Financial Report Analysis

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Financial Report Analysis
How Can We Identify Window Dressing of
the Accounts?
Presented by Dr. Peter Larose
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Definition of Window Dressing
These are financial techniques used by an
entity in order to show a strong or weak
financial position at a particular period in
time. Another word used in accounting language
for window dressing is Creative
Accounting. It is done to suit the purpose of
various Stakeholders. This practice is very
common with commercial companies.
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Example A high profit will be declared for
shareholders A reduced profit for Tax
Authorities A high profit for management to
negotiate new employment contract A reduced
profit to avoid a revision of salary for all the
employees. A high profit to prevent a corporate
takeover A reduced profit when the company
exceeds the market benchmark.
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A Real Life Example of Window Dressing the
Accounts of A Business
A vacancy appeared in a Newspaper advertising a
post for an Accountant to join one of the
multi-national companies. A short-list of the
candidates were made and the Head of the Human
Resources selected 3 of the highest qualified
Accountants for the interview. A Panel of 5
Executives were organized to interview the
candidates. The interview date was announced and
the candidates turned up for the interview at the
companys Head Office. One of the questions
asked by the Finance Director of the
Company was I want you to solve this accounting
problem for me What is the answer of 1
3 ?
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1st Candidates Answer 1 3 4 2nd
Candidates Answer 1 3 4 3rd Candidates
Answer 1 3 Scientifically the answer is 4

BUT Accounting wise what
you want me to
make of the
figures.

Who Do You Think Got the Job?
Can Anyone Guess? Read next Slide
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An amazing Incident with Window Dressing The
fact that the multi-national company was involved
in producing creative accounting for the
shareholders, the Panel of 5 Executives decided
to employ the 3rd candidate for the accountant
position. Unfortunately, the MNCs operations
did not last long because the executives lost
track of the number of creative
transactions. The following stakeholders lost
money in the end Shareholders, suppliers, banks,
employees, Tax Office, employees, and even the
New Accountant.
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Why Window Dress a set of Financial
Statements? The reason may be associated with
the following factors Directors or a group of
shareholders may want to impress a
prospective group of shareholders with the
companys past performance. Following a takeover
bid, management may wish to impress
existing shareholders of their strategic
decision. Earning fixation. Earnings-per-share
indicator as the top market news. Directors
remuneration may be fixed to profit performance
of the business (e.g. profit related
pay). Income smoothing to show a low variability
in income, thus give the impression of low risk
operation. Information Asymmetry managers are
privy to internal information than most outsiders
inclusive of analysts.
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Accounting Techniques Used to Window Dress a set
of Financial Statement

• T. Smith (1992) Accounting for Growth, Century
  Business, London
• Argued that there are at least 12 methods that
  can be used to produce profit.
• Capitalization of Operating Costs
• Off-Balance Sheet Financing
• Deferred purchase consideration
• Use of Brand Accounting
• Apply contingent liabilities
• Use of Profits on disposal of a business
• Treat Extra-ordinary exceptional items of
  income expenditure
• Changes in depreciation policy on fixed assets
• Use of Pension Fund Accounting
• Use of Convertible Securities
• Treatment of Foreign Exchange Currency Items
• Write down of pre-acquisition costs or potential
  future costs

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How Do We Spot Income Smoothing in the Financial
Results
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Management of Earnings Disclosures in the
Financial Statements
Davidson, Stickney Well (1987) Accounting
The Language of Business, 7th Edition, Horton,
Arizona. These scientists argued in their
research findings that window dressing accounting
is equivalent to magic accounting, when it
comes to disclosing earnings. It is a process
of taking deliberate steps within the
constraints of generally accounting principles to
bring about a desired level of earnings. Holmes
Sugden (1990) refer to the fact that financial
analysts expect some companies to try to show
continuous growth year after year and to pull out
all the stops to avoid reporting a downturn.
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Can the Market be Fooled by Window Dressing
Measures?
If a market is efficient, it should not be fooled
by the effect of window dressing Measures, which
a management may indulge. Some investors might
be influenced by its effect, but not the
market! Markets, which are considered as
efficient are primarily London, New York
Tokyo. However, there are some anomalies
sometimes. R. Watts (1986) Does it pay to
manipulate E.P.S. in the Revolution in
Corporate Finance (eds. J.M. Stern D.M. Chen),
Blackwell, Oxford. Argued in his research
findings manipulating reported earnings through
accounting changes to increase the corporation
stock prices will in most cases be a
futile exercise. Interestingly, most studies in
this area of research found that no reaction in
the share price of a company to new accounting
disclosures or to changes in accounting practices.

