Friday, June 12, 2020

Window Dressing - Free Essay Example

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. It is also defined as:  Ã¢â‚¬ËœA 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 asunethical. Reasons for Window Dressing: 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 dec isions †¢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 theyears by shifting income from good years to bad years. An example is reducinga Discretionary Cost (e. g. , advertising expense, research and development expense) in thecurrent year to improve current period earnings. In the next year, the discretionary costwill be increased. Ambiguity in Capitalizing and Revenue expenditure –  E. . Computer software with useful life of 3 years. As revenue expenditure it is treated as negative item on PLaccount. As capitalizing expenditure, it is treated as an asset in balance sheet, with yearlydepreciation in the PL. Changing depreciation policy   Increasing ex pected life of asset reduces depreciation provision in PL account, hence, increasing net profits. Also, net book value in balance sheet will be higher for a longer period, thereby, increasing firm’s asset values 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 closingstock inventory valuation, thereby reducing the COGS, and hence inflating the earnings. Similarly, in a falling price scenario, LIFO valuation method for inventory is morefavourable. 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 whichautomatically improves ratios such as Total Asset Turnover Ratio (TATO), Return onAssets, Equity Multiplier, etc. The costs saved are the interest expense on debt availed tofinance the capital lease and depreciation. Also, the debt-raising capacity of the companyincreases as the liabilities component tones down. Naturally, earnings are inflated underthis method. In the later years of use of asset, the company may revert back to capital lease financingsince the with net block having reduced considerably, the deprecation by WDV methodwill also be very less, thereby providing an opportunity to inflate earnings. Also, itprovides 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  Ã¢â‚¬â€œ Sales show up in the PL account when the order is received and not at t he point of transfer of ownership rights as mentioned in the notes to accountsof the Co. nder the heading of ‘Revenue Realisation’. Encouraging customers to placeorders earlier than planned increases the sales revenue figure in PL account. This bringssales 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 repeatedThey should be highlighted in accounts, and inserted after the calculation of Profit beforeInterest and Taxation. To include these in normal revenues will again exaggerate businessprofits. 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 ofRs 110 crore in Q1 FY09. Management declined to disclose the valuation methodology. Tata Motors also changed its methodology for calculating provisions for doubtfulreceivables,  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 usedto recognise hedging gains on effective hedges in its revenue line, thus boosting thereported revenue growth and Ebit margin. In FY08, TCS had Rs 421crore from hedginggains, 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 PL , 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 PL 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 forexlosses in the above manner. In addition, the company has not recognised Rs 399 crore oftranslation losses on FCCBs, since the FCCBs can potentially get converted, although theFCCBs are out of money. Adjusted for all the above, the company would have virtually no profits in Q1 FY09