Window Dressing in M&A Transactions

This is an Insight article, written by a selected partner as part of GAR's co-published content. Read more on Insight

Arbitration agreements are now considered the rule rather than the exception in M&A transactions. This is particularly true of international and cross-border M&A transactions in which the acquirer may be reluctant to rely on the local courts to resolve any dispute. Post-acquisition disputes therefore form a staple part of the caseload for many arbitral institutions.

In this chapter we discuss one of the major causes of post-­acquisition disputes: the exaggeration of the target company’s financial results to enhance its attractiveness to potential purchasers.

Technological developments in the US and Europe during the 1800s made plate-glass both affordable and widely available. Store owners took advantage of these developments to construct intricate window displays, designed to showcase the stores’ products to passing shoppers.

In 1883 the illustrated book A Guide to Window-Dressing was published anonymously in London. The book stated that:1

The magnificent window panes – a source of so much pride and pleasure to the connoisseurs – demand both skill and labour from those who undertake the task of dressing out.
…the window may be the direct means of bringing a customer, or it may be a good advertisement.

Since then, window displays have become ever more elaborate – to the point that the Christmas displays of large department stores in New York and London have become tourist attractions in themselves. In 2016 Macy’s Christmas window in New York attracted an estimated 8,000 to 10,000 people an hour.

In the context of M&A transactions, ‘window dressing’ refers to the techniques that a company’s sellers may use to enhance its apparent profitability and financial prospects. This may be done to attract potential purchasers, but is more frequently used to extract a higher transaction price once a purchaser has signalled interest.

In this chapter we review some of the techniques vendors may employ to exaggerate the financial performance and prospects of the target company. We then consider how potential purchasers can guard against these techniques and mitigate the risk of overpayment.

Exaggerated performance

Vendors can use a wide range of techniques to enhance a company’s apparent profitability and earnings potential. These techniques include:

  • qualitative or narrative distortions that seek to exaggerate the opportunities available to the company, by either overstating the prospects of the industry in which the company operates or by exaggerating the company’s place in the industry, competitive strength and strategic importance; and
  • manipulation of the company’s operations or accounting policies and assumptions to distort the financial results presented to the potential purchasers.

Many window-dressing schemes use both of these techniques to reinforce each other. For example, it may be easier to believe that a company occupies a dominant market position if its financial results show that it has consistently outperformed its competitors.

In this chapter we focus on the ways that a vendor may manipulate the company’s operations or accounting policies to distort its financial results, rather than on the narratives that may be woven around these results.

Manipulation of a company’s financial performance typically seeks either to (i) overstate the company’s recent and potential revenue, or (ii) understate its recent and future costs.2

We discuss common examples of such manipu­lation below.

Revenue-based manipulations

The most commonly used approaches to valuing companies with positive expected cash flows all explicitly or implicitly rely on some assessment of the target company’s growth potential.3

Potential purchasers will often assess a company’s growth potential by reference to its recent past. Ambitious projections of future growth may appear more reasonable when set against a recent history of rapid growth. A company’s vendors therefore have an incentive to manipulate its historical reported revenue to show rapid growth.

A company’s revenue can be relatively difficult to manipulate from a purely accounting perspective. This is because most accounting standards allow little flexibility as to how and when a company can recognise the revenue from the sale of a good or provision of a service.

For example, suppose that a publishing company sells a 24-month subscription to a popular monthly magazine, and receives full payment upfront. Under the most widely adopted accounting standards, the company would be unable to immediately recognise all of the cash it has received as revenue. Instead, the company would record the increase in cash on its balance sheet and also recognise a liability, known as ‘deferred income’, that reflects its obligation to send a magazine to the subscriber each month. As the company sends the magazines to the subscriber, it is able to gradually reduce the deferred income liability and recognise this reduction as revenue. In this way, the company recognises the revenue received from the subscription over its 24-month life (ie, matching revenues and expenses).

It is possible that, when selling the company, the vendors might try to inflate its revenue by recognising all of the upfront subscription payment as revenue in the current financial year, in violation of the applicable accounting standards.

However, simple accounting misstatements of this type are relatively easy to identify and are therefore unlikely to go unnoticed by the company’s auditors, or a reasonably sophisticated and informed purchaser. Revenue manipulations therefore often involve changes to the company’s operations, rather than a clear contravention of accounting standards.

