The financial position of a company plays a crucial role for a company to expand its business and gain the trust of investors and other interested parties. When a company’s financial data appeals to them, it facilitates in growing or expanding the business to new heights.
What is Window Dressing in Accounting?
If the financials of the company do not appear desirable or acceptable, the company’s management may manipulate the facts and figures mentioned in the financials using unethical methods, and this practice is voluntarily and intentionally carried out by the management. In accounting, such practices are known as window dressing. This assists management in gaining the trust of investors, shareholders, and users of the company’s financial statements.
The term “window dressing” refers to manipulation of accounts in a way that makes the financial statements appear better than they actually are. By painting a positive picture of the organization’s performance, window dressing essentially aims to deceive shareholders and investors. When portfolio managers try to boost a fund’s investment performance ahead of investor or shareholder presentations, this is known as window dressing.
It can be detected by carefully reviewing a company’s financial statements and looking for suspicious trades near the end of a quarter or fiscal year.
How does Window Dressing in Accounting Work?
Window dressing is described as “buying or selling portfolio securities shortly before the date as of which a fund’s holdings are publicly disclosed, in order to convey an impression that the manager has been investing in companies that have had exceptional performance during the reporting period” in relation to mutual funds by the Securities and Exchange Commission (SEC).
The SEC issued a rule requiring mutual fund companies to report their portfolio holdings at the end of each quarter in 2004 in response to numerous concerns about window dressing. This requirement allows investors to examine mutual fund holdings more thoroughly and frequently, which helps them better understand the performance of their investments.
But window dressing is still a possibility. For instance, funds may occasionally sell a stock that underperformed over the previous season in order to exclude it from their fourth-quarter report, only to repurchase it in the first quarter of the following year. Due to the high trading costs associated with this type of window dressing, investment returns suffer.
Purpose of Window Dressing
To hide a company’s true financial situation and accomplish the following goals, businesses use window dressing:
- To demonstrate that the business’s finances are stable– Businesses are always looking to demonstrate that they are growing and stable. Window dressing helps to reassure lenders about the company’s financial stability. As a result, the company attracts lenders and investors and keeps its employees.
- Attract More investors– When a company’s performance is demonstrated to be positive, existing investors will continue to make investments in the business, and prospective investors will be more likely to do the same. The company will have more money coming in with the addition of new investors.
- Stock price growth – A variety of factors affect how much companies’ stocks are worth. One of them is how well the business is currently doing financially. The value of the stock price rises if the company continues to report rising net operating profits.
- Masking poor management- Management mistakes can have a negative effect on the company’s finances. Financial statements that appear impressive in some ways suggest that the company is well-managed while also hiding the fact that it is on the verge of insolvency.
- Tax Avoidance: Tax avoidance can be done by showing poor financial results. Management has the power to alter the result in a way that benefits the company, whether that means profit or loss.
Methods of Window Dressing
Cash/Bank Balance- Delaying payments to vendors in order to have a large cash/bank balance at the end of the reporting period. Selling off the outdated assets to increase the cash balance and demonstrate a strong liquidity position. Since it is an older asset with more accumulated depreciation, the fixed assets balance will not change significantly at the same time.
Inventory valuation- The amount of inventories recorded will have a direct impact on the company’s profits. Making adjustments in the value of inventories in order to boost or drop profits. The profits may rise or fall, depending on the type of valuation used.
Depreciation Method- Similar to the valuation of inventories, when a business switches from an accelerated depreciation method to a straight line depreciation method, the expenses drop and the profits increase.
Provisions: The concept of prudence in accounting requires recording expenses and liabilities as soon as possible, but revenue only when it is realised or assured. Excess provisions can reduce profits and the corresponding tax payment.
Examples of Window Dressing
Window dressing is most likely found in investment brokers and mutual fund companies. Mutual fund managers frequently sell off underperforming stocks and other investments near the end of a period and reinvest the proceeds in high-performing stocks. This way, new investors can see the portfolio of high-performing stocks and decide whether or not to invest. Obviously, this is a short-term strategy for inexperienced investors. Any knowledgeable investor will examine portfolio trends over time to determine whether the fund managers are investing wisely.
For instance: A fund that invests solely in S&P 500 stocks has underperformed the index. Stocks P and Q outperformed the overall index but were underweight in the fund, whereas stocks R and S were overweight but underperformed the index.
Now, to make it appear as if the fund had always invested in stocks P and Q, the portfolio manager sells stocks R and S, replacing them with and overweighting stocks P and Q.
Conclusion
In accounting, window dressing is a short-term strategy used to make financial statements and portfolios appear better and more appealing than they actually are. It is done to deceive investors about the true performance. It is an unethical practice because it involves deception and is done for the benefit of management. Window dressing can give the appearance of higher returns, but these strategies frequently simply postpone losses that will eventually occur later.
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