deficit. This was no error: audit rules specifically permitted this. This accounting practice was widely used by the biggest corporations. Some showed huge profits, but showed even bigger sums owed to the company by ‘sundry debtors’. Such companies had a big paper profit, and even paid taxes on this profit, yet had a cash deficit.

Beyond a point, treating receivables as profits becomes sheer pretence: the sums should be written off as unpayable. Some companies do writeoffs honestly, but others resort to ‘ever-greening’ dud loans, quite legally. Given such accounting flexibility, loss and profit are clearly matters of opinion, and can be manipulated to suit the company’s strategy. Again, a company’s balance sheet may not show all assets and liabilities: some can legally be kept off balance sheet. This enables companies to hide enormous liabilities off the books, showing a very healthy but misleading picture on their books. A classic example of this was Enron, which looked highly profitable, but accumulated such huge debts offbalance sheet that these ultimately sank the company. Citibank’s off-balance sheet activities helped sink it in the 2008 collapse.

Profit is not a clean, unclut-tered concept. Operational profit is income minus expenses. But after that you have to deduct interest on loans, amortisation of old loans, depreciation and taxes. Here again, much flexibility is legally permissible, allowing a company to show profits or losses as it chooses. Contrary to Kapadia’s claim, all losses are not a fact. Back in the 1980s and 1990s, India had many large companies (notably Reliance) that paid no corporate tax.

Why not? Because the government had provided several tax breaks. The old ‘investment allowance’ allowed companies to deduct a certain percentage of new investment from gross income. Investing in backward areas or highpriority industries was sometimes tax deductible. ‘Accelerated depreciation’ allowed companies to deduct up to 100% of the value of new equipment in the first year or use, even though the equipment might last decades. ‘Weighted deductions’ were given for items like R&D — that is, if a company spent Rs 100 on R&D, the tax law permitted the company to treat this as Rs 150 for tax purposes.

In the 1990s, many companies took advantage of these tax incentives, entirely legally, and reduced their tax liability to zero. The balance sheets they presented to the taxman showed a loss after all deductions, so no tax was payable. Yet, the law allowed the same companies to present a totally different balance sheet to investors, showing bumper profits. That’s how zero-tax companies like Reliance enjoyed soaring stock market prices. This charade was finally checked by introducing a minimum alternative tax, ensuring that tax breaks could not be used to escape tax altogether.

Valuations are different from profits and losses. Profits and losses tell you about the past. But valuations are estimates of the future, and those are necessarily different from past performance. Facebook makes little profit, yet is seen as having such a huge future that it commands an astronomical price. By contrast, some profit-making companies sell at a discount because of poor future prospects.

A company with good corporate governance (like Nestle) will have a high market price relative to earnings. But a company with a poor image (Kingfisher) will have a much lower price, since investors don’t trust its accounts.

If a company is believed to have huge hidden bad debts — like Citibank in the US — its market price can be just half its book value. But a bank with a solid reputation — like HDFC Bank — is quoted at five times book value. In sum, all valuations are opinions. The only reality is the actual market price, which fluctuates as valuations of buyers and sellers keep shifting. Whatever Justice Kapadia believes, losses are not a more solid ground for valuation than profits. Losses can be manipulated in balance sheets no less than profits. Cash profits and losses are more real, but even they are uncertain guides to the future. The CAG’s valuations cannot but be matters of opinion.

What do you think?