It is a no-brainer that it is legally and ethically wrong for a company to overstate its profits. But is it equally wrong for a company to overstate its losses?
Unlisted companies resort to this sometimes; lower profits (or a loss) mean less tax. And for executives without morals, it is easy to siphon off the money in a variety of ways. But listed companies have other priorities. Lower profits impact share price, and this can be more damaging.
The issue has come to the foreground because India’s largest bank, State Bank of India (SBI), has reported a 99% drop in profits in the fourth quarter of 2010-2011 (January-March). SBI is ranked 282 on the Fortune Global 500 list with revenues of $28 billion and profits of $2.5 billion. The sharp decline in profits was because of increased provisioning for non-performing assets (NPAs) and retirement benefits, the bank said.
Meanwhile, observers have been quick to note that it is not coincidental that a new chairman — Pratip Chaudhuri — has just taken over. Following SBI’s announcement, Reserve Bank of India deputy governor K.C. Chakrabarty was unusually critical. “Reporting has to be credible,” Chakrabarty told the Indian newspaper Business Standard. “You see our banks. When the chairman retires, profit declines. Reporting should not be according to the chairman, but according to the books.”
And it’s not only SBI. A report by Mumbai-based business news channel CNBC-TV18 points out that profits of five banks during a 10-year period slipped almost every time a new chairman took over. According to MoneyControl.com, a CNBC-TV18 affiliate: “Some people in the banking sector believe this is because the outgoing chairman refuses to recognize NPAs to avoid looking bad towards the end of his career. On the other hand, the incumbent is extra cautious in the beginning of his career.”
“It is messy out there,” an unnamed executive director of a Mumbai-based public sector bank told Business Standard. “The chairman has the final say on how accounts are prepared. A retiring chairman often leaves the task of cleaning up the books for his successor [since] he wants to show higher profitability during his term. This makes the task of the new chairman difficult and erodes shareholder confidence.”
Analysts say this can only happen in public sector organizations where there is no clear succession planning. Also, a new chairman is often brought in from some other bank and can claim that he has no responsibility for earlier profit and loss accounts. (However, Pratip Chaudhuri was not an outsider; he was deputy managing director of SBI before his promotion.)
The main area where a bank chairman can exercise judgment is in NPAs. Some of the loans a bank has given are clearly not possible to recover. Others are good assets. Borderline cases can be pushed into one bucket or the other. In SBI’s case, the Q4 provisioning for NPAs was up 49% — from $487 million to $728 million. There was also a higher provisioning for retirement benefits, up from $10 million to $349 million. The Institute of Chartered Accountants of India (ICAI) wants clarity on why this was all provided in one quarter when, being an annual item, it should have been spread out over four.
“It is totally unethical to overstate losses,” says a professor from a leading Indian business school, who prefers anonymity. “It is strategic for a new CEO to do it, however. It sets a low base for him to ‘perform’ from, and lowers the legacy value of his predecessor. The board and the accountants should [intervene]. Attempts at this must have happened abroad as well, but the auditors are usually more vocal there. I am told the ICAI is less than happy about what has been done at SBI, and we may see more of this issue in the months to come.”