Understanding Business Accounting For Dummies, 2nd Edition (62 page)

Not all businesses use these techniques, but the extent of their use is hard to pin down because no business would openly admit to using these manipulation methods. The evidence is fairly convincing, however, that many businesses use these techniques. We're sure you've heard the term
loopholes
applied to income tax accounting. Well, some loopholes exist in financial statement accounting as well.

Fluffing up the cash balance by ‘window dressing'

Suppose you manage a business and your accountant has just submitted to you a preliminary, or first draft, of the year-end balance sheet for your review. (Chapter 6 explains the balance sheet, and Figure 6-1 shows a complete balance sheet for a business.) Your preliminary balance sheet includes the following:

Preliminary Balances, Before Window Dressing

Cash £0 Creditors £235,000

Debtors £486,000 Accrued expenses £187,000payable

Stock £844,000 Income tax payable £58,000

Overdraft

Prepaid expenses
£72,000
£200,000

Current assets £1,402,000 Current liabilities £680,000

You start reading the numbers when something strikes you: a zero cash balance? How can that be? Maybe your business has been having some cash flow problems and you've intended to increase your short-term borrowing and speed up collection of debtors to help the cash balance. But that plan doesn't help you right now, with this particular financial report that you must send out to your business's investors and your banker. Folks generally don't like to see a zero cash balance - it makes them kind of nervous, to put it mildly, no matter how you try to cushion it. So what do you do to avoid alarming them?

Your accountant is probably aware of a technique known as
window dressing
, a very simple method for making the cash balance look better. Suppose your financial year-end is October 31. Your accountant takes the cash receipts from customers paying their bills that are actually received on November 1, 2, and 3, and records them as if these cash collections had been received on October 31. After all, the argument can be made that the customers' cheques were in the mail - that money is yours, as far as the customers are concerned, so your reports should reflect that cash inflow.

What impact does window dressing have? It reduces the amount in debtors and increases the amount in cash by the same amount - it has absolutely no effect on the profit figure. It just makes your cash balance look a touch better. Window dressing can also be used to improve other accounts' balances, which we don't go into here. All of these techniques involve holding the books open to record certain events that take place after the end of the financial year (the ending balance sheet date) to make things look better than they actually were at the close of business on the last day of the year.

Sounds like everybody wins, doesn't it? Your investors don't panic and your job is safe. We have to warn you, though, that window dressing may be the first step on a slippery slope. A little window dressing today and tomorrow, who knows? - maybe giving the numbers a nudge will lead to serious financial fraud. Any way you look at it, window dressing is deceptive to your investors who have every right to expect that the end of your fiscal year as stated on your financial reports is truly the end of your fiscal year. Think about it this way: If you've invested in a business that has fudged this data, how do you know what other numbers on the report are suspect?

Smoothing the rough edges off profit

Managers strive to make their numbers and to hit the milestone markers set for the business. Reporting a loss for the year, or even a dip below the profit trend line, is a red flag that investors view with alarm.

Managers can do certain things to deflate or inflate profit (the net income) recorded in the year, which are referred to as
profit-smoothing
techniques. Profit smoothing is also called
income smoothing.
Profit smoothing is not nearly as serious as
cooking the books
, or
juggling the books
, which refers to deliberate, fraudulent accounting practices such as recording sales revenue that has not happened or not recording expenses that have happened. Cooking the books is very serious; managers can go to jail for fraudulent financial statements. Profit smoothing is more like a white lie that is told for the good of the business, and perhaps for the good of managers as well. Managers know that there is always some noise in the accounting system. Profit smoothing muffles the noise.

Managers of publicly-owned companies whose shares are actively traded are under intense pressure to keep profits steadily rising. Security analysts who follow a particular company make profit forecasts for the business, and their buy-hold-sell recommendations are based largely on these earnings forecasts. If a business fails to meet its own profit forecast or falls short of analysts' forecasts, the market price of its shares suffers. Share option and bonus incentive compensation plans are also strong motivations for achieving the profit goals set for the business.

The evidence is fairly strong that publicly-owned businesses engage in some degree of profit smoothing. Frankly, it's much harder to know whether private businesses do so. Private businesses don't face the public scrutiny and expectations that public corporations do. On the other hand, key managers in a private business may have incentive bonus arrangements that depend on recorded profit. In any case, business investors and managers should know about profit smoothing and how it's done.

Most profit smoothing involves pushing revenue and expenses into other years than they would normally be recorded. For example, if the president of a business wants to report more profit for the year, he or she can instruct the chief accountant to accelerate the recording of some sales revenue that normally wouldn't be recorded until next year, or to delay the recording of some expenses until next year that normally would be recorded this year. The main reason for smoothing profit is to keep it closer to a projected trend line and make the line less jagged.

Chapter 13 explains that managers choose among alternative accounting methods for several important expenses. After making these key choices the managers should let the accountants do their jobs and let the chips fall where they may. If bottom-line profit for the year turns out to be a little short of the forecast or target for the period, so be it. This hands-off approach to profit accounting is the ideal way. However, managers often use a hands-on approach - they intercede (one could say interfere) and override the normal accounting for sales revenue or expenses.

Both managers who do it and investors who rely on financial statements in which profit smoothing has been done should definitely understand one thing - these techniques have robbing-Peter-to-pay-Paul effects. Accountants refer to these as
compensatory effects.
The effects on next year's statement simply offset and cancel out the effects on this year. Less expense this year is counterbalanced by more expense next year. Sales revenue recorded this year means less sales revenue recorded next year.

Two profit histories

Figure 8-2 shows, side by side, the annual profit histories of two different companies over six years. Business X shows a nice steady upward trend of profit. Business Y, in contrast, shows somewhat of a rollercoaster ride over the six years. Both businesses earned the same total profit for the six years - in this case, £1,050,449. Their total six-year profit performance is the same, down to the last pound. Which company would you be more willing to risk your money in? We suspect that you'd prefer Business X because of the steady upward slope of its profit history.

Question: Does Figure 8-2 really show two different companies - or are the two profit histories actually alternatives for the same company? The year-by-year profits for Business X could be the company's
smoothed
profit, and the annual profits for Business Y could be the
actual
profit of the same business - the profit that would have been recorded if smoothing techniques had not been applied.