Window Dressing

Prepared by

Sweta Soni
Saumya Brata Das
Faculty: Prof. Arup Choudhuri
 Window Dressing
“Chairman of the board: How much profit did we make last year? ....Finance Director: How
Much Profit do you want us to have made? You can take a pick from the following profit
figures…”

What is window dressing?

Window-dressing involves emphasizing positive facts above and beyond their actual importance,
while selectively soft pedaling or even omitting other information that is less positive. Thus, the
presented information contains real information that can be verified. However, the presentation is
not properly balanced in the way the particulars are portrayed.

Purpose of Window Dressing

At the end of the financial year every company is accountable for its performance to its
shareholders. Window dressing is a tool which helps the company to create a rosy appearance
regarding the financial position and performance of the company, hence satisfying the
shareholders expectations. Thus it helps in influencing the share prices positively. Companies are
liable to pay tax on its profits; window dressing can be useful in reducing such tax liability.
Management gets its remuneration on the basis of its performance. Poor management decisions,
inability to meet targets and other forms of inefficiency are concealed by using window dressing.
It is also used to reflect a good image of the company in respect of liquidity and credibility to its
prospective investors and creditors. Take over bids are often a threat to an underperforming
company, therefore company might take help of window dressing to avoid such situation.

Many of the companies use window dressing to some extent, depending upon its performance
and its objectives. Some use it for creating a favorable impact to its stakeholders while some use
it for fraudulent purposes. The following types companies are likely to use window dressing:

 Companies with a weak control environment

- No independent members
- Lack of competent/independent auditor
- Inadequate internal audit function

 Management facing extreme competitive pressure or known or suspected of having

questionable character.

 Small fast-growth companies requires funds more often to expand

 Newly-public companies aiming to influence the share prices

 Privately held companies often do not disclose its information to its stakeholders
Window Dressing- Law & Ethics
Some methods of window dressing are contrary to the law or contrary to the accounting
standards and would not be employed by reputable firms. But accounting standards permits some
flexibility of interpretations. When coupled with managerial interest in presenting figures in the
most favorable light the result is window dressing. Some forms of window dressing a permitted
within the law and accounting standards but if the intension is to deceive stakeholders then they
are unethical.
Window Dressing Methods
There are certain procedures which are commonly used for the purpose of window dressing.
Such methods have been discussed below.
 Income Smoothing: It redistributes income statement credits and charges among different
time periods. The prime objective is to moderate income variability over the years by shifting
income from good years to bad years. An example is reducing a Discretionary Cost (e.g.,
advertising expense, research and development expense) in the current year to improve
current period earnings. In the next year, the discretionary cost will be increased.

 Ambiguity in Capitalizing and Revenue expenditure – E.g. Computer software with

useful life of 3 years. As revenue expenditure it is treated as negative item on P&L account.
As capitalizing expenditure, it is treated as an asset in balance sheet, with yearly depreciation
in the P&L.

 Changing depreciation policy - Increasing expected life of asset reduces depreciation

provision in P&L account, hence, increasing net profits. Also, net book value in balance
sheet will be higher for a longer period, thereby, increasing firm’s asset value.

 Changing stock valuation policy - Change in method of stock valuation policy (LIFO,
FIFO) can lead to increase in value of closing stock, boosting up the profits. For example, in
a rising price scenario, usage of FIFO method helps in increasing closing stock inventory
valuation, thereby reducing the COGS, and hence inflating the earnings. Similarly, in a
falling price scenario, LIFO valuation method for inventory is more favorable.

 Sale and Lease Back– This involves selling fixed assets to a third party and then paying a
sum of money per year to lease it back. Thus, the business retains the use of the asset but no
longer owns it.

 Not Disclosing all Liabilities- Reporting revenue upon receipt of cash before rendering
services. Failing to accrue expected or contingent liabilities. Applying means to keep debt off
the books.
 Off-Balance Sheet Financing – Conversion of capital lease to operating lease so that the
asset no longer features in the assets or liabilities of the balance sheet which automatically
improves ratios such as Total Asset Turnover Ratio (TATO), Return on Assets, Equity
Multiplier, etc. The costs saved are the interest expense on debt availed to finance the capital
lease and depreciation. Also, the debt-raising capacity of the company increases as the
liabilities component tones down. Naturally, earnings are inflated under this method.
In the later years of use of asset, the company may revert back to capital lease financing since
the with net block having reduced considerably, the deprecation by WDV method will also
be very less, thereby providing an opportunity to inflate earnings. Also, it provides the
addition benefit of saving on tax.

 Including intangible assets - If intangible assets like goodwill are not depreciated the firm
can maintain value of its assets giving a misleading view.

