Window Dressing.ppt
- 3. Xerox Corporation On April 11, 2002, the U.S. Securities and Exchange Commission filed a complaint against Xerox. The complaint alleged Xerox deceived the public between 1997 and 2000 by employing several "accounting maneuvers," the most significant of which was a change in which Xerox recorded revenue from copy machine leases – recognizing a "sale" when a lease contract was signed, instead of recognizing revenue over the entire length of the contract. In response to the SEC's complaint, Xerox Corporation neither admitted nor denied wrongdoing. It agreed to pay a $10 million penalty and to restate its financial results for the years 1997 through 2000. On January 29, 2003, the SEC filed a complaint against Xerox's auditors, KPMG, alleging four partners permitted Xerox to "cook the books" to fill a $3 billion "gap" in revenue and $1.4 billion "gap" in pre-tax earnings. In April 2005 KPMG settled with the SEC by paying a US$22.48 million fine. As part of the settlement KPMG neither admits nor denies wrongdoings.
- 4. WorldCom Beginning modestly during mid-year 1999 and continuing at an accelerated pace through May 2002, the company used fraudulent accounting methods to disguise its decreasing earnings to maintain the price of WorldCom’s stock. The fraud was accomplished primarily in two ways: • Booking ‘line costs’ (interconnection expenses with other telecommunication companies) as capital expenditures on the balance sheet instead of expenses. • Inflating revenues with bogus accounting entries CEO Bernard became very wealthy from the increasing price of his holdings in WorldCom common stock.
- 5. - Non-provision of diminution in the value of long-term investments due to discretion available to management
- 11. • In 1994-95, WIPRO Ltd. transferred land of Rs.197 million from fixed assets to current assets, pending its sale. Asset was transferred at the fair market value of Rs.4500 million and the surplus of Rs.4303 million was transferred to capital reserve improving the net worth per share and current ratio. In subsequent years (1996-97 to 1999-2000), reduction in the value of land was charged to the profit & loss account and an equivalent amount was withdrawn from the capital reserve to offset the impact on profit & loss account. The actual sale of land took place after 5 years from the date of conversion.
- 12. • In 1999-2000 and 2001-02, L & T assigned some of its outstanding debt to one of its subsidiaries at a lower value and reported the difference between the outstanding loan amount and the transfer value as income in P & L A/c with a note to accounts.
- 13. • Hindustan Zinc Ltd.’s marketable investments represented investments of Rs.6193 million in mutual funds as at 31-03-2004 and Rs.688 million as at 31-03-2005. The company changed the classification of these investments to Intangible Assets. The motive behind such reclassification might be to avoid the requirements for providing for losses in value of investment as provided in AS 13. The auditors qualified the accounts in respect of the investments disclosed by the company as Intangible Assets.
- 14. • Anantraj Industries, a north Indian commercial developer, transferred part of one of its projects (0.52 mn sf out of 0.75 mn sf in a mall in Delhi) to its wholly-owned subsidiary and consequently showed equivalent revenues in its standalone results (93% of Q1 FY09 revenues).
- 15. • Jet Airways changed its depreciation policy from WDV to SLM, and thereby wrote back Rs 920 crore into its P&L, which helped the company to report profits during the quarter.
- 16. • Prajay Engineers, Hyderabad-based developer, reported a loss in its fourth quarter results against expectations of a profit. The company “lost” records for a project worth 40% of its annual revenues at the site office. The company, in its press release, said - “After the year end, basic records relating to sale agreements/revenue and construction expenses of one of the projects of property development were lost at the site office, Vishakapatnam. The auditors in their report have stated that they were not able to verify the books and records relating to income of Rs 143.77 crore and relevant construction cost of Rs 75.26 crore. Management is making all efforts to locate/ retrieve the lost records.”
- 17. Earnings Quality Key objective of financial statement analysis is to estimate future earnings from current earnings Profit reported in the annual report is a noisy measure of a company’s operating performance Earnings are said to be of high quality if - can be distributed in cash - derived primarily from continuing operations - methods used in measuring profit are conservative. Earnings are said to be of low quality if - have only a small percentage of distributable cash - derived from non-operating sources - computed using liberal accounting methods
- 18. Earnings Quality Quality of earnings is lowered by management’s discretionary actions. Managers have great temptations to choose accounting policies that will maximize their own utility and/or market value of the company. Managing earnings through accounting manipulations is known as earnings management. Creative accounting means accounting practices that may follow the letter of the rules of standard accounting practices, but certainly deviate from the spirit of those rules.
- 19. Motivation for earnings management Imagine you're a kid with a lemonade stand and you want to build a roof over it so that you and your customers aren't in the hot sun. You don't have the money because business hasn't been that good. Your brother has the money, but he won't lend it to you unless he knows that he'll make something in the deal. You're sure that having a covered lemonade stand will make all the difference for your business because your customers will enjoy sipping their drinks in the cool shade. So you decide to creatively boost your current sales figures and offer your brother a chance to invest in your business. He gives you the money to build your roof in exchange for 25 percent of your profits. For reasons unknown to you, the covered stand doesn't really sell any more lemonade than the uncovered stand did. Now your brother is mad, because the profit he thought he was going to make was based on phony sales figures. At this rate, it'll take four summers to break even and much more to actually make a profit.
