E-LESSON-9 ,

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M.B.A FINANCIAL REPORTING AND ANALYSIS Course Code: MBA604 Semester: 1 SLM UNITS : 9 E-lesson Unit: 7 www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

WINDOW DRESSING 3 OBJECTIVES INTRODUCTION Student will be able to : As Financial Analysis is based on financial statements, the limitations of financial Explain the limitations of Financial Statements analysis also become the limitations of financial statements. Understand the concept of window dressing Window dressing is a technique used by companies and financial managers to manipulate financial statements and reports to show more favourable results of a period. www.cuidol.in Unit - 9 (MBA 604) INASllTITriUgThEt aOrFeDreISsTeArNveCdE AwNitDh OCNUL-IIDNOE LLEARNING

TOPICS TO BE COVERED > Limitations of Financial Statements > Window Dressing > Techniques of Window Dressing www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Limitations of Financial Statement  Financial statements are released by the company and hence the obvious limitation is that the information an analyst gets is limited to what the company wants to show and how it is planned to manipulate the information.  Below is the list of top 10 limitations of financial statement 1. Historical Costs 2. Inflation Adjustments 3. Personal Judgments 4. Specific Time Period Reporting 5. Intangible Assets 6. Comparability 7. Fraudulent Practices 8. No Discussion on Non-Financial Issues 9. It May Not be Verified 10 Future Prediction www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Limitations of Financial Statement 1 Historical Costs Financial reports depend on historical costs. All the transactions are recorded at historical costs. The value of the assets purchased by the Company and the liabilities it owes changes with time and depends on market factors. The financial statements do not provide the current value of such assets and liabilities. Thus, if a large number of items available in the financial statements are based on historical costs and the Company has not revalued them, the statements can be misleading. 2 Inflation Adjustments The assets and liabilities of the Company are not inflation-adjusted. If the inflation is very high the items in the reports will be recorded at lower costs and hence, not giving much information to the readers. 3 Personal Judgments The financial statements are based on personal judgments. The value of assets and liabilities depends on the accounting standard used by the person or group of persons preparing them. The depreciation methods, amortization of assets, etc. are prone to the personal judgment of the person using those assets. All such methods cannot be stated in the financial reports and are, therefore, a limitation. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Limitations of Financial Statement 4 Specific Time Period Reporting The financial statements are based on a specific time period they can have an effect of seasonality or sudden spike/dull in the sales of the Company. One period cannot be compared to other periods very easily as there are many parameters that affect the performance of the Company and that reported in the financial reports. A reader of the reports can make mistakes while analyzing based on only one period of reporting. Looking at reports from various periods and analyzing them prudently can give a better view of the performance of the Company. 5 Intangible Assets The intangible assets of the Company are not recorded on the balance sheet. Intangible assets include brand value, the reputation of the Company earned over a period of time which helps it generate more sales, is not included in the balance sheet. However, if the Company has done any expense on intangible assets they are recorded on the financial statements. This is, in general, a problem for start-ups which based on the domain knowledge create a huge intellectual property but since they have not been in business for long could not generate enough sales. Hence, their intangible assets are not recorded on the financial statements and neither reflected in the sales. 6 Comparability While it is a common practice for analysts and investors to compare the performance of the Company with other companies in the same sector but they are not usually comparable. Due to various factors like the accounting practices used, valuation, personal judgments made by the different people in different Companies comparability can be a difficult task. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Limitations of Financial Statement 7 Fraudulent Practices The financial statements are subject to fraud. There are many motives behind having fraudulent practices and thereby skewing the financial results of the Company. If the management is to receive a bonus or the promoters would like to raise the price of the share they tend to show good results of the Company’s performance by using fraudulent accounting practices, creating fraud sales, etc. 8 No Discussion on Non-Financial Issues Financial statements do not discuss non-financial issues like the environment, social and governance concerns and the steps taken by the Company to improve the same. 9 It May Not be Verified The financial statements should be audited by an auditor, however, if they are not, they are of minimal use to the readers. If no one has verified the accounting practices of the Company, operations, and general controls of the Company there will be no audit opinion. 10 Future Prediction The financial statements provide the historical performance of the Company, many analysts use this information and predict the sales and profit of the Company in future quarters. However, it is prone to many assumptions. Thus, financial statements as a standalone cannot provide any prediction on the future performance of the Company. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