Perhaps the simplest manipulations of this type are ‘sales cut-off’ manipulations. Broadly speaking, most accounting standards only allow a company to recognise the revenue associated with the provision of a good or service once that good or service has been provided to the consumer and the customer has accepted that provision.

A company may therefore seek into inflate the revenue it recognises in a given year by accelerating the delivery of a good or service to the customer, so that the delivery takes place before the end of the financial year. This effectively allows the company to recognise additional weeks, or even months, of revenue within the financial year, usually to the detriment of the subsequent financial period.

This technique is particularly effective in highly seasonal companies with year ends that coincide with a period of peak demand.

A more sophisticated variation of this technique is known as ‘channel stuffing’. A company engaging in channel stuffing provides aggressive incentives for its customers to bring forward their purchases into the current financial year, usually to the detriment of the subsequent financial period.

These incentives can take many forms, including additional discounts, improved credit and payment terms, or assistance with marketing or storage costs.

As with sales cut-off manipulations, channel stuffing allows a company to recognise, in the current financial year, revenue that would, in the normal course of business, be earned in the subsequent financial year.

However, unlike sales cut-off manipulations, channel stuffing has the potential to damage the company’s profitability after the acquisition. This is because, it can be difficult to move customers off the discounted prices and favourable credit terms that were used during the channel stuffing, thus eroding the margins the company is able to achieve. Selling large volumes of product at a considerable discount may also damage customers’ perception of the company’s brand.

Cost-based manipulations

In contrast to their approach in respect of revenue, many accounting standards allow a company’s management some discretion in deciding how and when to record certain costs in the financial statements. Cost-based manipulations of a company’s earnings may therefore include matters of accounting treatment, as well as changes to the company’s operations.

Two areas where the applicable accounting standards may allow a company’s management considerable discretion relates to (i) the recognition of provisions and (ii) the capitalisation of certain costs. These areas are therefore especially open to accounting manipulation.

In simple terms, a provision is a liability held on the company’s balance sheet in anticipation of costs that it expects to incur, but has not yet incurred.4 For example, a mining company may have a contractual obligation to restore the site of a mine to its original condition on the expiry of a 20-year mining concession. Accounting standards oblige the company to recognise a provision for these clean-up costs on its balance sheet. This provision is equal to the present value of the expected cost of returning the site to its original condition.

Although provisions themselves sit on the balance sheet, movements in provisions are recorded through the income statement; decreases in provisions are recorded as income and increases are recorded as expenses.

Since it may be difficult to determine the amount and timing of the future costs, provisions are measured based on management’s best estimates. A company’s management is therefore able to overstate its profitability by underestimating the size of the necessary provisions or by not recognising certain provisions at all.

Whereas provisions address the recognition of costs yet to be incurred, issues around capitalisation relate to how certain costs already incurred are recorded in a company’s financial statements. These issues arise particularly in relation to research and development (R&D) costs.

Many companies engage in R&D activities. In general, both US Generally Accepted Accounting Principles and International Financial Reporting Standards (IFRS) require companies to record these costs as expenses on the income statement as they are incurred.

However, under certain circumstances, IFRS allow companies to record a portion of their development costs as an asset on the balance sheet, rather than as an expense in the income statement. This is known as the ‘capitalisation’ of expenses, and increases the company’s reported profit in the current financial period.5

Under IFRS a company may capitalise the development costs associated with a project when it can demonstrate, among other conditions: technical feasibility, intent to complete the asset and the ability to use or sell the asset in the future.6

Determining whether, and when, a project satisfies these criteria involves an element of subjectivity. A company wishing to increase its reported profits may exaggerate the technical feasibility or commercial readiness of a product in order to capitalise more of its development costs. Equally, a company may seek to allocate costs that more properly relate to research activities to a project that satisfies the criteria for capitalisation.

Finally, a company may also seek to manipulate the figures that a potential acquirer will use to estimate an appropriate purchase price. These figures may differ from the figures it reports under the applicable accounting standards.