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Income
Expenditure
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• What about the Enron, Worldcom Scandals?
• Use of high-risk Accounting Principles
• Conflict of Interests in Boardroom
• Too Much Off-Balance Sheet Transactions
• Executive Were Paid High Compensations
• Lack of Proper Corporate Governance
• Failure of Board of Directors Corporate
  Responsibilities

These signs are common occurrence associated
with Corporate Scandals
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Enron Scandal
High Risk Accounting The Board of Directors of
Enron allowed the company to used high-risk
accounting Practices to process all their
commercial transactions. Conflict of Interests
in Boardroom The Board exercised inadequate
oversight of LJM transaction and compensation
controls and failed to protect Enron
shareholders from unfair dealing. Too Much
Off-Balance Sheet Transactions The Board of
Directors failed to ensure adequate public
disclosure of material Off-Balance Sheet
liabilities. These transactions were hidden from
the stakeholders Awareness. Executive Were Paid
High Compensations The Board of Directors paid
excessive compensation for company
executives, failed to monitor the cumulative cash
drain caused by Enrons 2000 annual bonus and
performance unit plans, and failed to monitor the
financial outcome.
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Enron Scandal..

Lack of Proper Corporate Governance The Board of
Directors did not allowed the directors to
operate independently and there were some
financial transactions involving the directors
and the company The independence of the external
auditors was also compromised involving
other Financial services, which could have been
offered by a different party. A Scenario of
Scratch my back, I will scratch
yours. Failure of Board of Directors
Corporate Responsibilities The Board were
associated with numerous indications of
questionable practices by Management team over
several years. They chose to ignore them to the
detriment of the shareholders, employees and
other stakeholders.
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What about the Auditors Role in Window Dressing
Accounting?
The auditors has a crucial role to identify
fraud, mistaken, incorrect value, manipulation,
errors in his clients accounts. Auditors are
responsible directly under the law especially the
international standards to report directly to the
shareholders on the status of the companys or a
banks account at a particular point in
time. With regards to window dressing, if they
have been unable to identify such a Practice,
then they cannot be made to be solely liable for
negligence because its it the responsibility of
the Board of Directors and the management to
ensure that the accounts are not tempered with.
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Impact of Accounting standards It is not easy
too implement rigorous standards without changing
Incentives. This situation can be seen in South
East Asian countries like Singapore,
Thailand, Hong Kong, China. Each country can
implement its own accounting standards, but did
not implement the substantial institutional
changes required to make these standards
effective. According to various studies
conducted in this area, new standards did not
result in better-quality financial
reporting. It appears that managers have great
temptation to manipulate numbers on financial
reports just to make a good impression in the
market. Executives have a personal interest in
the information disclosed, because of the
potential incentives linked to the companys
performance such as bonuses, promotions, stock
options, and other financial benefits.
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• What Lessons Have the Corporate World Learnt
  About the Enron Type Debacle?
• The Emergence of Sarbanes-Oxley Act 2002.
• New Emphasis on Corporate Governance
• More Power Responsibilities to the External
  Internal Auditors
• Strengthening Risk Management Practices
• Accountability by All Executives
• More Power to the Shareholders
• New Accounting Auditing Standards inclusive of
  Disclosure Requirements.

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I Wish You All Good Luck In Your Studies
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Thank You for Your Participation
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The End