On June 06, 2020, Economic Times published an article contending that some companies were using Covid-19 adjustments to shore up the numbers.
While preparing financial results, some companies are reporting certain items like loss of revenue and increased costs in a special category — exceptional items — so that the profit figure looks better.
Many companies and banks are in discussions with their auditors regarding categorisation of operational items like revenue and losses as exceptional items.
Companies say that since these adjustments are Covid-related and would not occur under ‘normal’ circumstances — and some of these losses may be material in nature — they should be treated differently.
But before we jump the gun, what are exceptional items?
The meaning as generally understood in the market parlance is appropriately captured by Kotak Securities,
These are one-off events that either cause a great expense or a big bout of revenue. For example, suppose a company sold off some of its machinery because it did not use it anymore. This led to an income of INR 1 crore – a big sum for a single transaction. This could easily boost the company’s profits in that particular quarter/year. However, this is not likely to recur again. So, it is counted as an ‘Exceptional Item’.
So why do exception items matter?
They are important for calculating the actual growth of the business without distortions. Exceptional income or expenses are not expected to recur on a year to year basis; hence, they might temporarily inflate or deflate the earnings of a company. Considering that such items are non-recurring in nature and will not repeat in the long term, they need to be excluded from the analysis to estimate long term earnings growth rate of the company.
Let us consider both the stories in tandem. Companies have complained that due to Covid-19, their earnings have been adversely affected, either by loss of income or no corresponding change / increase in expenses (primarily due to fire-fighting the situation with sanitisation and safety measures). Companies argue that such decline in earnings is temporary and will fade out as and when the situation becomes normal.
Make no mistake! These exceptional items are still part of the financial statements – companies are required to adjust their profitability to account for these and provide details of such items in the notes to the accounts. Then why is there hue and cry over such a practice?
Let us take an example of HUL and analyse its financial statements for FY 2019-20.
As can be seen from the snippet above, exceptional items do feature in the profit and loss statement of the company and profitability is accordingly adjusted. Then what is the problem?
Let us look at another snippet*.
*Slight discrepancy is noted in Sales because the Sales figure in the investor presentation consists of only the sales from the products, whereas the Sales figure in the annual report consists of other operational income of INR 512 crores as well.
Did you notice something? The company did not take into account the exceptional items in its EBITDA figures. Additionally, even PAT, which is supposed to account for exceptional items is reported before exceptional items (‘bei’), albeit alongside net profit. And, the investor presentation, which in probable circumstances is what investors will look at, reports profit before exceptional items and inflates the figure**.
**We are not criticising HUL’s strategy to report financials without considering exceptional items. Looking at its notes to the accounts, the exceptional items seem legitimate to us – these are from either disposal of an asset or due to restructuring. We will now take a more critical look at some of the more questionable practices of a few other companies now.
As per the aforementioned article by The Economic Times, some companies want to include loss of income from the operational business and incurrence of additional cost on account of increased safety as part of exceptional items. And it does not stop there – due to the fact that they couldn’t fire the employees due to government regulations, they couldn’t lower their fixed costs and had to take additional provisions due to liquidity issues with the customers, these companies are proposing to charge the expense from these items under exceptional items because in their view, they wouldn’t have incurred these under normal scenario. All these items, which should have flown through operational income, would now reflect as non-operational elements under the financial statements.
And that is the beauty of interpretation and presentation. There are various ways to measure the profitability of a company. Companies can comply with the regulations and keep net profit (GAAP complied) unchanged, but it can shore up the profitability by showing higher than normal operational income (EBITDA).
However, there is one more problem with EBITDA. Rules around using terms such as EBITDA are not regulated by professional accounting bodies and are referred to as non-GAAP measures. Companies are hence free to include / exclude certain items of income and expenditure based on their discretion and interpretation, fuelling subjectivity and more importantly (perhaps disturbingly) creativity. If net profit is plain milk, EBITDA (and adjusted EBITDA) is lip-smacking Nutella Blueberry Smoothie – tasty but unhealthy!
