The shareholders of Ruia’s controlled Essar Oil will be in for a rude shock to know that the company had boosted its net profit and net worth for many years for thousands of crores of rupees, on the basis of mere accounting entries, which will now have to be reversed.
Essar Oil has asked its shareholders to vote on February 18 for a special resolution to be passed by the board on reduction in the peak net worth of the company being Rs 6,370.18 crore during the four financial years immediately preceding financial year ended March 31, 2012, that is, from financial year 2007-08 to financial year 2010-11. This will result in accumulated losses of Rs 4,230.33 crore as at March 31, 2012, the company has said in a notice to the stock exchanges.
The resolution has been necessitated following a adverse Supreme Court order last year with respect to sales tax benefits availed by Essar Oil from Gujarat government.
Questioning the accounting policies of Essar Oil, proxy advisory firm Stakeholders Advisory Services (SES) run by J N Gupta, has said that shareholders should only vote for such a resolution after they get satisfactory response from the company and its auditors. SES says Essar Oil’s accounting policies may not be in accordance with Accounting Standard (AS) 39. Gupta is a former executive director of the Securities and Exchange Board of India (Sebi).
Essar oil had registered itself under the Capital Investment Incentive Premier/Prestigious Unit Scheme - 1995-2000 of the Gujarat Government. Under the scheme, the company was eligible to claim deferment in the payment of sales tax. However, on account of delays in commissioning of refinery project, the Gujarat government declined to grant the company the tax deferment benefits available under the scheme and Essar had been asked to pay the tax to government in instalments. The sales tax had been deferred for the last 13 years.
Essar Oil assigned this sales tax liability to a third party Essar House Ltd., under an agreement of defeasement. Essar Oil was to pay the assignee the net present value of the deferred tax liability, and in turn, the assignee was to pay the liability to the government of Gujarat on behalf of the Company when it became due for payment.
SES says, Essar Oil has accounted the sales tax benefit available under the scheme as the difference between the gross sales tax liability and assignment value in its books of accounts as income.
“As per accounting standard AS 39, unless the government had allowed the transaction and agreed to hold related party liable, the liability could not be removed from the company’s books. However, there is no disclosure in the annual reports of company regarding the same. Further since the liability is being written back in company’s books, it is clear that transaction was not irrevocable. Therefore the liability of sales tax could not have been removed from company’s balance sheet. Therefore, in our opinion, the transaction and its accounting treatment was not in accordance with AS 39,” said SES.
Such a third party transaction is amounted to advancing future gains to present, an accounting treatment perfectly legal and allowed, provided the company remained neutral to future liability.
SES says, one should ask if the state government, being the creditor, allowed this transaction? If yes, then why is the transaction being reversed? Further, shareholders should seek clarification as to why a related party, where promoters have significant control, were used for defeasement? What process was followed by the board in selecting the counterparty for this transaction? Did the related party have any experience of managing such liability? Was creditworthiness of the related party taken into account before initiating the transaction? Whether the NPV calculation was done on an arm’s length basis? How did the discount factor compare with cost of capital of the company? If no, then how was the transaction consummated since the assets of the company remained charged with the government?
SES is of the opinion that state government could not have approved the same as it was fighting the case with the company. In case of bankruptcy of or default by the third party to pay up the dues to government, was the company liable to pay to government? What was the benefit to the company except the fact that company was able to treat the difference as income to shore up the profits, net worth and manage debt equity ratio and borrow funds?
Clarification should also be given if the transaction had covenants for the use of funds by the related party to invest only in permissible securities or to allow it to be used for business purposes? If latter, whether proper risk management and controls were in place? Did the company receive any additional benefit from the transaction?
Further SES says, since the liability is being written back in company’s books, it is clear that transaction was not irrevocable. Therefore, the liability of sales tax could not have been removed from company’s balance sheet. Thus, the accounting entries could have only temporarily boosted company’s net worth and profits.