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Project at
Financial Analysis
on the topic
Window Dressing

























2

Acknowledgments





Introduction...........3
Other nomenclature of creative accounting in literature...4
Why do firms use Window Dressing?.......5
Goodwill....................5
Extraordinary items...7
Artificial methods of boosting liquidity........................7
Receipts of receivables..........................8
Income smoothing.................9
Bringing sales forward..........................9
Changing depreciation policies.....................9
Changing the stock valuation policy...............10
How to spot window dressing.................10
Conclusion.......................11










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Introduction
Despite of the growth of the potential importance of the summaries documents the
accounting information doesnt achieve to fulfill all the functions assigned to it. Perhaps, the
biggest peremptory of this finding are the numerous financial scandals that have occurred in the
last decades. These financial scandals are based on the discovery of false information or in the
discovery of new techniques that conceal the real situation of the firm.
The notion of creative accounting (windows dressing) was firstly found in the literature in
1973 by the British researcher J. Argenti. He established a direct connection between the practices
used by creative accounting, the incompetence of the managers and the declines in big businesses.
He also specified that the usage of creative accounting is an ominous sign of a coming financial
crisis.
Trotman (1993) defines window dressing, appreciating that it is a communication
technique having in view the amelioration of the information provided to the investors. Thus, the
economic entity is presenting to the investors or to the prospective investors financial statements
passed through the filter of some techniques capable of generating a more favorable image on the
market, but also the illusion of some more attractive results than the real ones.
Defining window dressing through a well-known practice, that is the result of smoothing
(smoothing income), Barnea, Ronen and Sadan (1976) appreciate that this makes its presence felt
each time the profits have a high fluctuation, unjustified through the economic reality.
From the perspective of a financial analyst, Smith (1992) considers that the highest part of
the economic growth of the 80s is due to window dressing that is to the accountants skills than
rather to a real economic growth. In the book, Accounting for Growth, he motivates the previous
idea, exemplifying the cases of some British companies which use creative accounting practices
(finding concrete proofs at 45 economic entities of Great Britain), taking the example of three
companies which experienced the financial collapse shortly after they had presented their
financial statements which clearly reflected: financial stability.
Most firms try to look better just before reporting their financial statement to the public
even though their current situation is much worse. This practice is known as Window dressing on
the Wall Street. This activity has accelerated since the 2008 when the financial crisis brought
actions like these under greater scrutiny.
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Window dressing is form of creative accounting used by the management to improve the
appearance of a companys financial statement. This method is also known for carrying out
transactions in order to manipulate the financial position shown by the financial statement.
Windows dressing can be used at any time of the fiscal year, but is usually used shortly before the
end of an account period (year; quarter). Though window dressing isnt illegal, many financial
analysts consider it as an unethical method and an inefficient method in the long run. By
employing it more often this method may also be considered as a deceptive practice that can lead
to a number of negative repercussions. Window dressing can be an illegal or fraudulent action if it
contradicts the law or accounting standards.
Window dressing is used both by companies and mutual funds. This technique is
commonly used when a certain business has a large number of shareholders or investors. In this
situation the management can give a false impression about how the business works, because they
usually give the appearance of a well-run company to investors who probably do not interact
much with the day-to-day activity of the business. This technique can also be used when a
company wants to impress a creditor in order to qualify a loan. Window dressing is usually used
shortly before the end of an accounting period.
Other nomenclature of creative accounting in literature
Creative accounting has developed geographically both in its practices complexity and in
its nomenclature. The term of Windows Dressing is mostly used in the United Kingdom and in
the United States of America. The term for this kind of accounting in Europe is called as
creative accounting. In the literature the term of Windows Dressing can still be found in
different countries under the name of income smoothing earnings smoothing, cosmetic
accounting, financial crafts or accounting crafts.
Creative accounting has known a global geographical development and today is
considered as a world discussed phenomenon. Even though it has spread worldwide because of
the globalization process Window Dressing still remains an important technique for most
multinational companies. There are several differences in Window Dressing worldwide because
of the difference in the accounting and fiscal policies of the certain countries.
In the table below are stated some explanations on all the various global
nomenclatures in countries as Switzerland, Germany, Holland, France, USA, Japan, Australia
and the Great Britain.
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Why do firms use Window Dressing?
Window dressing is also commonly used when selling a business. In this situation
owners usually increase their profits, reduce the expenses and they plan some projects that will
have some effect in the future. This reaction is typical for a lot of business owners who are
suddenly facing a prospect of selling their company. The main idea of this using window dressing
is to jack up profits in the short term and hope that this will translate into multiples so that they
will get a higher value of their business in the future. The most often used strategy is to delay
expenditure, reduce costs which have no short term effect such as public relations or marketing,
research expenditure and the delay of some refurbishments of some equipment or premises. By
doing this the owner of the company pushes up expenses into the future, so that todays profits are
increased.
This typical strategy may be very risky, because there are smart buyers that are looking
