Executive SummaryCompanies increasingly use accounting policy changes—permitted under IFRS and Indian AS—to artificially inflate reported profits while maintaining technical compliance. Investors and auditors must distinguish between economically justified changes and those designed primarily to smooth earnings or obscure deteriorating performance.
What Happened
A growing pattern has emerged across listed companies whereby changes to accounting policies, estimation techniques, and classification methods are being deployed strategically to enhance reported financial performance. These shifts—such as moving items between operating and non-operating categories, altering depreciation lives, changing revenue recognition thresholds, or reclassifying one-time charges—remain technically compliant with Indian Accounting Standards (IAS) and International Financial Reporting Standards (IFRS), yet systematically work to inflate headline earnings.
The issue is not that these changes breach regulations. Indian AS 1 (Preparation of Financial Statements) and AS 5 (Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting Policies) explicitly permit policy changes when they improve the relevance of financial information. The problem lies in the timing, frequency, and selective application of such changes—often occurring when underlying operational performance is weakening, raising questions about intent rather than substance.
Recent analysis of listed entity disclosures reveals companies making multiple accounting adjustments in tandem: lowering provisions for doubtful debts precisely when credit stress rises, extending useful lives of assets to reduce depreciation charges, reclassifying material expenses from COGS to administrative costs, or adopting more liberal revenue recognition policies. While each change may stand alone as defensible, their cumulative effect systematically improves reported profitability without corresponding operational improvement.
Why It Matters
For investors, equity analysts, and credit rating agencies, this represents a material governance and disclosure risk. Headline profit figures become partially disconnected from cash-generating reality. A company reporting 15% earnings growth through accounting adjustments while operating cash flows decline signals deteriorating fundamental quality—but only to those who dig beneath the surface.
Under Indian Securities and Exchange Board of India (SEBI) Listing Obligations and Disclosure Requirements (LODR) and the Companies Act, 2013, companies must disclose accounting policy changes with quantified impact. However, disclosure alone does not ensure investors understand the economic substance. Many disclosures are buried in footnotes, use technical language, or lack forward-looking context that would signal whether management is managing earnings.
For audit teams and statutory auditors, this creates heightened professional scepticism requirements. Auditors must evaluate whether changes reflect improved estimation (legitimate) or appear timed to smooth earnings (questionable). Under SA 240 (The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements), the auditor must consider whether accounting changes indicate potential management override or fraudulent intent. Similarly, internal audit functions must assess whether policy changes align with strategic business drivers or serve reporting objectives.
For CFOs and finance teams, the stakes include reputational damage, potential regulatory enquiries from SEBI or the Ministry of Corporate Affairs (MCA), and creditor or investor backlash when the accounting adjustments unwind or are subsequently reversed. Companies that systematically deploy such practices risk loss of analyst and institutional investor confidence.
Practical Impact
**For Finance Leadership:** CFOs should conduct an internal audit of the last 3–5 years' accounting policy changes. Map each change to (a) underlying business trigger, (b) quantified impact on reported profit and EPS, and (c) external communication. If changes cluster in periods of operational stress, or if reversals have occurred, prepare explanatory narratives for stakeholders and consider whether policies should be re-established on more conservative bases.
**For Audit Committees and Boards:** Enhanced scrutiny of accounting policy changes is essential. Request that management articulate the business case for each change independent of earnings impact. Ask external auditors to quantify cumulative impact of all prior-year changes and to opine on whether the aggregate suggests earnings management intent. Consider whether audit committee oversight of accounting policies meets best-practice standards.
**For Auditors and Compliance Professionals:** When evaluating accounting policy changes, document the original estimation basis and the new basis. Challenge management on timing and ask whether stakeholders (lenders, rating agencies, internal forecasts) were informed before the policy change. Consider whether the change reduces or increases comparability with prior periods or peer companies. If a pattern of pro-earnings changes emerges, escalate to the audit partner and consider impact on audit opinion.
**For Investors and Analysts:** Beyond reading disclosure notes, calculate adjusted EBITDA and operating cash flow trends independently. Compare accounting policies with industry peers. If a company's reported profit growth significantly outpaces peer growth and cash flow growth, investigate the accounting footnotes. Request management presentations that reconcile reported profits to underlying operational metrics.
**For Regulators:** While SEBI's emphasis on cash flow disclosure and segment reporting has improved transparency, further standardization of accounting policy change disclosures—including mandatory quantification and forward-looking impact assessment—would reduce the scope for selective application.
Key Takeaways
- →Accounting policy changes remain a subtle yet potent tool for earnings management; compliance with IFRS/IAS does not guarantee economic transparency or alignment with cash generation.
- →Audit and compliance teams must apply heightened scepticism to policy changes that occur in clusters, during periods of operational stress, or that systematically improve reported metrics without operational justification.
- →CFOs should inventory and evaluate all policy changes made in recent years, quantify cumulative impact, and ensure boards and external auditors have challenged the business case for each change.
- →Investors should treat reported profit growth with caution if it diverges significantly from cash flow trends; request management reconciliations and compare accounting policies with peer companies.
- →Internal and external auditors should consider whether patterns of pro-earnings accounting changes signal management override risk, warranting escalation to audit committees and potential expansion of audit scope.
Disclaimer: This update is for general information only and does not constitute legal, tax or professional advice. Regulatory positions may change. Please consult APRA & Associates LLP for advice specific to your business. Contact us.