Window DressingWindow Dressing

The old jokes are the best The old jokes are the best jokesjokes

• Chairman of the board: How much Chairman of the board: How much profit did we make last year?profit did we make last year?

• Finance director :What profit do you Finance director :What profit do you want us to have made? You can take want us to have made? You can take your pick from the following profit your pick from the following profit figuresfigures

What is window dressing? What is window dressing?

• Window dressing is presenting company Window dressing is presenting company accounts in a manner which enhances the accounts in a manner which enhances the financial position of the companyfinancial position of the company

• It is a form of creative accounting It is a form of creative accounting involving the manipulation of figures to involving the manipulation of figures to flatter the financial position of the businessflatter the financial position of the business

• The focus of window dressing The focus of window dressing – Liquidity Liquidity – hiding a deteriorating liquidity – hiding a deteriorating liquidity

positionposition– ProfitabilityProfitability - massaging profit figures - massaging profit figures

Definition of creative Definition of creative accountingaccounting• ““A form of accounting which, while complying A form of accounting which, while complying

with all the regulations, nevertheless gives a with all the regulations, nevertheless gives a biased impression (generally favourable) of biased impression (generally favourable) of the company’s performance” (CIMA)the company’s performance” (CIMA)

• Creative accounting involves using the Creative accounting involves using the flexibility within accounting to manage the flexibility within accounting to manage the measurement and presentation of the measurement and presentation of the accounts so that they serve the interests of accounts so that they serve the interests of people who prepare the accounts rather than people who prepare the accounts rather than those for whom accounts are preparedthose for whom accounts are prepared

The law and ethicsThe law and ethics

• Some methods of window dressing are contrary to the Some methods of window dressing are contrary to the law or contrary accounting standards and would not law or contrary accounting standards and would not be employed by reputable firmsbe employed by reputable firms

• But accounting standards permit some flexibility of But accounting standards permit some flexibility of interpretationinterpretation

• When coupled with managerial interest in presenting When coupled with managerial interest in presenting figures in the most favourable light the result is figures in the most favourable light the result is window dressingwindow dressing

• Some forms of window dressing are permitted within Some forms of window dressing are permitted within the law and accounting standards but if the intention the law and accounting standards but if the intention is to deceive stakeholders then they are unethicalis to deceive stakeholders then they are unethical

• In the continuum that follows there is no scope for In the continuum that follows there is no scope for creative accounting in 1, 4 represents fraud whereas creative accounting in 1, 4 represents fraud whereas 2 and 3 are the “grey” areas2 and 3 are the “grey” areas

Continuum of creative Continuum of creative accountingaccounting1. No flexibility permitted.1. No flexibility permitted.

No scope for creative No scope for creative accountingaccounting

Accounting standards Accounting standards eliminate choice in accounting eliminate choice in accounting policiespolicies

2.Flexibility to give a true 2.Flexibility to give a true and fair viewand fair view

Work within regulatory Work within regulatory framework to ensure the framework to ensure the interests of stakeholdersinterests of stakeholders

3.Flexibility used to give a 3.Flexibility used to give a creative viewcreative view

Working within the regulatory Working within the regulatory framework but this time to framework but this time to serve the interests of serve the interests of managers preparing the managers preparing the accountsaccounts

4.Flexibility used to give a 4.Flexibility used to give a fraudulent viewfraudulent view

Outside the regulatory Outside the regulatory framework.framework.

Therefore this is illegalTherefore this is illegal

Reasons for window Reasons for window dressingdressing• To show a stronger market position than is warrantedTo show a stronger market position than is warranted• To influence share priceTo influence share price• To reduce liability for taxationTo reduce liability for taxation• To hide liquidity problemsTo hide liquidity problems• To ward off takeover bidsTo ward off takeover bids• To encourage investorsTo encourage investors• To re-assure lenders of financeTo re-assure lenders of finance• To hide poor management decisionsTo hide poor management decisions• To satisfy the demands of major investors concerning To satisfy the demands of major investors concerning

the level of returnthe level of return• To achieve sales or profit target thereby ensuring that To achieve sales or profit target thereby ensuring that

management bonuses are paidmanagement bonuses are paid

Method used to window Method used to window dressdress

• Sale and leasebackSale and leaseback

• Short term borrowingShort term borrowing

• Chasing debtorsChasing debtors

• Bringing sales forwardBringing sales forward

• Changing depreciation policyChanging depreciation policy

• Including intangible assetsIncluding intangible assets

• Changing stock valuation policyChanging stock valuation policy

Changing accounting Changing accounting policiespolicies• The easiest way to do a snow job on investors The easiest way to do a snow job on investors

is to change one factor in the accounting each is to change one factor in the accounting each month. Then you can say, ”It’s not comparable month. Then you can say, ”It’s not comparable with last month or last year. And we can’t with last month or last year. And we can’t really draw any conclusion s from the figures”really draw any conclusion s from the figures”