What is Window Dressing in Accounting? Window Dressing in Accounting refers to the manipulation done by the management of the company intentionally in the financial statements in order to present a more favorable picture of the company in front of the users of the financial statement before the same is released in the public. Window dressing in accounting means an effort made by the management to improve the appearance of a company’s financial statements before it is publicly released. It is a manipulation of financial statements to show more favorable results of the business. It is done to mislead the investors. It can be used by companies and mutual funds.  It is done when a company/business has a large number of shareholders, and the management wants to project to the investors/ shareholders that the business is doing well, and wants their financial information to look appealing to them.  It is done as the financial position of a company is one of the important parameters, and it plays a key role in bringing in new business opportunities, investors, and shareholders.  Window dressing can mislead the investors and other stakeholders who do not have the proper operational knowledge of the business.  In closely held business it is not done as the owners are aware of the company’s performance. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Purpose of Window Dressing in Accounting  Shareholders and Potential shareholders will be interested to invest in the company if the financial look is good.  It is useful to seek funds from investors or to obtain any loan.  The stock price of the company will shoot up if the financial performance is good.  Tax avoidance can be done by showing poor financial results.  To cover up the poor management decisions taken.  It improves the liquidity position of the business  To show a stable profit and results for the company.  It is done to reassure the financial stability of the company to money lenders.  It is done to achieve targeted financial results.  It is done to showcase a good return on investment.  To increase the performance bonus to the management team based on the overstated profits.  To cover up the actual state of business in case the business is nearing insolvency. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Methods of Window Dressing in Accounting Top Methods of Window Dressing in Accounting 1. Cash/Bank: Postponing the payment to suppliers, so that at the end of the reporting period the cash/bank balance will be high. Selling off the old assets, so that the cash balance will improve and show a better liquidity position, at the same time fixed assets balance will not differ much since it is an old asset with more accumulated depreciation. 2. Inventories: Changing the valuation of inventories to increase or decrease profits. 3. Revenue: Companies sell products at a discounted price or gives special offers to boost up the sales at the year-end so that the financial performance of the company looks better. 4. Depreciation: Changing the depreciation method from accelerated depreciation to the straight-line depreciation method so the profits will be improved. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Methods of Window Dressing in Accounting 5. Creation of Provisions: As per the concept of prudence, it requires recording expenses and liabilities as soon as possible but revenue only when it is realized or assured. If an excess provision is created it can reduce the profits and reduce corresponding tax payment. 6. Short Term Borrowing: Short term borrowing is obtained to maintain the liquidity position of the organization 7. Sale and Leaseback: Selling off the assets before the end of the financial year and uses the money to fund the business, and maintain the liquidity position and leasing it back for a longer term for the business operations. 8. Expenses: Presenting the capital expenditure as revenue expenditure to understate the profits. The above mentioned are a few ideas for window dressing in accounting, there are many other ways where the financials can be manipulated and presented according to management needs. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Means to Check Window Dressing 1. Verification and Valuation of Assets: Verification of assets would help to guard against improper increase of values or creation of those assets which actually do not exist. This is primary and important responsibility of management accountants. The modern function of management accountant is not only to verify but to protect the assets also verification further includes valuation of assets. Generally valuation of assets will involve following points for consideration: (i) Acquisition cost of asset (ii) Life of the asset (iii) Depreciation and method of depreciation to be applied (iv) Scrap value at the end of the life of asset (v) Provisions for contingencies (vi) Basis of Valuation Management accountant has to keep in mind which basis of the valuation is being followed since asset can be valued at realizable values or replacement cost. He should ensure that the method of valuation conforms to the principles on which assets are being valued. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Means to Check Window Dressing 2. Verification and Valuation of Inventories: Verification and valuation of inventories is another mean available to check window dressing. Inclusion of obsolete stock or dead stock may cheat the user of the financial statements. Valuation of stocks may be done on the FIFO system or LIFO system, market price or average price. Choice of the method may lead to understatement or overstatement of stocks. However a General principle of market price or cost price whichever is lower followed by accountants. But valuation of stock is another tool in the hands of creative accountants to put glamour to the balance sheet. 3. Verification of provisions: Generally provisions are created to meet losses or to meet a specific contingency for instance provision for bad debts, discount on debtors, etc. An excessive provision for bad and doubtful debts will lower the income shown in profit and loss account. A trend can be framed so as to put a check on this malpractice. More over creation of provisions is subjective in nature. More conservative accountant will create more provision and vice versa. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Means to Check Window Dressing 4. Verification of Capital and Revenue Items: A distinction between capital and revenue item is very important from the point of view of calculating the correct profit or loss of a business concern. Window dressing can be done by shifting any capital expenditure from balance sheet to income statement so as to lowering down the profits and vice & versa. A check is also required to determine whether revenue item is deferred revenue or not. Deferred revenue expenditure is basically a revenue item but the benefit of which will extend beyond the period in which it is incurred. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Reasons for Window Dressing 1. Window Dressing is done for enhancing liquidity position of the corporate unit. 2. Window Dressing is done for showcase stable profitability of the company. 3. Window Dressing is done for reducing tax liability of the corporate unit. 4. Window Dressing is done to attract more investors. 5. Window Dressing is done to reassure money lenders. 6. Window Dressing sometime is done to ward off take-over bids. 7. Window Dressing is also done to influence market prices of shares of the company. 8. Window Dressing is needed sometimes for hiding poor managerial decisions. 9. Window Dressing is done to satisfy major investors because they feel concerned with desired rate of return. 10. Window Dressing is done for achieving sales and profit targets. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Window Dressing of Income Statement  A creative accountant can prepare an attractive income statement of an inefficient business firm in such a way that lapse on the part of management can be concealed. Following are the ways of window dressing in Income Statement: 1. Under and over valuation of inventories. 2. Excess/less creation of provision of Bad debts and Discount on Debtors. 3. Excess/Less Depreciation on Fixed assets. 4. Excess/less amortization of fictitious assets. 5. Creation of General Reserve. 6. Showing capital expenditure as a revenue expenditure in income statement. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Window Dressing of Balance Sheet  Balance sheet being a static statement shows financial position and condition of an organisation on a particular date. This statement does not depict the position of the whole accounting period. Clever accountant can create a balance sheet on the whims of owner in following ways: 1. Under or over valuation of closing stock. 2. Inclusion of obsolete or dead stock. 3. Excess slow moving debtors by adopting liberal credit policies. 4. Showing long term items as short term so as to improve liquidity ratios. 5. Window dressing of portfolios maintained by the firms. 6. Utilization of reserves for issuing bonus shares. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