This is because, when reviewing a company’s recent financial performance in the context of a potential acquisition, it is usual to remove non-recurring or one-off costs from measures of the company’s earnings. This process is known as ‘normalisation’.

If done appropriately, normalisation provides a better understanding of the company’s underlying earnings potential than the unadjusted figures. However, determining which costs are non-recurring and which are recurring involves a degree of judgement. The distinction is not always clear-cut.

For example, a vendor might seek to exclude a company’s legal costs from an assessment of normalised income, because they related to a major litigation that has now concluded. On the face of it, this treatment is reasonable.

However, the company may operate in an industry, such as the development and manufacture of electronics, in which legal disputes are common. Although the company will no longer incur costs associated with a specific legal action, it would be reasonable to expect it to incur costs for similar legal actions in the future. In this case, it would not be appropriate to exclude all of the company’s legal costs from an assessment of its normalised earnings.

Equally, many companies regularly incur non-recurring costs of some sort, even if the costs themselves are not of a consistent nature. Therefore, while there could be grounds to exclude each non-recurring item present in a company’s financial statements, it may be prudent to allow for the fact the company is likely to continue to incur non-recurring costs in the future.

The examples of cost-based manipulation outlined above are by no means exhaustive. Other potential manipulations include:

  • changes to the accounting assumptions used to estimate the value of certain liabilities and expenses. For example, a company might overstate the estimated useful economic lives of its assets, in order to understate its annual depreciation and amortisation expense;
  • changes to the ownership of certain assets. For example, sale and lease-back arrangements may allow a company to recognise a significant profit on the sale of the asset, while increasing the costs it will incur in the future;
  • adjustments to the estimated value of its inventory. Under most accounting standards, inventory should be valued in the accounts at the lower of its cost or its net realisable value. It can be difficult for an outsider to determine when a company’s inventory is overvalued; and
  • deferring costs, such as maintenance or R&D, in the years leading up to the acquisition to understate the costs required to maintain the company’s operations.


There is ample scope for unscrupulous vendors to manipulate the figures presented to potential acquirers in order to enhance the appeal and apparent value of a target company.

Just as A Guide to Window-Dressing advises that ‘the key to success is a fund of resource. To have only one way of placing a piece of calico, puffing a silk, or opening a ribbon … is but a poor effort to the great end’,7 window-dressing techniques can be particularly effective when they are used in combination, or to distort the figures presented for several accounting periods.

For example, a company that offered large discounts to its customers as part of a channel-stuffing operation may also claim that the costs associated with those discounts were one-off and non-recurring, and so should not be factored into an analysis of the company’s normalised profits. This would lead to an overstatement of the company’s revenue growth and profit margins.

Alternatively, a company may intentionally exaggerate its costs in an earlier period, while understating its costs in subsequent periods when revenue is higher. This could make it appear that the company has a strong management team, able to drive revenue growth while maintaining control of costs; which may be particularly attractive to investors who wish to retain the existing management.

If successful, window dressing can lead to substantial overpayment on the part of the acquirer, and leave it with a company that requires significant resources and management time to return it to a competitive position. The actions that a potential purchaser can take to reduce the probability of this outcome are discussed below.

Mitigating actions

Depending on the jurisdiction and the manner in which they are employed, there may be nothing inherently unlawful about any of the activities outlined above. As a result, purchasers who feel that they have overpaid in a transaction may struggle to recover their perceived losses from the vendors.

It is, therefore, important to ensure that steps are taken during the acquisition process to minimise the risk of overpayment. In the first instance, many potential purchasers will rely on due diligence to identify potential accounting manipulations.

However, due diligence alone may be unable to fully mitigate the risk of overpayment. Potential purchasers may therefore seek to supplement the effects of due diligence through the valuation techniques they use to assess a reasonable acquisition price, or by seeking contract protection through the terms of the sale and purchase agreement.

Due diligence

Due diligence is a common part of the M&A process and is often performed by experienced third parties engaged by and on behalf of the purchaser.8 The due diligence performed during an acquisition can include:

  • financial due diligence, which reviews the target’s financial position and performance;
  • commercial due diligence, which reviews the target’s commercial strength and competitive positon;
  • forensic due diligence, which looks at the disclosed documents and key personnel for red flags that may indicate impropriety;
  • legal due diligence, which involves a review of the target’s key contracts and other potential legal issues;
  • tax due diligence, which assess the target’s tax position and potential tax liabilities; and
  • technological due diligence, which reviews the quality of the target’s assets and technologies.

