Financial Report Analysis

1. Financial Report Analysis How Can We Identify Window Dressing of the Accounts? Presented by: Dr. Peter Larose

2. 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.

3. 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.

4. 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 company’s 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 = ?

5. 1st Candidate’s Answer 1 + 3 = 4 2nd Candidate’s Answer 1 + 3 = 4 3rd Candidate’s 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

6. 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 MNC’s 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.

7. 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 company’s 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.

8. 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

9. How Do We Spot Income Smoothing in the Financial Results

10. 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”.

11. 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.”

13. Income Expenditure

14. What about the Enron, Worldcom Scandals? • Use of high-risk Accounting Principles • Conflict of Interests in Boardroom • Too Much Off-Balance Sheet Transactions • Executives 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

15. 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 Enron’s 2000 annual bonus and performance unit plans, and failed to monitor the financial outcome.

16. 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.

17. 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 client’s accounts. Auditors are responsible directly under the law especially the international standards to report directly to the shareholders on the status of the company’s or a bank’s 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.

18. 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 company’s performance such as; bonuses, promotions, stock options, and other financial benefits.

19. 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.

20. I Wish You All Good Luck In Your Studies

21. Thank You for Your Participation

22. The End