- 20. Motivation for earnings management Employee compensation may be linked to current year’s earnings Reduce tax liability Maintain financial parameters like debt-equity ratio, net worth, etc. Show rosy picture to prospective investors before IPO Retiring CEO would like to enhance his retiring benefits that are linked to earnings Borrowing from financial institutions Camouflage poor management decisions Shoot up market price of shares and build good future expectations Gain institutional support Improve credit rating Increase revenue from takeovers Gain shareholder approval
- 21. Limitations of Financial Statements Quality of earnings suffers from certain limitations of financial statements, which stem basically from two sources: 1. Leverage provided by GAAPs in the choice of accounting policies and changes therein 2. Window dressing in accounts and financial statements
- 22. Leverage provided by GAAPs Ind AS 8 allows changes in accounting policies when is considered to result in more appropriate preparation or presentation of financial statements While provision is well intended, it leaves management with a handle to justify the appropriateness of its decision to effect a change suiting its own requirements Even within the framework of GAAPs, it is possible for management to fabricate the financial statements, thus affecting the quality of earnings
- 23. Leverage provided by GAAPs AS permit management choice between alternative accounting policies in certain areas Property, plant & equipment (cost of acquisition and revaluation) Depreciation (Method, estimation and revision of useful life and residual value) Assets under lease Inventories (valuation method and estimating net realizable value) Recognition of profit on long-term contracts Treatment of contingent liabilities
- 24. Window dressing Financial statements are said to be window dressed when management tries to portray a rosier performance and financial position of the company than is true - Capitalization of revenue expenses inflate bottom-line WorldCom - Revaluation of fixed assets to show better financial position Wipro - Advancing billing on the customers towards the year-end inflate top-line as well as bottom-line Xerox
- 25. Window dressing - Extension of accounting year Liberty Shoes Ltd. / Annual Report 1999-2000 Extracts from the directors’ report: The financial results as on 30th June, 2000 are for the period of 15 months as compared to the previous 12 months period ended on 31st March, 1999 and are therefore not comparable. The intention of extending the financial year by 3 months was to implement the then ongoing restructuring programme. However considering its complexity and financial burden, the programme has been postponed for the time being. Financial year may be extended to cover up a major loss or to include a major likely gain of immediately following 2-3 months
- 26. Window dressing - Inadequate or no provision for doubtful debts to inflate the financial position and bottom-line; Hindustan Motors - No separate disclosure of prior-period adjustments or extraordinary income - Increasing the estimates of useful life of fixed assets to charge a lower depreciation; Cadila Healthcare - Round-tripping: Getting into fictitious transactions to inflate revenue; Satyam Computers A company sells unused assets to a party with the promise of buying back at a later date at the same or different price.
- 27. Window dressing - Companies put aside money for possible loan defaults. Some companies, during periods of high revenue growth, increase the amount of reserves and release the same during periods of poor revenue, offsetting the impact of low sales growth. cookie jar reserves e.g. Dell
- 28. Window dressing - Non-operational/non-recurring income being the major source of income OMCs encountered sharp reductions in their profits during the last FY. In fact, during the first nine months of the last FY all OMCs registered operating losses. Indian Oil Corporation, India’s largest company, only prevented itself from sliding into losses by selling-off their shares in India’s upstream major, ONGC. Clearly, this one-off non-operational profit cannot be repeated.
- 29. Big bath/kitchen sinking - Practice of making big asset write-downs, huge provisions for restructuring or liabilities - Enables a firm to come clean - Productive assets/saleable inventories may be written off, large impairment charges, excessively large provisions for credit losses, losses on disposal of assets - Even if business does not do well, reported profit will go up in next period because of lower depreciation and COGS - Big bath is usually done when a new CEO takes over or M&A
- 30. Other things which companies do to manipulate earnings- modify operating decisions - Reducing discretionary expenditures- R&D, advertising, training, plant maintenance - Offering price discounts to boost sales - Selling surplus assets at a gain - Generous credit terms - Overproduction- reduce cost per unit and hence COGS - Delaying plant commissioning- defers recognition of depreciation, extends interest capitalization - Deferring capital expenditure- reduces current depreciation (but would hurt future production capacity) - Deferring planned maintenance- reduce current maintenance (but damages the equipment) Perfectly within GAAP, may be harmful to firm value More difficult to detect
- 31. Beating window dressing We have to live with street smart managements and their window dressed financial statements We can just make some efforts and resort to some measures to beat window dressing to the extent possible in analyzing financial statements - Careful study of ‘notes to accounts and accounting policies’ and assessment of variations in policies, accounting estimates, extraordinary items and contingent liabilities - Assessment of the financial impact of qualifications in auditors’ report on the corporate profitability and financial position - Comparison of basic and diluted EPS to predict EPS sustainability in future
- 32. Beating window dressing - Study of chairman’s statement, directors’ report, corporate governance report, management discussion and analysis and integrate them with the study of financial statements - Analysis of related party transactions to find out whether any undue benefit is being provided to them at the cost of the company - Analysis of segment results to analyze whether any line of business is making a dent on the overall bottom-line
- 33. Ten Commandments Prof. W H Beaver put together a list of warnings for those intending to use financial statements 1. Do not use financial statements in isolation, but only in the context of other available information. 2. Do not use financial statements as the only source of firm-specific information. 3. Do not avoid reading the footnotes, which are an integral part of financial statements. 4. Do not focus on a single number. 5. Do not overlook the implications of what is read. 6. Do not ignore events subsequent to the financial statements. 7. Do not overlook the limitations of financial statements. 8. Do not use financial statements without adequate knowledge. 9. Do not shun professional help. 10. Do not take unnecessary risks.
- 34. Potential red flags An analyst should develop the skill of identifying red flags - Unexplained change in accounting policy - Unusual increase in accruals including receivables, inventory, creditors and depreciation - Increasing gap between reported earnings and cash flow from operations - Increasing gap between reported income and taxable income - Increase in unusual short-term financing - Large adjustments in fourth quarter - Qualified audit opinion - Change in external or internal auditor - Increase in related party transactions