(Robert Townsend, Up the Organisation)(Robert Townsend, Up the Organisation)

• This points to the importance of maintaining This points to the importance of maintaining consistency in accounting policies. By consistency in accounting policies. By changing accounting policies it is possible to changing accounting policies it is possible to mislead stakeholdersmislead stakeholders

Sale and leasebackSale and leaseback

• This involves selling fixed assets to a third party This involves selling fixed assets to a third party and then paying a sum of money per year to and then paying a sum of money per year to lease it backlease it back

• The business retains the use of the asset but no The business retains the use of the asset but no longer owns itlonger owns it

• The liquidity or cash position of the improves The liquidity or cash position of the improves but:but:– the asset no longer features on the balance sheetthe asset no longer features on the balance sheet– there is a continuing commitment to pay rental to use there is a continuing commitment to pay rental to use

the assetthe asset– the business is not tackling the cause of the liquidity the business is not tackling the cause of the liquidity

problemproblem

Short term borrowing Short term borrowing

• Short term borrowing just before the Short term borrowing just before the date on which the balance sheet is date on which the balance sheet is drawn updrawn up

• This enhances the apparent ability to This enhances the apparent ability to pay its short term debtspay its short term debts

• But creates an additional liabilityBut creates an additional liability

Chasing debtorsChasing debtors

• Special effort to chase debtors before the Special effort to chase debtors before the balance sheet is drawn upbalance sheet is drawn up

• This might involve discounts for prompt This might involve discounts for prompt paymentpayment

• Conversion of debtors into cash will Conversion of debtors into cash will improve the balance sheet and cash improve the balance sheet and cash position of the organisationposition of the organisation

• Liquidity does improve but at the expense Liquidity does improve but at the expense of sales revenueof sales revenue

Bringing forward salesBringing forward sales

• Sales show up in the P&L account when the Sales show up in the P&L account when the order is received - not when the cash is receivedorder is received - not when the cash is received

• Encouraging customers to place orders earlier Encouraging customers to place orders earlier than planned will increase the sales revenue than planned will increase the sales revenue figure in the P&L accountfigure in the P&L account

• This can bring sales forward from next year to This can bring sales forward from next year to this yearthis year

• The drawback is that the sales cannot be The drawback is that the sales cannot be included in next year’s figureincluded in next year’s figure

• It fails to tackle the underlying problemIt fails to tackle the underlying problem

Changing depreciation Changing depreciation policypolicy• Increasing the expected life of the asset will Increasing the expected life of the asset will

reduce the depreciation provision in the P&L reduce the depreciation provision in the P&L accountaccount

• This will increase the net profit shown in the This will increase the net profit shown in the accountaccount

• Lengthening expected life boosts profits - Lengthening expected life boosts profits - shortening it reduces profits.shortening it reduces profits.

• It will also mean that net book value in the It will also mean that net book value in the balance sheet will be higher for a longer balance sheet will be higher for a longer period thereby increasing the firm’s asset period thereby increasing the firm’s asset value on the balance sheetvalue on the balance sheet

Including intangible assetsIncluding intangible assets

• Intangible assets: brand names, goodwillIntangible assets: brand names, goodwill

• Normally only included if purchasedNormally only included if purchased

• They are subject to depreciation (known They are subject to depreciation (known as amortisation) like other fixed assetsas amortisation) like other fixed assets

• But if they are not depreciated the firm But if they are not depreciated the firm can maintain the value of its assets thus can maintain the value of its assets thus giving a misleading view of the asset giving a misleading view of the asset value of the firmvalue of the firm

Capitalising expenditureCapitalising expenditure

• The distinction between revenue expenditure The distinction between revenue expenditure and capital expenditure is not clear cutand capital expenditure is not clear cut

• Example: computer software with a useful life Example: computer software with a useful life of 3 yearsof 3 years

• If treated as revenue expenditure it is treated If treated as revenue expenditure it is treated as a negative item on the P&L accountas a negative item on the P&L account

• If treated as capital expenditure it is treated as If treated as capital expenditure it is treated as an asset on the balance sheet (with yearly an asset on the balance sheet (with yearly depreciation as a negative item on the P&L) depreciation as a negative item on the P&L)

Stock valuationStock valuation

• There are various methods of stock There are various methods of stock valuation: LIFO,FIFO,AVCOvaluation: LIFO,FIFO,AVCO

• A change in method will lead to different A change in method will lead to different figure forfigure for– issue price used in costing issue price used in costing – closing stock which then impacts on profitsclosing stock which then impacts on profits– stock in the balance sheet which then impacts stock in the balance sheet which then impacts

on the value of the firm’s assetson the value of the firm’s assets

• Anything which increases the value of Anything which increases the value of closing stock will increase profits closing stock will increase profits

A final thoughtA final thought

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

(Ian Griffiths, Creative Accounting, 1989)(Ian Griffiths, Creative Accounting, 1989)