Depreciation & Window dressing

What is depreciation?

Depreciation is the fall in value of a fixed asset over time.

How is depreciation calculated?

Historical cost - Residual value / useful life.

*This is straight line depreciation.

Why do businesses have to depreciate?

Accounts should give a ‘true and fair view’ of a business.

What is window dressing?

The manipulation of the financial accounts by a business to improve the appearance of its performance.

Give some examples of methods of window dressing.

• Overstating the value of brands – Brand value is an intangible fixed asset, and therefore increases in brand value increases the assets of a company and gives the impression that the company is more valuable.

• Sale and leaseback – This is where a business sells the fixed asset but still uses it by renting the fixed asset from the new owner. This method will allow the company to increase the amount of cash balance at the end of the year – improving the current assets.

• Presentation of data – An example of how businesses use the presentation of data to window dress an account is by using graphs with distorted scales to give the appearance of bigger or smaller changes in sales. In some instances, businesses might only highlight certain data or use deliberate examples in their reporting documents, for instance highlighting product lines that have done particularly well in an attempt to disguise other areas of the business that have not performed very well.

• Exceptional items – Exceptional items are costs and revenues to the business that arise from normal business activity but are unusual in some way. Exceptional revenues can be used as a method of window dressing because businesses might try to pass these off as normal business revenues.

Extraordinary items should be highlighted in the accounts and inserted after the calculation of profit before interest and taxation. To include extraordinary items as normal revenues will, as with exceptional revenue, exaggerate business profits.

• Hiding poor investments – Businesses can disguise poor investments (which result in high levels of expenses) as investment in fixed assets. This will inflate the profits, giving the impression that a company is hugely successful and profitable when in reality they may actually be struggling.

What are some reasons for a business to use window dressing?

• It may be done to try to improve the share price. If the profits of a business are recorded to be higher because of window dressing, this could improve the share price as investors might be attracted to the business.

• A more valuable business could attract a takeover as the company is seemingly more successful, which could also impact on the price they get. On the other hand, if they don’t want to be taken over then the value of the business could be falsely inflated, e.g. through brand valuations - this makes the business more expensive and might deter take-over bids.

• By making the profits look smaller, a business can reduce the amount it has to pay in taxes.

• A business may wish to improve its credit rating. A business with high profits and higher asset values can gain finance more easily from banks as they seem to pose less of a risk.

• Having a set of good financial accounts could result in praise and financial rewards for managers.

What external factors may affect the financial accounts of a business?

• Economic conditions

• Competition

• Social and political change

How may economic conditions affect a business financial accounts?

For example, during the business cycle sales revenue, costs and profits could be affected both positively and negatively. This was demonstrated by the Credit Crunch, where the economic downturn forced many businesses to reappraise their financial objectives in favour of cost minimisation and maximising cash inflows and balances. This is because sales revenue is likely to fall for many businesses as customers have less disposable income due to job losses. In addition to this, significant changes in interest rates and exchange rates also have the potential to threaten the achievement of financial targets such as ROCE. For example, high interest rates may reduce consumer spending and businesses may see a fall in sales revenue and net profit. A weak pound may mean that import costs are more expensive so a business may make less net profit.

How may competition affect a business financial accounts?

A competitive environment directly affects the achievability of financial objectives. For example, cost minimisation may become essential if a competitor is able to grow market share because it is more efficient.

How may social / political change affect a business financial accounts?

These two types of external change factors may often have an indirect impact on a business’ financial accounts. For example, legislation on environmental emissions or waste disposal may force a business to increase investment in some areas and cut costs in others. Increased investment may negatively impact on profit, while reduced investment in other areas may negatively impact on sales revenue.

What are some non financial methods of assessing business performance?

• market share

• sales targets

• productivity

• quality

• environmental impact

• customer feedback

• employee attitude.