exclusively for these adjustments and when they find them, all the made effort will reverse
against the firm. By finding some adjustments the buyers will become aware that the business
owner has tried to put a misrepresentation in terms of the profitability of the potential business.
Therefore the buyers can reverse the changes back and thereby the profit will revert back in line
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with what was before. The valuation of the profits may even slightly decrease because the buyer
may feel that he didnt find all the misrepresentations.
In the end the business may get much worse off because not only the profits of the
company have reverted back but in the fact the valuation of the firm will decrease because the
buyer will discount the future potential of the company. Thats why all the changes made by
window dressing to the revenue or expense should be on a sustainable basis and the company
should have evidence behind in order to show the source of the adjustments.
Other motivating factors can be the existence of tax levies based on income, where the
management that is able to report stable earning obtain confidence of shareholders and
employees, incidence of big bath accounting whereby an organization that is currently making a
bad loss in that year so that the result of future years will look better.
Other motivations of using Window Dressing is the need to create an appearance of a
good profit trend so that the company can be able to raise capital through the issue of new shares,
or resist takeover bids or offer its own shares in takeover bids.
Personal gains are also an important factor that can influence the manager of the company
for using Window Dressing. Company directors engage in insider dealings with their company
shares will be motivated towards using Window Dressing for delaying the release of information
to make personal gains. An example of this is when the company didnt manage to achieve its
planned business plan. So by doing some window dressing the manager can simulate reaching the
financial business plan. Some directors and managers by achieving their business plan get some
bonuses for the working year.
So the final reasons for window dressing are:
- To show a stronger market position than it actually is;
- To influence the price of the share;
- To reduce liability for taxation;
- To hide the liquidity problems;
- To ward off takeover bids;
- To encourage investors;
- To re-assure lenders of finance;
- To hide poor management decisions;
- To satisfy the demands of the major investors concerning the level of return;
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- To achieve sales or profits target to ensure that the management bonuses are paid.
Goodwill
Goodwill represents the attaching value of the successful running of the company. It is an
indication of the value of the enterprise that can arise over and above the value of the fixed assets
and liquid assets. Goodwill is an example of an intangible asset. It is not a physical asset, but
however it is an asset. Some companies might pay big money for popular and well-developed
brand name. So intangible assets as tangible assets can be bought and sold.
Nowadays people are very attracted to brands. Most people even though find products
with the same quality but with different prices, they will choose the brand that is more popular.
This concept of branding has developed a lot in the last years and it has created some new
concepts in marketing. Many firms will take the advantage of the branding concept and will buy
these products (brands) or will work as franchises. Firms are ready to spend huge deals of money
only to have the opportunity to sell these products.
Goodwill is often used in the accounts, but it is arguable that it represents the real assets
value of the company. Often goodwill is overestimated in the accounts; therefore it creates a false
impression and the users may confuse the real value of the company.
Extraordinary items
Another window dressing technique is by using the extraordinary items. These items are
gains or losses included in a companys financial statements, which are infrequent and unusual in
nature. All extraordinary items must be disclosed and explained by the management in the
financial statements, showing the firms earnings before and after taking into account the effects
of the extraordinary items. That is why some firms use them to hide their real financials in order
to make them look better or worse than they actually are. These events are very unusual and
unlikely to be repeated so thats why they should be highlighted in accounts and inserted after the
calculation of profit before interest and taxation. By including these in normal revenues there will
be an increase of the business profits.
Artificial methods of boosting liquidity
Liquidity is one of the most important indicators of the company. It is characterized by a
high level of trading activity. It indicates the possibility of the company to pay back the
obligations that occurred during a business cycle. Usually a high indicator of liquidity in a firm is
a bad because this minimizes the possibility of a company to maximize its profits, but a low
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indicator of liquidity relates to the incapacity of the debtor to return all its obligations to creditors
and investors.
Companies usually tend to use the window dressing technique for increasing the liquidity
ratio so that it will appear better than it really is. Sometimes this technique can be a life saver
because it can help the company solve rapidly the liquidity crisis.
One way of increasing the liquidity ratio is to sell the assets just before the accounting
period comes to an end. Some managers tend to sell the fixed to a company and then lease the
same fixed assets on yearly or monthly basis. For example, a taxi company sells 100 automobiles.
By selling these fixed assets they boost up some cash in their current account, therefore the
company increases its liquidity ratio. Since the company needs those automobiles to run up their
business, it will lease them back. This method is efficient in the short run because the liquidity
ratio of the company increased rapidly, but this will reduce the liquidity ratio of the company in
the long-run. With this technique the company also can simulate sells and therefore their profits
will increase.
This technique increases the risks of the company and it increases the future expenses on
the long-run. Usually the fixed assets that are sold in a minimum amount of time have big
discounts, because the company is interested in increasing its liquidity. Using this method the
company may mislead the creditors (banks or other financial institutions).
Another method of increasing the liquidity on short term is by getting some additional
short term borrowings just before the date on which the balance sheet is drawn up. This will
increase the liquidity ratio of the company and it will enhance the apparent ability to pay the short
