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. It is also defined as: ‘A form of accounting, which while complying with all the regulations, nevertheless, gives a biased impression of the company’s performance.’ Though it is not illegal, it is considered by many financial pundits as unethical. Reasons for Window Dressing:
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Enhance Liquidity position of the Co. – hiding a deteriorating liquidity position, and Showcase stable Profitability of a company – massaging profit figures with methods such as income smoothing or profit smoothing Reduce Liability for Taxation Ward-off takeover bids Encourage Investors Re-assure Lenders of Finance To influence share price Hide poor management decisions Satisfy the demand of major investors concerning the desired level of return Achieve the sales or profit target, thereby ensuring that management bonuses are paid
Methods used for Window Dressing:
Income Smoothing: It redistributes income statement credits and charges among different time periods. The prime objective is to moderate income variability over the years by shifting income from good years to bad years. An example is reducing a Discretionary Cost (e.g., advertising expense, research and development expense) in the current year to improve current period earnings. In the next year, the discretionary cost will be increased. Ambiguity in Capitalizing and Revenue expenditure – E.g. Computer software with useful life of 3 years. As revenue expenditure it is treated as negative item on P&L account. As capitalizing expenditure, it is treated as an asset in balance sheet, with yearly depreciation in the P&L.
Changing depreciation policy - Increasing expected life of asset reduces depreciation provision in P&L account, hence, increasing net profits. Also, net book value in balance sheet will be higher for a longer period, thereby, increasing firm’s asset value.
Changing stock valuation policy - Change in method of stock valuation policy (LIFO, FIFO or AVCO) can lead to increase in value of closing stock, boosting up the profits. For example, in a rising price scenario, usage of FIFO method helps in increasing closing stock inventory valuation, thereby reducing the COGS, and hence inflating the earnings. Similarly, in a falling price scenario, LIFO valuation method for inventory is more favourable.
Sale and Lease Back– This involves selling fixed assets to a third party and then paying a sum of money per year to lease it back. Thus, the business retains the use of the asset but no longer owns it. Off-Balance Sheet Financing – Conversion of capital lease to operating lease so that the asset no longer features in the assets or liabilities of the balance sheet which automatically improves ratios such as Total Asset Turnover Ratio (TATO), Return on Assets, Equity Multiplier, etc. The costs saved are the interest expense on debt availed to finance the capital lease and depreciation. Also, the debt-raising capacity of the company increases as the liabilities component tones down. Naturally, earnings are inflated under this method. In the later years of use of asset, the company may revert back to capital lease financing since the with net block having reduced considerably, the deprecation by WDV method will also be very less, thereby providing an opportunity to inflate earnings. Also, it provides the addition benefit of saving on tax. Including intangible assets - If intangible assets like goodwill are not depreciated the firm can maintain value of its assets giving a misleading view. Bringing sales forward – Sales show up in the P&L account when the order is received and not at the point of transfer of ownership rights as mentioned in the notes to accounts of the Co. under the heading of ‘Revenue Realisation’.Encouraging customers to place orders earlier than planned increases the sales revenue figure in P&L account. This brings sales forward from next year to this year.
Extraordinary Items- Extraordinary items are revenues or costs that occur, but not as a result of normal business activity. These events are unusual and unlikely to be repeated They should be highlighted in accounts, and inserted after the calculation of Profit before Interest and Taxation. To include these in normal revenues will again exaggerate business profits.
Examples of window dressing in Indian Companies:
1. Tata Motors transferred 24% stake in Tata Automotive Components (TACO), a company with revenue of $675 in FY07, to Tata Capital, a group company, and booked a profit of Rs 110 crore in Q1 FY09. Management declined to disclose the valuation methodology. Tata Motors also changed its methodology for calculating provisions for doubtful receivables, which resulted in higher reported Ebitda to the extent of Rs 50.7 crore (10% of Ebitda). 2. TCS, the software major, increased its depreciation policy on computers from two years to four years. As a result, Q1 FY09 PBT was higher by an estimated Rs 50 crore (4% of net profit in 1QFY09). TCS followed cash-flow hedge accounting and till FY08, it used to recognise hedging gains on effective hedges in its revenue line, thus boosting the reported revenue growth and Ebit margin. In FY08, TCS had Rs 421crore from hedging gains, of which, Rs 137 crore was included in the revenue line. However, from Q1 FY09, TCS is expected to report all forex losses/gains below the Ebit line in other income. Thus, the losses it had on its hedge position will no longer be booked in the operating line. 3. Jet Airways, changed its depreciation policy from WDV to SLM, and thereby wrote back Rs 920 crore into its P&L, which helped the company to report profits during the quarter. It also helped Jet to report a higher net worth, which will help in keeping reported gearing low.
4. Dr Reddy’s adjusted mark to market losses (Q1 FY08) on outstanding $250 million of
hedges in the balance sheet, while P&L reflects forex gains realised. 5. Reliance Communications adjusted short-term quarterly fluctuations in foreign exchange rates related to liabilities and borrowings to the carrying cost of fixed assets. The company adjusted Rs 109 crore of realised and Rs 955 crore of unrealised forex losses in the above manner. In addition, the company has not recognised Rs 399 crore of translation losses on FCCBs, since the FCCBs can potentially get converted, although the FCCBs are out of money. Adjusted for all the above, the company would have virtually no profits in Q1 FY09.