Typically the purchaser determines the scope and scale of the due diligence undertaken, taking in to account, among other factors:

  • the size and complexity of the potential acquisition;
  • the time available to perform the due diligence;
  • the budget for the due diligence; and
  • its own appetite for risk.

In theory, commercial and financial due diligence should identify many of the window-dressing techniques outlined above.

One of the major parts of most financial due diligence engagements is ‘quality of earnings analysis’. This comprises a detailed review or all of the material components of a company’s revenue and expenses, and considers what adjustments should be made to these figures to provide a more accurate picture of the company’s underlying financial performance and cash generative capability.

Commercial due diligence may include a review of:

  • the structure and size of the market in which the target operates, and the forces driving the development of the market;
  • the target company’s major competitors and competitive position;
  • the target company’s relationship with its major customers and suppliers; and
  • the threats and opportunities facing the target.

This analysis should help a potential purchaser assess the merits of the qualitative information it has been told regarding the target’s place in the industry, competitive strength and growth potential.

However, in some cases it can be difficult to distinguish window dressing from legitimate commercial activity. For example, discounts offered as part of a channel-stuffing scheme may be hard to distinguish from discounts offered for legitimate commercial reasons; such as to move stock that is close to expiry or to quickly raise funds to meet upcoming debt repayments.

Additionally, the firms engaged to perform the due diligence rely on information disclosed by the company. While it is rare for a company to provide information that is entirely fraudulent, companies are often unwilling to provide all of the information that the due diligence providers request. This may be because the information requested does not exist or because it is considered too commercially sensitive.

Limits on the information available to the due diligence providers may materially constrain the scope and depth of the due diligence that can be performed. It is then for the potential acquirer to assess whether it is sufficiently comfortable, based on the due diligence that has been performed, to proceed with the acquisition.

Therefore, while due diligence is an important step in any acquisition, in isolation it may not be able to fully offset the risk of overpayment caused by window dressing.

Valuation approaches

The value of a business depends upon expectations about the size and timing of its cash flows in the future and the degree of uncertainty inherent in those expectations. There is no universally applicable approach rendering the expected future financial returns of an asset into a monetary value at a point in time – a ‘present value’.

Each valuation technique relies to a different degree on the various aspects of a company’s reported and projected financial performance. A purchaser may be able to reduce the risk of overpayment by employing multiple valuation techniques, as part of a robust valuation process.

The two primary bases for the valuation of income-­generating assets are comparative (or relative) approaches and income (or intrinsic) approaches.

Comparative approaches seek to ascribe a value to the subject asset at the date of valuation on the basis of prior transactions. These could be previous transactions in the asset itself or transactions in assets that share similar economically relevant characteristics to the asset that is the subject of the valuation.

Economically relevant characteristics are those characteristics that determine the growth prospects and risk of the company. Examples of economically relevant characteristics include the industry and geographic location of the business.

Income bases of valuation rest on the premise that an asset’s value is equal to the value of the cash flows that it is expected to generate in the future, discounted at a rate that reflects the relevant risks inherent in those cash flows. The most common method is the discounted cash flow (DCF) approach.

There are many variations to both the income approach and the comparative approach to valuation. By relying on more than one valuation approach and variation, a purchaser may be able to minimise the effects of window dressing.

For example, DCF analysis relies on projections of the target company’s cash flows, ideally for at least the next five years. These projections may be based on historical growth rates that have been inflated through window dressing. If this is the case, the implied value of the company will be overstated.

This risk may be offset by also considering the results of the comparative approaches to valuation as part of the valuation process. Comparative approaches often rely on ‘multiples’, which express the comparable companies’ values as multiples of their income or profit. These multiples are then applied to the target company’s income or profit to estimate its value.

Multiples can be calculated from projected financial performance (‘prospective multiples’), as well as from historical performance shown on the company’s financial statements (‘historical multiples’).9

If the values implied by prospective multiples and historical multiples are broadly consistent, this is an indication that the company’s projected income growth is consistent with that of its peers. If the value implied by prospective multiples significantly exceeds the value implied by historic multiples, then the company is projected to grow much faster than its peers.

