Window Dressing And Corporate Scandals

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By:Sam Kern

Business managers would like to present the operations as showing healthy profit. However, often they resort to certain tactics to prepare the financial reports that do not actually reflect the correct position; window dressing or profit smoothing is one such method.

In profit smoothing, the current year's net income shows a higher figure just because some expenses that relate to the current year are not charged against the profit. These should actually be accounted in the same year under the accrual and prudence concepts. However, due to the discretionary nature of charging off such expenses, many items like maintenance, employee training costs, amortization of research and development costs and impairment of assets are treated as deferred revenue expenditure. They would be adjusted in next year's income.

Window dressing usually has compensatory effect. Even if current year profits are presented as high, the next year would have to absorb the deferred expenses and hence there will be a dip.

Although technically window dressing is not illegal or fraudulent, it encourages the attitude for committing more serious misrepresentations. Hence, the Legislature, regulatory authorities and professional bodies have created the framework for reporting requirements. Adherence to the reporting guidelines is mandatory.

Auditors and public accountants hold the torch for independent reporting on the financial statements of firms, corporations and other entities. The recent slew of corporate scandals has shaken the public's trust in the credibility of reporting. Therefore, giving more teeth to the reporting guidelines including punitive measures should minimize the scope for presenting misleading financial reports.

Interestingly, most accounting scandals have involved public corporations mainly because the corporate managers wanted to present a rosy picture to the shareholders and impress the stock market. Enron overstated its earnings by $570 million and concealed its over $6 billion debt through murky partnerships. Despite the impending catastrophe, the CEO of Enron promised that its share price would move up. When the Securities and Exchange Commission revealed the real picture after an investigation, the prices nose-dived and thousands of shareholders, some who had invested under 401K plans for retirement, were left in the cold. When the company had to pay off investors immediately, it could not raise cash and filed for bankruptcy.

Another instance of personal greed forcing directors to fudge financial records and discard ethical standards is the WorldCom scandal. The compan's financial statements did not disclose $408 million loan made to the CEO. The financial reports had discrepancies to the tune of $9 billion with respect to operating costs. The story is the same at Tyco Corporation, where the company's CEO, CFO and the Chief Legal Officer all obtained loans running to millions without the approval of the compensation committee.

All these scandals had a similar pattern: unjust enrichment of a few individuals at the expense of thousands of shareholders' money. The absence of strict punishments encouraged them to get away.

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Sam Kern has also recently published aan article on Tax Return Calculator.