Meaning: Window Dressing
Window dressing is a strategy used to portray an exaggerated positive image of the current situation. Or to suppress the negative performance. Fund managers and accountants use this technique to boost their fund performance, save taxes and showcase an elevated financial position or understate their losses. For example, fund managers will sell loss-making stocks and purchase high potential stocks to save on taxes at the end of the year. The key objective remains to allure and attract clients and customers and gain an edge over the competition.
Window dressing happens in the figures and books of accounts. So it is an accounting technique and methodology.
Types of Window Dressing in Accounting
The objective of window dressing can be achieved by influencing the various components of the financial statements. These can be:
Cash Window Dressing
One of the ways through which a company shows a positive cash balance is by delaying payments to creditors. Paying creditors later than the stipulated time will increase the cash balances.
Another way of window dressing is capitalizing few regular expenses to manipulate earnings. For example, if a firm capitalizes on the research expenses (Although it is not legally permissible by US GAAP with few exceptions) to inflate the net profit. If a firm capitalizes on the expenses, the total expenditure will reduce, and the profit will be higher to that extent. Of course, there may be a portion debited to profit and loss accounts in the form of depreciation or amortization. But that will be a minor one. Hence, the firm can choose to manipulate profits by altering the capitalization policies. Worldcom, a large telecommunications company in the US, is an example of capitalizing expenses and inflating earnings. The scandal led to bankruptcy and is one of the largest scandals in US history.
Changing valuations of inventory either way – increasing or decreasing the value of current assets and thus, increasing or decreasing the company’s earnings.
One of the most common ways of window dressing is playing around with the Depreciation method and changing the depreciation method from accelerating to straight-line method to elevate the current year’s earnings.
To make the firm cash positive, firms resort to short-term borrowings, which increases the firm’s current liabilities and is instead a risky affair.
Turnover is an indicator of the demand and potential of the business. To look good, firms will increase their shipment discounts to accelerate revenue. Although the firm will be receiving the order value in the next financial year, recording the sale this year will ramp up turnover. This is in no way illegal but does not stand validated on the concept of true and fair business ethics.
Why Window Dressing?
There are several reasons why corporates adapt to window dressing practices. Let us discuss a few of them:
It is an easy answer, and the business wants to portray a positive image in front of the investors, lenders, and shareholders. Any third party would like to be part of the growing story when the financial statements show the correct numbers. Hence, one of the reasons for firms to window dress their accounts is to raise funds by creating a positive image of profitability and performance.
Higher Stock Price
For a public company, its share price plays an essential role in deciding its market capitalization. A company with high market capitalization is considered credible, stable, and successful. As a result, manipulating earnings will attract more investors to buy the firm’s shares. Resultantly, an increase in buying will increase the firm’s share price. And this will increase the wealth of the promoters of the company.
Tax avoidance is also one of the reasons for firms to manipulate their earnings. As we know, loss-making firms are not liable to pay taxes. Firms will start to show increased expenditure, not necessarily in cash. But, they will identify higher bad debts expense out one-time costs instead of capitalizing or amortizing them. All this will decrease earnings, and thus the company can avoid paying taxes.
Another important and most common of all is when the firm is facing insolvency. A firm is out of cash and cannot pay back some of the loans. This is when a firm will resort to more loans and manipulate the financial statements to raise money.
Projections play an important role in understanding the future of the firm. A firm will anticipate its potential growth, earnings, and cash balance based on its past records. And projections play a crucial role in bringing investors on board. Due to this, firms sometimes put up exaggerated projections to attract investors.
Signs to Identify Disparity
- Resorting to short-term borrowings to improve the cash balance. The focus should be more on operating cash flow to understand if the company is earning enough cash from its day-to-day operations.
- Change in accounting policy like switching the inventory valuation method or depreciation method.
- Increase in revenue due to an increase in discounts.
- Loans from relatives, friends and family.
- The firm is not realizing cash and is selling goods on credit, that is increase in receivables. This can be a sign of low cash balances.
Window dressing is a short-term activity used to serve a specific purpose of the business, whether to avoid taxes or present great numbers on paper. When a firm does window dressing, it is not always illegal or against the law but can be seen as unethical. Many analysts have a different stance on this practice. Few say it is an inevitable practice and is vital for business growth only when done correctly and for the right purpose. For example, Microsoft in the 1990s was expensing costs that were supposed to be capitalized. But, they wanted to reduce their tax burden and smoothen their earnings. So, it depends on company to company on how they present their financial statements. Not all practices are unethical or illegal.