Window Dressing The old jokes are the best

Window Dressing

The old jokes are the best jokes • Chairman of the board: How much profit did we make last year? • Finance director : What profit do you want us to have made? You can take your pick from the following profit figures

What is window dressing? • Window dressing is presenting company accounts in a manner which enhances the financial position of the company • It is a form of creative accounting involving the manipulation of figures to flatter the financial position of the business • The focus of window dressing – Liquidity – hiding a deteriorating liquidity position – Profitability - massaging profit figures

Definition of creative accounting • “A form of accounting which, while complying • with all the regulations, nevertheless gives a biased impression (generally favourable) of the company’s performance” (CIMA) Creative accounting involves using the flexibility within accounting to manage the measurement and presentation of the accounts so that they serve the interests of people who prepare the accounts rather than those for whom accounts are prepared

The law and ethics • Some methods of window dressing are contrary to the • • law or contrary accounting standards and would not be employed by reputable firms But accounting standards permit some flexibility of interpretation When coupled with managerial interest in presenting figures in the most favourable light the result is window dressing Some forms of window dressing are permitted within the law and accounting standards but if the intention is to deceive stakeholders then they are unethical In the continuum that follows there is no scope for creative accounting in 1, 4 represents fraud whereas 2 and 3 are the “grey” areas

Continuum of creative accounting 1. No flexibility permitted. No scope for creative accounting Accounting standards eliminate choice in accounting policies 2. Flexibility to give a true and fair view Work within regulatory framework to ensure the interests of stakeholders 3. Flexibility used to give a creative view Working within the regulatory framework but this time to serve the interests of managers preparing the accounts 4. Flexibility used to give a fraudulent view Outside the regulatory framework. Therefore this is illegal

Reasons for window dressing • • • To show a stronger market position than is warranted To influence share price To reduce liability for taxation To hide liquidity problems To ward off takeover bids To encourage investors To re-assure lenders of finance To hide poor management decisions To satisfy the demands of major investors concerning the level of return To achieve sales or profit target thereby ensuring that management bonuses are paid

Method used to window dress • Sale and leaseback • Short term borrowing • Chasing debtors • Bringing sales forward • Changing depreciation policy • Including intangible assets • Changing stock valuation policy

Changing accounting policies • The easiest way to do a snow job on investors is to change one factor in the accounting each month. Then you can say, ”It’s not comparable with last month or last year. And we can’t really draw any conclusion s from the figures” (Robert Townsend, Up the Organisation) • This points to the importance of maintaining consistency in accounting policies. By changing accounting policies it is possible to mislead stakeholders

Sale and leaseback • This involves selling fixed assets to a third party • • and then paying a sum of money per year to lease it back The business retains the use of the asset but no longer owns it The liquidity or cash position of the improves but: – the asset no longer features on the balance sheet – there is a continuing commitment to pay rental to use the asset – the business is not tackling the cause of the liquidity problem

Short term borrowing • Short term borrowing just before the date on which the balance sheet is drawn up • This enhances the apparent ability to pay its short term debts • But creates an additional liability

Chasing debtors • Special effort to chase debtors before the balance sheet is drawn up • This might involve discounts for prompt payment • Conversion of debtors into cash will improve the balance sheet and cash position of the organisation • Liquidity does improve but at the expense of sales revenue

Bringing forward sales • Sales show up in the P&L account when the • • order is received - not when the cash is received Encouraging customers to place orders earlier than planned will increase the sales revenue figure in the P&L account This can bring sales forward from next year to this year The drawback is that the sales cannot be included in next year’s figure It fails to tackle the underlying problem

Changing depreciation policy • Increasing the expected life of the asset will • • • reduce the depreciation provision in the P&L account This will increase the net profit shown in the account Lengthening expected life boosts profits shortening it reduces profits. It will also mean that net book value in the balance sheet will be higher for a longer period thereby increasing the firm’s asset value on the balance sheet

Including intangible assets • Intangible assets: brand names, goodwill • Normally only included if purchased • They are subject to depreciation (known as amortisation) like other fixed assets • But if they are not depreciated the firm can maintain the value of its assets thus giving a misleading view of the asset value of the firm

Capitalising expenditure • The distinction between revenue expenditure • • • and capital expenditure is not clear cut Example: computer software with a useful life of 3 years If treated as revenue expenditure it is treated as a negative item on the P&L account If treated as capital expenditure it is treated as an asset on the balance sheet (with yearly depreciation as a negative item on the P&L)

Stock valuation • There are various methods of stock valuation: LIFO, FIFO, AVCO • A change in method will lead to different figure for – issue price used in costing – closing stock which then impacts on profits – stock in the balance sheet which then impacts on the value of the firm’s assets • Anything which increases the value of closing stock will increase profits

A final thought • “Every company in the country is fiddling its profits. Every set of published accounts is based on books which have been gently cooked or completely roasted. The figures which are fed twice a year to the investing public have been changed to protect the guilty. It is the biggest con trick since the Trojan Horse” (Ian Griffiths, Creative Accounting, 1989)