What is window dressing in accounting?
Explanation of window dressing and examples in companies and mutual funds.
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 company’s 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:
Illustration 1: Reasons for window dressing
Beneficiary |
Reason |
Window dressing Action |
Who is misled |
Company |
To obtain funding (to borrow money) |
Increase profits and liquidity ratios |
Borrowers (banks, other financial institutions) |
To reduce tax payments |
Decrease profits by increasing expenses |
Government |
|
To smooth financial data (sales, expenses, accounts receivable, etc.) |
Record sales or purchases in an inappropriate period; give large discounts to debtors for payments received before period end |
Owners |
|
To hide some problems (liquidity, profitability, poor management decisions) |
Increase cash account balance at the period end; increase useful life of fixed assets |
Owners |
|
Mutual Fund |
To improve fund portfolio structure |
Buy more well-performing stocks and selling nonperforming ones |
Investors |
To increase portfolio value |
Buy additional well-performing stocks at a higher price |
Investors |
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