What Is an \"Ethical Issue\" in Financial Accounting  Ethics in accounting are concerned with how to make good and moral choices in regard to the preparation, presentation and disclosure of financial information. During the 1990s and 2000s, a series of financial reporting scandals brought this issue into the forefront. Knowing some of the issues presented in accounting ethics can help you ensure that you are considering some of the implications for the actions that you take with your own business.  Fraudulent Financial Reporting  Most accounting scandals over the last two decades have centered on fraudulent financial reporting. Fraudulent financial reporting is the misstatement of the financial statements by company management. Usually, this is carried out with the intent of misleading investors and maintaining the company's share price.  While the effects of misleading financial reporting may boost the company's stock price in the short-term, there are almost always ill effects in the long run. This short-term focus on company finances is sometimes known as \"myopic management.\" www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

What Is an \"Ethical Issue\" in Financial Accounting  Misappropriation of Assets  On an individual employee level, the most common ethical issue in accounting is the misappropriation of assets. Misappropriation of assets is the use of company assets for any other purpose than company interests. Otherwise known as stealing or embezzlement, misappropriation of assets can occur at nearly any level of the company and to nearly any degree.  For example, a senior level executive may charge a family dinner to the company as a business expense. At the same time, a line-level production employee may take home office supplies for personal use. In both cases, misappropriation of assets has occurred.  Disclosure Violations  As a subtopic of fraudulent financial reporting, disclosure violations are errors of ethical omission. While intentionally recording transactions in a manner that is not in accordance with generally accepted accounting principles is considered fraudulent financial reporting, the failure to disclose information to investors that could change their decisions about investing in the company could be considered fraudulent financial reporting, as well. Company executives must walk a fine line; it is important for management to protect the company's proprietary information. However, if this information relates to a significant event, it may not be ethical to keep this information from the investors. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

