Window Dressing Financial Statements
Window Dressing is an unethical way of preparing financial statements and making them look better than they really are. It is the short-term strategy that management can use to cover the company’s performance from the users. In a serious case, it is not only unethical but also illegal when the management tries to manipulate the financial statements of the relevant stakeholders such as shareholders, lenders, and the government.
If the management team prepares financial statements which do not comply with accounting standards to benefit themselves, they must take full responsibility for law and regulations.
The management wants to impress the shareholders and receive better compensation, so they try to ensure that the company is performing better than reality. Sometimes it involves shareholders as well, they want to get more loans from banks and investors, so they must make a highly profitable financial statement to increase the chance of getting a loan.
A company’s financial statements are important for a number of reasons. First, they provide information about the company’s financial health. This is important for shareholders and potential investors, as it can help them to make informed decisions about whether or not to invest in the company.
Second, financial statements can be used to assess the performance of the company. This information is important for management, as it can help them to identify areas where the company is doing well and areas where improvements need to be made.
Finally, financial statements are also used by creditors, as they can help to assess the riskiness of lending money to the company.
It is clear that there are a number of good reasons why a company would want to have good-looking financial statements.
It is not wrong when the company and management want to have a good financial statement as long as they present the real company performance. The management team can prepare a good business strategy to increase sales, and reduce costs in order to ensure a good profit. And there are many more business strategies that they can use. As a result, the performance will present in the financial report.
However, if the management use different technique to make the report look good which is opposite from the actual performance, it will be a problem. It will be considered window dressing which is an illegal and unethical practice.
Purpose of Window Dressing
There are many factors that push the management to window dressing their financial statement:
- To attract new investors: New investors are always looking for opportunities to invest their money. They want to put their money into something that will grow and provide them with a return on their investment. Many factors go into deciding where to invest, but one of the most important is the potential for growth.
- To obtain a new loan: It is very normal for the company to acquire new capital to expand the operation. Besides the equity, the company also looking for a loan from a bank or creditors. Financial statements are the first things that banks will review to ensure that they will lend money to the company that is able to pay back.
- To receive the performance bonus: The company usually provides a performance bonus to management depending on the company’s performance. So management will try their best to ensure the company hits the target profit. They may try to manipulate the financial report as well.
Example of window dressing financial statements
Sale and leaseback: It is the way that the owner sells the property but still uses the property by the rent from the new owner. This method will allow the company to increase the amount of cash balance at the end of the year. It will improve the return on asset ratio, current ratio, quick ratio, and so on.
Change accounting estimate: The management may improve the company’s performance by changing some accounting estimates such as fixed asset useful life, and the provision on accounts receivable. The depreciation expense will decrease when the company extends the useful life, so the profit also increases. Management also is able to decrease Allowance on bad debt expenses by changing the policy.
Capitalization: The company can reduce expenses by decreasing the fixed asset capitalization threshold. The purchase of small tools will be capitalized as fixed assets rather than go direct to operating expenses. They will spend at least 2-3 years to depreciate the full value.
Accounts Receivable: The company will ask the major customers to pay for outstanding balance right before year-end which will improve the cash balance and liquidity. They offer an early payment discount to increase the amount of cash collected. However, it will hurt the income statement as we need to increase expenses (discount). Moreover, the management will hide the uncollectible receive which suppose to adjust to bad debt expenses.
Revenue: management will boost the revenue of the year when they realize that it is below the target. They can give a huge discount to customers right before year-end to make sure the revenue reaches a certain level. For a serious case, management negotiates with another party to make a fake sale before year-end and return back in the next accounting period. Moreover, the management may ask the customer to purchase the goods which they suppose to buy next year. They will try all way around to boost the sale at the year-end.
Expense: The management can reduce expenses by holding suppliers’ invoices and forwarding them to the next period. It will reduce some expenses around year-end and push them to next year.
Delay payments: Another way to keep cash balance is to delay payment before the year-end. It will help to improve the cash and liquidity ratio.
How to spot window dressing financial statement
As we can see in the above examples, there are many techniques used by the management to manipulate financial statements, so we have to perform some reviews such as:
- Revenue sale before and after year-end to check if there are any unusual transactions such as returns. A significant decrease in sales in the new year is also a sign of a forward sale.
- Suddenly change in accounting estimate: accounting estimate is very subjective, if there are any immediate changes, it can be the indication of window dressing in financial statements. We have to review the previous accounting estimate and evaluate the impact on financial statements.
- Unusual items in the income statement: management is highly likely to manipulate the income statement as it represents their current performance. If the sales increase, the cost of goods sold must be increased to align with it. If it is not, there must be something wrong with them, we have to check it.