FINANCIAL MANAGEMENT Accounting Frauds

Roles and Significance of Financial Statements: 1. 2. 3. 4. 5. 6. 7. To determine the profitability of the concern during the accounting period(P&L) To give an outlook on the financial position at the end of the year(B/S) To judge the cash flow position and liquidity of the firm(Cash Flow statement) To help in forecasting future potential of the business To enable a firm to benchmark itself with other firms and industry To help in compliance with various statutory and legal requirements To provide insights into business to all stakeholders and concerned people and also help in decision making.

So what is the meaning of the term Window Dressing? The financial statements viz. Trading and P/L A/C, Balance Sheet, Cash Flows Statement provide information on revenues, expenditures, cash flows, assets, liabilities, owned funds and so on. Using some degree of tact, the management can influence the appearance, extent of appearance and reporting of these items. They may use their freedom and position to influence the reported results and give a rosy picture. It can be named as Creative Accounting so as to influence the actual reported figures to butter up the financial statements. Frauds are masked by blowing up the income or downplaying the expenses or in other words, exaggerating assets and belittling liabilities. Eg. 1. Showcasing high profits to stakeholders but less profit for tax authorities, 2. Displaying high profit to negotiate new employee contracts but reduced profits to evade salary revisions. 3. Presenting high profits to prevent corporate takeover but low profits when company performs beyond market benchmarks. Why do these financial statement frauds and Window dressing take place? 1. 2. 3. 4. 5. To ensure the lenders of finance about the liquidity position of the company. To camouflage poor management decisions taken on part of the company. To display steady profitability position and encourage investors. To bring down liabilities for taxation purpose. To shoot up the market price of shares and build good future expectations.

Various approaches used for Window Dressing: 1. Income Smoothing Here, the credits in the income statement are reallocated across various time periods. The main motto in doing so is to reduce the variances in income figures over a period of years to show consistent income and hence, income is shifted from periods of high income to that of low income. For instance, lessening a discretionary cost like R&D and advertising expense in ongoing year to enhance ongoing years earnings. In the next year, discretionary cost will be increased.

2. Ambiguity in Capital and Revenue Expenditure Consider the example of computer software which has a useful life of three years. As revenue expenditure it is treated as negative item on P&L account. With regards to capital expenditure, it is treated as an asset in B/S, with yearly depreciation in the P&L. 3. Changing Depreciation Policy When there is an increase in expected life of asset, it will bring down the depreciation provision in P/L account and that will lead to increased net profits. To add to it, the firms asset value shall also increase as a result of increase in high net book value in B/S for a longer period. 4. Changing stock valuation policy A change in the method of stock valuation (FIFO, LIFO) can result in increased value of closing stock which will elevate the profits. For instance, when prices are rising and FIFO method is used, it increases closing stock inventory valuation. This decreases COGS and amplifies profits. In the same way, when prices are falling, LIFO method for valuation of stock is favored. 5. Sale and Lease Back Here, fixed assets are sold to a third party. Later, each year a certain sum is paid and asset is leased back. In this way, the asset does not belong to the firm but it still can use the asset. It solves problems of cash flows and is commonly used in department stores to build a new retail outlet and then sell the outlet to a property company or investment fund, and then lease back the use of the store. 6. Off Balance Sheet Financing It involves conversion of capital lease to operating lease. Hence, asset will not feature in assets/liabilities in B/S. This will help in improving the Total Assets Turnover Ratio (TOTA), Return on Assets (ROA), Equity Multiplier and so on.The costs saved are the interest expense on debt availed to finance the capital lease and depreciation. The capability of the company to raise debt increases as the liabilities component tones down. Obviously, earnings get blown up with this method. In the later years of use of asset, the firm shall resort to capital lease financing as net block will have diminished to a considerable extent, the deprecation by WDV method shall also be considerably less, thereby putting forward prospects of inflating earnings. Moreover, one enjoys added benefit of savings on tax. 7. Including Intangible Assets Firms can put a misleading picture of value of their assets by not providing depreciation on intangible assets like patents, goodwill, trademarks, copyrights etc. 8. Bringing Sales Forward As per the Revenue Realization principle of accounting, sales will show up in P/L account once order is received and not at point of transfer of ownership rights. So if customers are probed to place orders prior to planned will increase sales revenue figure in P/L account i.e. sales are brought forward from next year to this year. 9. Extraordinary Items Revenues or costs which arise not because of normal operations of business are extraordinary items. They are uncommon and not likely to be repeated in normal course of business. They need to be highlighted in

accounts, and inserted after the calculation of PBIT (Earnings before Interest and Taxation). If included in normal revenues it will overstate earnings. 10. Short Term Borrowing A firm wants its liquidity position to appear as stable and considerably good. So before the end of its financial reporting period it may borrow a short-term loan from its bank to increase its reported cash balance. Similar results can be achieved by postponing payment of accounts payable. In both cases, the companys cash and current assets increase. Even though current liabilities are also higher, the liquidity of the balance sheet has enhanced and the firm looks stronger with respect to liquidity position. 11. Chasing Debtors If a firms accounts receivable are too high, it signals possible collection inefficiencies and a reduction in liquidity. Prior to the statement date, the firm will provide additional discount to customers so as to probe them to pay instantly. Even though the profitability on the slashes down by the discount, the firm succeeds in reducing its accounts receivable, increasing its reported cash balance and thereby displays a somewhat improved financial picture. In my further posts, I shall throw more light on the various accounting frauds and scandals and lessons to be learnt from them.

Q. Which amongst these do you think was the topmost accounting scandal? Enron WorldCom Satyam Xerox Others