CREATIVE ACCOUNTING (WINDOW DRESSING)

Well it goes by its name.

The phenomenon of Creative Accounting is closely associated with corporate failure. Normal accounting conventions already allow some latitude to companies that are trying to present accurate accounts. One can therefore understand the temptation of companies in trouble to adopt cosmetic accounting techniques to show a better position in the hope that matters will soon improve.

The key focus for a banker is to be able to recognise:

• when creative accounting is taking place
• the impact on the financial statements
• the motive of the directors in using such techniques

In some cases banks offer products to its customers to help them Window Dress.

Example of Creative Accounting
Account Receivables - Fail to disclose debts which are long overdue and almost certainly bad.

Inventory & Work-In-Progress

• In many cases these are shown at director's valuation and accepted by the auditors without verification.
• Fail to disclose the slow moving/obsolete lines of stocks
• Change the bases of valuing stock and take the surplus into normal trading profits rather than disclose as "extra ordinary item"
• Change costing system so that more production overheads are included in closing stock valuation
• In long term contracts recognise profit early by loading advice fees or manipulating the costing

Fixed Assets

• Revalue of fixed assets without valid commercial justification
• Sale and lease back to reduce the level of on balance sheet borrowing and perhaps increase Tangible Net Worth if assets sold in excess of book value
• Depreciation policy. In some cases depreciation is not charged on idle assets
• Amortisation policy are intangible

Revenue Expenditures
Capitalise expenditures such as research and development, pre-operating expenses or advertising and write off over a number of years. Good example is in oil and gas exploration companies...

Subsidiaries

• Avoid consolidating unprofitable offshoots
• Re-classify an associate company as an investment then its losses need not be disclosed
• Instruct subsidiaries to increase dividend to parent company
• Each year progressively bring in more results from subsidiaries to the consolidated accounts. First companies 100% owned, then 75% owned, then 50% owned
• Run part of the business in the form of a partnership. There is then no need to reveal any information other than shares of partnership profits in "parent" accounts.

Gearing

• Use operational leasing to improve the apparent gearing
• Transfer debts to a associated company, which reduces, on balance sheet borrowings although contingent liabilities may be increased if guarantee is given
• High cash balances may suggest that the net gearing position should be considered but this assumes that the cash is instantly available to reduce the borrowings.

Directors/shareholders' loan

• Inject money on the final day of the financial year end and withdraw on the first day of the next financial year

Sales

• Fail to record some cash transactions - very common for a family owned business
  
• carry forward sales invoices into the next accounting period thereby depressing profit or bring back from a subsequent period into the current year
• Include unenforceable sales agreements of goods on sales or return basis

Costs

• Delay or advance costs from the next year
• Increase/decrease provisions more than is required by the business
• Take a pension holiday

Reserve Accounting

• Material adjustments for prior years and extraordinary items should be separately identified in the profit and loss account that can be seen
• Taking them directly to reserves or adjusting the opening balance of retained will conceal them
• transfer from reserve to profits will improve apparent distributable earnings and it is often difficult to tell whether such reserves are legally available for dividend payment.

Quasi Equity / Long Term Funds

• Some items are described as capital or long term funds but maybe payable in the short to medium term such as:

1. Convertible bonds. The may be converted to equity or become payable
2. Redeemable shares could become a claim on the company depending on their conditions
3. Subordinated loans rank behind creditors and senior debt in a gone concern basis but may be repayable soon

Working Capital / Ratio Juggling

• Take in short-term funds overnight to improve liquidity at balance sheet date
• Liquidate stocks a few days before the year end to improve stock turn
• Re-classify fixed assets, which are to be sold, as stock
• Squeeze debtors and delay paying creditors immediately prior to year end to improve liquidity
• Convert short term borrowings to medium term borrowings

• Delay purchase and speed up submission of invoices prior to year end
  

SOME ADVICES
IF BANKERS SUSPECT BUT CANNOT CONFIRM CREATIVE ACCOUNTING, BANKERS' BEST PROTECTION IS TO TRACK THE CASH.