 Bringing sales forward – Sales show up in the P&L account when the order is received and
not at the point of transfer of ownership rights as mentioned in the notes to accounts of the
Co. under the heading of ‘Revenue Realization’. Encouraging customers to place orders
earlier than planned increases the sales revenue figure in P&L account. This brings sales
forward from next year to this year.

 Extraordinary Items- Extraordinary items are revenues or costs that occur, but not as a
result of normal business activity. These events are unusual and unlikely to be repeated they
should be highlighted in accounts, and inserted after the calculation of Profit before Interest
and Taxation. To include these in normal revenues will again exaggerate business profits.

The Enron Scandal

Enron Corporation was an American energy company based in Houston, Texas, and the
dissolution of Arthur Andersen, which was one of the five largest audit and accountancy
partnerships in the world. In addition to being the largest bankruptcy reorganization in American
history at that time, Enron undoubtedly is the biggest audit failure.
Initial Success
Kenneth Lay founded Enron in 1985 through the merger of Houston Natural Gas and Inter
North, two natural gas pipeline companies. By 1992, Enron was the largest merchant of natural
gas in North America, and the gas trading business became the second largest contributor to
Enron's net income, with earnings before interest and taxes of $122 million. Enron pursued a
diversification strategy. By 2001, Enron had become a conglomerate that both owned and
operated gas pipelines, pulp and paper plants, broadband assets, electricity plants, and water
plants internationally. The corporation also traded in financial markets for the same types of
products and services. The prices of Enron’s stocks were increasing by leaps and bounds. By
December 31, 2000, Enron’s stock was priced at $83.13 and its market capitalization exceeded
$60 billion, 70 times earnings and six times book value, an indication of the stock market’s high
expectations about its future prospects. In addition, Enron was rated the most innovative large
company in America in Fortune's Most Admired Companies survey.
Some of the Major Accounting Discrepancies by Enron
Enron's nontransparent financial statements did not clearly detail its operations and finances with
shareholders and analysts. From late 1997 until its collapse, the primary motivations for Enron’s
accounting and financial transactions seem to have been to keep reported income and reported
cash flow up, asset values inflated, and liabilities off the books. The combination of these issues
later led to the bankruptcy of the company.
 Revenue Recognition: Enron and other energy merchants earned profits by providing
services such as wholesale trading and risk management in addition to developing electric
power plants, natural gas pipelines, storage, and processing facilities. When taking on the
risk of buying and selling products, merchants are allowed to report the selling price as
revenues and the products' costs as cost of goods sold. In contrast, an "agent" provides a
service to the customer, but does not take on the same risks as merchants for buying and
selling. Enron reported the entire value of each of its trades as revenue. This "merchant
model" approach was considered much more aggressive in the accounting interpretation than
the agent model. Enron’s use of distorted, "hyper-inflated" revenues was more important to it
in creating the impression of innovation, high growth, and spectacular business performance
than the masking of debt.
 Mark to Market Accounting: Enron was the first non-financial company to use Mark to
Market Accounting. Mark-to-market accounting requires that once a long-term contract was
signed, income was estimated as the present value of net future cash flows. Often, the
viability of these contracts and their related costs were difficult to judge. Due to the large
discrepancies of attempting to match profits and cash, investors were typically given false or
misleading reports. While using the method, income from projects could be recorded, this
increased financial earnings. However, in future years, the profits could not be included, so
new and additional income had to be included from more projects to develop additional
growth to appease investors. For one contract, in July 2000, Enron and Blockbuster Video
signed a 20-year agreement to introduce on-demand entertainment to various U.S. cities by
year-end. After several pilot projects, Enron recognized estimated profits of more than $110
million from the deal. But the network failed to work and Blockbuster pulled out of the
contract. Enron continued to recognize future profits, even though the deal resulted in a loss.
 Special Purpose Entities: Enron used special purpose entities—limited partnerships or
companies created to fulfill a temporary or specific purpose—to fund or manage risks
associated with specific assets. The company elected to disclose minimal details on its use of
special purpose entities. These shell firms were created by a sponsor, but funded by
independent equity investors and debt financing. For financial reporting purposes, a series of
rules dictates whether a special purpose entity is a separate entity from the sponsor. In total,
by 2001, Enron had used hundreds of special purpose entities to hide its debt.
 Other Accounting Issues: Enron made a habit of booking costs of cancelled projects as
assets, with the rationale that no official letter had stated that the project was cancelled. This
method was known as "the snowball".
On November 28, 2001 Enron was fully bankrupt. The Enron scandal is one of the most
infamous incidents in the history of accounting. It resulted in the creation of Sarbanes-Oxley Act
due to its corporate governance failure. Various provisions were created to prevent occurrence of
incident in the future.
Conclusion
Thus, it can be concluded that a company can use window dressing to create a favorable situation
for it self in the short run but in the long run it is detrimental to the company’s interest and
extensive practice of window dressing can lead the company to termination as it was seen in case
of Enron.