3. Is window dressing legal?

Generally, window dressing is considered to be an unethical practice because it involves deception and advancement of management’s 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

Company’s window dressing example

Let us look at an example of window dressing used by a company’s 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 company’s 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 company’s financial position:

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.

Mutual fund’s window dressing example

Now let us look at an example of window dressing used by a mutual fund. Assume the mutual fund is preparing its quarterly report with a list of holdings as of June 30, 20X0. On June 27, 20X0, the fund’s portfolio contains an investment in Company ABC, whose performance has been decreasing. The fund’s portfolio also includes investments in Company XYX1, Company XYX2, and Company XYX3, whose stock prices have increased by 20%, 5% and 8%, respectively, during the quarter.

The fund managers decide to use window dressing to reduce the impact of falling stock prices of Company ABC. For this purpose the fund managers sell their holding in Company ABC and buy additional stocks of Company XYZ1 on June 28, 20X0. After these transactions, the fund’s portfolio does not include nonperforming stocks of Company ABC and includes more stocks of well-performing Company XYZ1. This makes the portfolio structure and performance more appealing in the eyes of fund clients.

5. How to spot window dressing

The ability to compare and attentiveness to detail can help recognize window dressing in a company or mutual fund’s 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 company’s policies were changed during the period
• Strong sales are accompanied by increases in accounts payable

When choosing a mutual fund, an investor should compare the year-end reports with the quarterly reports side by side to determine whether:

• The portfolio consists of only the most popular investments without any nonperforming investment
• There are abnormal period-end selling or purchase transactions
• The portfolio is diversified
• The portfolio structure and investment style are supported

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