1.

Definition of window dressing Window dressing is a set of actions or manipulations with financial or other information in financial documents (financial statements, reports, etc.) to make this information look more attractive to its users. Even though window dressing can occur at any time, it is commonly used at the end of a period. Window dressing can be used by companies and mutual funds. A company can use window dressing when preparing financial statements to improve the appearance of its performance or liquidity. In this case, window dressing may consist of changing asset depreciation or valuation policies, making short-term borrowings, or engaging in sales and leaseback transactions at the end of a period. By doing so, management embellishes the companys results or liquidity and obtains some benefits. Other examples of window dressing by companies may include advertising, selling, and marketing. In these cases, window dressing occurs when positive characteristics of products or services are a little exaggerated to increase demand for them while negative characteristics are not mentioned or kept hidden. Mutual funds use window dressing when preparing periodic (quarterly, yearly) reports. Window dressing by mutual funds consists of selling underperforming stocks and buying well-performing stocks near the reporting period end. This practice makes a fund portfolio look more profitable and thus more attractive to its (prospective) clients. 2. Reasons and beneficiaries of window dressing In most cases, beneficiaries of window dressing are those who use this practice, i.e., companies and mutual fund managers. In many cases, managers remuneration (i.e., salaries and bonuses) depend on how well their companies or mutual funds performed; so there is a direct interest in making financial results or liquidity look better than they really are. Refer to the table below to see specific reasons for window dressing:

llustration 1: Reasons for window dressing Beneficiary Company Reason To obtain funding (to borrow money) To reduce tax payments To smooth financial data (sales, expenses, accounts receivable, etc.) Window dressing Action Increase profits and liquidity ratios Decrease profits by increasing expenses Record sales or purchases in an inappropriate period; Who is misled Borrowers (banks, other financial institutions) Government Owners

Mutual Fund

To hide some problems (liquidity, profitability, poor management decisions) To improve fund Buy more wellportfolio performing stocks and structure selling nonperforming ones To increase Buy additional wellportfolio value performing stocks at a higher price

give large discounts to debtors for payments received before period end Increase cash account Owners balance at the period end; increase useful life of fixed assets

Investors

Investors

3. Is window dressing legal? Generally, window dressing is considered to be an unethical practice because it involves deception and advancement of managements interests instead of interests of information users (i.e., owners, investors, government). From the legal point of view window dressing isn't illegal, but in some cases it can be so. Window dressing can be an illegal or fraudulent action if it contradicts the law or accounting standards. Some well-known examples of illegal window dressing practices relate to Enron, Peregrine Systems, WorldCom, and Xerox.

4. Examples of window dressing situations Companys window dressing example Let us look at an example of window dressing used by a companys management. Assume the company has its accounting year ending on Dec. 31, 20X0. At Dec. 27, 20X0, the balance in the cash account is $2,000. Before the end of the year the company must pay $3,000 for the services it received during the year. Paying this obligation will negatively impact the companys liquidity, so it decides to do some window dressing. The company postpones the payment of $3,000 till Jan. 4, 20X1, by negotiating the payment terms with the vendor. The company also decides to sell a fixed asset for $4,000 cash. Refer to the extract of the balance sheet below to see how these two actions of window dressing impacted the companys financial position: 4. Examples of window dressing situations Companys window dressing example Let us look at an example of window dressing used by a companys management. Assume the company has its accounting year ending on Dec. 31, 20X0. At Dec. 27, 20X0, the balance in the cash account is $2,000. Before the end of the year the company must pay $3,000 for the services it received during the year. Paying this obligation will negatively impact the companys liquidity, so it decides to do some window dressing. The company postpones the payment of $3,000 till Jan. 4, 20X1, by negotiating the payment terms with the vendor. The company also decides to sell a fixed asset for $4,000 cash. Refer to the extract of the balance sheet below to see how these two actions of window dressing impacted the companys financial position:

ABC Company Extract of Balance Sheet as of Dec. 31, 20X0 WITHOUT AFTER Applying window dressing Assets Current assets: Cash and cash equivalents Accounts receivable Inventories Total current assets (1,000) 5,000 9,000 13,000 Applying window dressing

6,000 5,000 9,000 20,000

Note that the cash and cash equivalents changed from a negative balance of $1,000 (which would need to be presented in the liabilities section of the balance sheet) to a positive balance of $6,000. 5. How to spot window dressing The ability to compare and attentiveness to detail can help recognize window dressing in a company or mutual funds reporting. When analyzing overall management performance, business owners and shareholders should review all financial statements (i.e., balance sheet, income statement, statement of cash flows, and statement of changes in equity) and any additional available information to determine whether:

A positive cash balance is a result of short-term borrowing or non-operating activities (refer to the statement of cash flows to see which activities generated cash) There is an abnormal increase or decrease in any balances The companys policies were changed during the period Strong sales are accompanied by increases in accounts payable