Window Dressing

Window dressing is the practice of improving the appearance of a company's financial statements, or an investment fund's portfolio, just before the end of a reporting period. The aim is to present stronger liquidity, lower debt, higher profit or better-looking holdings to investors, lenders or customers than the business or fund would show on a typical day. The changes are usually temporary and are often reversed shortly after the reporting date.

Not all window dressing is illegal. Some techniques are legitimate business decisions that happen to be timed for the period end, such as paying down a credit line with surplus cash. Others exploit accounting rules in ways that mislead, and at the extreme they become financial statement fraud. The line depends on whether the transactions are real, properly recorded and adequately disclosed.

• Delaying payments to suppliers so that cash looks higher at the period end, or paying them early to reduce accounts payable and improve certain ratios.
• Temporarily repaying short-term borrowings just before the balance sheet date and borrowing again just after.
• Accelerating sales into the current period with heavy discounts or by shipping goods early, sometimes with generous return rights, which raises questions under revenue recognition rules.
• Deferring discretionary expenses such as maintenance, advertising or training into the next period.
• Selling assets with unrealized gains to boost profit, while holding those with losses.
• Using short-term financing transactions that move assets and liabilities off the balance sheet at the period end, a form of off-balance-sheet financing.

A company has current assets of $1,000,000, including cash of $400,000, and current liabilities of $800,000. Its current ratio is 1.25, below the 1.5 required by its loan covenant. Two days before year end, it uses $400,000 of cash to pay suppliers. Current assets fall to $600,000 and current liabilities to $400,000, so the current ratio rises to 1.5. Nothing about the company's real liquidity has improved; it simply has less cash and fewer bills. In January it orders stock on credit again and the ratio returns to its normal level. Because the ratio is above 1, paying liabilities with assets raises it, a mechanical effect that also applies to the quick ratio.

One of the best-known examples was Lehman Brothers' use of Repo 105 transactions before its 2008 collapse. The bank treated certain short-term repurchase agreements as sales at quarter ends, temporarily removing tens of billions of dollars of assets and liabilities from its balance sheet and lowering its reported leverage, as described in the court-appointed examiner's report in 2010.

In investment management, window dressing refers to fund managers buying recent winners and selling losers shortly before the end of a quarter, so that the holdings listed in reports to investors look impressive. Banks have also been observed shrinking certain activities at quarter ends to improve regulatory ratios, a pattern that has drawn attention from regulators. For mutual funds, the practice does not change past performance but can raise trading costs.

Analysts look for unusual movements around reporting dates: large drops in borrowings or payables at quarter end that reverse shortly after, sales spikes in the final weeks followed by returns, or average balances, where disclosed, that differ markedly from period-end balances. Auditors test cut-off, review transactions just before and after the period end and assess whether arrangements have commercial substance, as reflected in their auditor's report. Lenders may base covenants on average balances or test them at random dates. The Securities and Exchange Commission requires public companies to discuss known trends and short-term borrowing arrangements in management's discussion and analysis, so investors can see whether period-end figures are representative of the company's usual liquidity.