What Is an \"Ethical Issue\" in Financial Accounting  Faking the Numbers The most common ethical concern within reporting and analysis is “faking the numbers“. If poor documentation is being kept about the financial outlook of an organization, a reporter may feel pressure to come up with an estimate. An estimate that isn’t valid. The trouble with estimates is that they can be incorrect. Incorrect estimates in reporting are fraudulent numbers that can create legal concerns. Beyond these consequences, for eg, the healthcare industry relies on investors for important purchases such as hospital campuses, new and improved treatments, etc. With fake numbers, investors may look to something that isn’t actually there. An organization who fails to report is an organization that will soon not be able to provide care for suffering patients – costing you lives in the end. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Few Finance Scandals in India 2018 Punjab National Bank Scam  What Happened: Bank fraud with help of senior officials  Current Status: Absconding  Estimated: Rs13, 700 crore  PNB official file a complaint with the CBI against three companies and four people that included Nirav Modi and Mehul Choksi, claiming they had defrauded the bank and caused a loss of Rs280 crore but revised it later to more than Rs13,000 crore. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Few Finance Scandals in India  2018 Vikram Investments Scam  What Happened: Collected money promising 40 per cent returns on commodity trading  Current Status: Arrested  Estimated: Rs800 crore  Cricketer Rahul Dravid, Badminton stars Prakash Padukone and Saina Nehawal lost money in this Ponzi scheme that assured 40 per cent returns on their investment through investment in commodity trading. The Bengaluru-based wealth management firm owned by Raghavendra Sreenath had duped more than 500 investors of more than `800 crore. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

Few Finance Scandals in India  2018 Bitcoin Scam  What Happened: Collected Rs2000 crore from 8,000 people for mining bitcoins. Also provided bitcoin mining hardware  Current Status: Arrested  Estimated: Rs2000 crore  Amit Bhardwaj, who claimed to be a bitcoin entrepreneur, collected more than Rs2000 crore from 8,000 people from across the country. He operated bitcoin mining units Gain Bitcoin and GB Miners and promised 10 per cent returns. Bhardwaj also provided bitcoin mining hardware to the investors so that they can mine their own coins. But within months, he fled the country and was arrested from Bangkok. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

SUMMARY  Limitations of Financial Statement  What is 'Window Dressing'?  Means and Methods of Window Dressing  Ethical Issue in Financial Accounting  Few Finance scandals in India from the recent past www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

MULTIPLE CHOICE QUESTIONS Q1. Which among the following is the limitaiton of Financial Statement? a) Hinders the performance b) Affected by window dressing of financial analysis c) Lack of qualitative analysis d) All of the above Q2. Which among the following is the feature of window dressing? a) Off balance sheet financing b) The concept of window dressing is unethical c) It is usually done to mislead d) All of the above investors from the true company or fund performance Q3. Which among the following is the need of window dressing? a) It is done for reducing tax b) It is done to reassure liability of the firm moneylenders c) To ward off takeover bids d) All of the above Ans: 1 (d) 2 (d) 3 (d) www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

FREQUENTLY ASKED QUESTIONS Q1. List the limitations of Financial Statement. Ans. Some of the limitations of Financial statements are: 1. Historical Costs 2. Inflation Adjustments 3. Personal Judgments 4. Specific Time Period Reporting 5. Intangible Assets 6. Comparability 7. Fraudulent Practices 8. No Discussion on Non-Financial Issues 9. It May Not be Verified 10 Future Prediction For further detail Refer SLM Q2. What do you understand by 'Window Dressing' in Accounting? Ans. Window Dressing in Accounting refers to the manipulation done by the management of the company intentionally in the financial statements in order to present a more favorable picture of the company in front of the users of the financial statement before the same is released in the public. For further detail Refer SLM Q3. What is an 'Ethical Issue' in financial accounting? Ans. Ethics in accounting are concerned with how to make good and moral choices in regard to the preparation, presentation and disclosure of financial information. During the 1990s and 2000s, a series of financial reporting scandals brought this issue into the forefront. Knowing some of the issues presented in accounting ethics can help you ensure that you are considering some of the implications for the actions that you take with your own business. For further detail Refer SLM www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

REFERENCES  Thomas P Edmonds, et al., Fundamenta Financial Accounting Concepts, 2011  Baruch Lev, financial Statement Analysis, New Approach, Prentice Hall, 1975, p.5.  Accounting Principles Board, Statement No 4, Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises, NewYork: AICPA, 1970, p.50  Financial Accounting Standards Board, Concept No 6, Elements of Financial Statements, Stamford: FASB, December 1985, p 35  The Institute of Chartered Accountants of India, Guidance note on Terms Used in Financial Statements, New Delhi, ICAI September 1983, p. 19  Ahmed Belkaoi, Accounting Theory, Thomson Learning, 2000, p. 168  Eldon S Hendriksen, Accounting Theory, Irwin, 1984, p. 459  American Institute of Certified Public Accountants, Accounting Research Bulletin, No 43, AICPA, 1968. www.cuidol.in Unit - 9 (MBA 604) All right are reserved with CU-IDOL

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