term debts. This strategy is very risky because besides increasing its liquidity the company
increases its liabilities.
Receipts of receivables
Through this technique the company is asking its debtors to pay their debt early so that the
cash is received before the end of the year. If the debtor doesnt have the necessary amount of
money, the company can make some discounts. Usually the debtors agree with the discounted
amount of money and pay the company before the end of the year. This technique increases the
amount of the current cash and increases the liquidity. This technique also has a negative side,
because by using it the company will lose some of its profit, or in some cases the company can
state losses. The liquidity ratio increases at the expense of the sales revenue.
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Income smoothing
This Window Dressing method is used for redistributing the already existing incomes and
charges among different periods. The primarily objective of this technique is to moderate the
income variability over the years by shifting the income from the good years to the bad years. An
example of this technique is by reducing some costs that a manager may eliminate or postpone
without disrupting the firms operations or affecting its productive capacity in the short run (ex:
advertising, preventive maintenance, research and development costs). By reducing these costs
the management will improve the current period earnings. The disadvantage of this technique is
that these Discretionary Costs will be increased in the next year, so the company may suffer
important losses in the long-run.
Bringing sales forward
By using this technique the company will encourage its customers to place orders earlier
than planned and thereby it will increase the sales revenue figure in the P&L account. With this
technique the company can stimulate their sales before the end of the year. By doing this the
company will increase their profits before the end of the year, but they will lose profits for the
next year. The company doesnt have the right to recognize the same profits in the following
years. By using this method the companies usually sell their products at a discounted price or they
are informing their customers that their products will increase in price in the following years. The
company will show its sales in the P&L account when the order is received and not when the cash
is received.
Changing depreciation policies
This is a common technique used by most companies. The first step is to extend the useful
lives of the non-current so that the depreciation charge is reduced. This increases profits and the
carrying value of the non-current asset. Using this technique the management also can change the
way of calculating the depreciation of the long-lived assets. There are 4 methods of depreciation:
the straight line method, units of production method, sum of years digits and the double declining
method. Usually when the company faces a crisis or the current period is a recession one the
companies tend to change their depreciation methods to either depreciate their long lived assets,
or otherwise to minimize the depreciation so the company will have less losses. In practice, unless
there is tax reasons to employ accelerated methods, large companies tend to use straight line
method depreciation. This has the merit that it is simple to apply, and where a company has a
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large pool of similar assets, some of which are replaced each year, the aggregate annual
depreciation charge is likely to be the same, irrespective of the method chosen. If the company
suffers huge losses over that year it will mostly change its depreciation method into the straight
line depreciation method.
Changing the stock valuation policy
With this technique the company changes the stock valuation policy (LIFO, FIFO, and
AVCO). This can lead to the increase in value of the closing stock, boosting up the profits. A
typical example is the usage of FIFO method that helps us in increasing closing the stock
inventory valuation, thereby we will reduce the COGS and we will increase the earnings. In a
falling price scenario the LIFO valuation method for inventory is considered more favorable for
the business. Window dressing can be used by the companies according to the current situation of
the business.
How to spot window dressing
There are a lot of techniques of spotting Window Dressing and most of the techniques do
not refer only to a particular industry. A very important ability in financial analysis is spotting
Window Dressing. The ability to compare attentively the details can help us recognize Window
Dressing in a company or in a mutual funds reporting. When analyzing the overall of the
management performance the user of the financial report should review the balance sheet, the
income statement, the statement of changes in equity, statement of cash flows and any additional
available information.
There are certain methods of spotting Windows Dressing. In the beginning the analyst of
the financial statement should take a look if some of the companys policies were changed
during this period. Usually almost all the changes in the companys policies are very sneaky and
they may generate some hidden information. An abnormal increase or decrease in any balance is
also an indicator that something in the company has changed.
The positive cash balances are the result of short-term borrowing or non-operating
activities (referring to the statement of cash flows where we can see the activities that generate
cash). An abnormal period-end selling or purchase transaction need to be extra checked
because usually Window Dressing is done in the end of the period and we can find some extra
changes in the financial report.

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Conclusion
Some businesses unfortunately feel that it is necessary to make some changes in their
financial statements at the end of a quarter to pump up their financial statement. This technique
is completely against the concept of financial and business ethics and it flies in the face of
corporate finance. In creating a financial statement the preparer must ensure that all the
information is based on an honestly and fairly information. If the financial statements are altered
so that they do not present the fairly performance and position of the entity the users will be
misled, and then things can get ugly.
Windows dressing can transform into a dangerous game to play. This technique could be
the first step on a slippery slope. Window dressing is like using a drug, if you use it just one
time, you will have to face a long journey that can lead to serious accounting deceptions, such as
profit smoothing techniques or even to accounting fraud.



















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References


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