But you may ask, why all the fuss around EBITDA. The problem lies in the fact that the EBITDA serves as the metric in valuing most of the companies for investment and transaction analysis. Equity research and valuation professionals value the securities primarily using EBITDA. Ask any investment banker and he will tell how EBITDA can make or break a deal (throw in some expected synergies and cost efficiencies from an M&A transaction and you have even more disputable figure of adjusted EBITDA – in the coming weeks, we will discuss this more in detail). All the major bank covenants are based on EBITDA. There is indeed huge pressure on companies to shore up their operational financials such that they can be considered positively by the markets or meet its covenants.
TVS Motor Company Limited reported Covid-19 related expenses of INR 32.3 crores, which comprise 26.5% of the profit before exceptional items, in exceptional items for the FY 2019-20.
CEAT Limited registered Covid-19 related expenses of INR 29.8 crores, which comprise 8.9% of the profit before exceptional items, in exceptional items for the FY 2019-20.
These amounts might seem low, but they are for FY 2019-20, and the impact was felt for the last 15 days of the financial year. It is not tough to ascertain what will be the impact of 2 months of lockdown in the April to June 2020 quarter.
We repeat – companies intend to carry out these adjustments only till the time situation becomes normal. The financial statement would contain an aberration for 1 or 2 or maximum 3 quarters post which status quo will ensue. Companies expect pain to be short term in nature and things to magically turn around in 2 quarters. After all, an item would be classified as an exceptional one only if it is expected to be non-recurring.
But what if whole assumption of short-termism of pain is wrong? What if the situation does not return to normal in 2 quarters? What if pain lingers and the economy / industry / company continues to suffer? With the fear of second wave of Covid-19 creeping in around the world (and rather the first wave itself not flattening in India), such concerns have become distinct possibilities. Some industries have been damaged considerably and chances of a ‘V shaped’ recovery have been ruled out.
Sure, there has been some pick-up in demand in some of the industries, but such pick up is mostly attributable to the fulfilment of pent-up demand as the economy emerged out of the extended lockdown.
The Ken, in its 53rd edition of the BFO, brilliantly summarised the impact of current pandemic:
The supply-side shock has trickled down into the demand side as well. The work-from-home movement is no longer just lip service, so why would one buy formals or even cars? There are job losses and furloughs galore, while whole industries—like hospitality and aviation—face an existential crisis. This has a ripple effect on other sectors as well.
The result is that the disruption to the supply side has transformed into a collapse of demand, three economists argue in a recent paper. The authors present a theory of Keynesian supply shocks: supply shocks that trigger changes in aggregate demand larger than the shocks themselves.
Let us understand this further. We all know that GDP comprises of consumption expenditure, investment, government purchases and net exports. The economy works in a cycle, in which different components feed each other. Investments lead to employment of capital and labor, such capital and labor are paid their share of interest and wages, respectively and depending on the level of marginal propensity to consume, such wages lead to consumption that in turn lead to demand for more products and that demand is met by increased investment in capital and labor and the cycle continues. This is what we call multiplier effect, which effectively means increase in one of the components of the GDP by 1x leads to more than 1x impact on the GDP. In the real world, the interaction of different variables is more complicated, but you get the basic idea.
What happens when one of the components stops functioning? The cycle breaks off. The workers at the restaurant or travel portal are laid off. They do not earn any income. Their consumption goes down that in turn affects investments by the other companies, say an apparel store or a hotel or a B2B online marketplace. Lower investments in these sectors further cascades into lower wages leading to lower consumption and so on. The eventual downward effect on aggregate demand is much larger and more persistent, leading to long-lasting contraction in the economy or GDP. This is what India is facing right now.
Let us take another example. Following are the most recent estimates by leading rating agencies for the GDP growth rate in FY 2020-21 and FY 2021-20.
|FY 2020-21||FY 2021-22||CAGR|
Indian GDP grew at the rate of 4.2% in FY 2019 – 20. Although the January – March FY 2020 GDP growth rate of 3.1% reflects the impact of Covid-19, as per the two rating agencies, India will not reach pre-Covid – 19 growth rate till at least FY 2022. If the economy is not able to get back on the pre-Covid-19 growth rate for at least two years, can its businesses expect to return to the normal scenario in 2 to 3 quarters. If such an abnormal scenario prevails, we wonder till when can businesses reflect loss of operational income or incurrence of additional expenditure, which will eventually become recurring in nature, as exceptional items.