While there may be compelling reasons to believe that the target company will outperform its peers, a considerable disconnect between the results of prospective multiples valuation and historical multiples valuation may be an indication that the projections on which the company is valued are overstated, and hence the purchase price is excessive.

On the other hand, DCF analysis relies on an assessment of the company’s cash flow rather than its profits and is therefore potentially less susceptible than comparative approaches to cost-based manipulations, such as the excessive capitalisation of development costs.

A potential acquirer may be able to mitigate the risk of overpaying as a result of window dressing by performing a combination of DCF analysis, historical multiples analysis and prospective multiples analysis, and seeking to reconcile and understand the different values each approach produces.

Contractual protections

An acquirer may also seek to protect itself from overpayment through the terms of the contract governing the acquisition. These protections often seek to tie some element of the purchase price to the target company’s subsequent performance. This can be achieved through a number of contractual arrangements, including:

  • earn-out provisions, under which the vendor receives additional compensation based on the performance of the target. For example, the vendor might receive US$100 million up-front and 2 per cent of sales over a certain threshold for three years;
  • contingent consideration arrangement, under which the portions of the agreed consideration are only payable if the target’s financial performance meets certain levels; and
  • claw-back mechanisms, under which portions of the consideration are repayable if the target’s financial performance fails to meet certain levels.

Equally, a potential purchaser may try to protect against exaggerations and misstatements in the qualitative information provided by the vendor by including representations and warrantees from the vendors and the company’s management in the contract. These representations and warranties survive the acquisition’s completion and may provide the basis for a claim against the vendors in the event that the representations and warranties turn out to be false.

Both contractual representations from management and price adjustment mechanisms can protect a seller from over-paying based on inflated expectations of a company’s profitability and growth potential. However, they also ensure that the vendor retains continued exposure to the company’s performance. This may make the sale unpalatable to many vendors.

Whether the purchaser is able to secure these contractual protections depends on the relative bargaining position of both parties and the purchaser’s willingness to risk the completion of the deal in order to obtain the protections it desires.


Just as department stores use bright lights and intricate designs to attract customers at Christmas, a company’s vendors may seek to use flashy growth rates and profit margins to entice prospective buyers. These growth rates and profit margins can be inflated through a variety of window-dressing techniques.

The vendors may also present the company’s recent performance as part of a narrative that emphasises the company’s continued profitability and capacity for growth, while minimising any potential weaknesses or commercial threats.

These narratives are all the more convincing if supported by the company’s reported financial results. Therefore, some vendors may also use window-dressing techniques to ensure that the company’s apparent results fit the desired narrative.

A vendor wishing to engage in window dressing can do so through accounting manipulations, short-term changes to the company’s underlying operations or a combination of the two. In more sophisticated cases, the vendor may seek to disguise its window dressing as part of the target company’s ordinary business activities.

Window dressing not only seeks to induce a potential purchaser to overpay for the company in question, but may unintentionally weaken the target company’s brand, competitive position and commercial operations.

Given the sustained interest in cross-border M&A transactions, and the continued popularity of arbitration clauses in those transactions, there is every reason to suspect that tribunals will continue to hear cases of alleged window dressing in post-acquisition disputes.

However, pursuing these claims can be expensive and time-­consuming, and it may be difficult for tribunals to distinguish sophisticated window dressing from legitimate commercial decisions.

A purchaser may therefore wish to take steps to guard against overpayment prior to the completion of the transactions. Such steps may include: in-depth due diligence, a robust valuation process and contractual provisions.

However, none of these strategies in isolation is fully able to mitigate the risks of over-payment. A prudent acquirer may wish to adopt a combination of several mitigation strategies to ensure that, unlike the crowds that flock to the bright lights of Macy’s, it is not beguiled by window dressing.


  1. Anonymous, 2010. A Guide To Window Dressing (1883). Edition. Kessinger Publishing, LLC, p. 7.
  2. Vendors may also seek to inflate the target company’s balance sheet by overstating the value of its assets or understating the value of its liabilities. These balance sheet manipulations may have a material effect on the perceived value of the target. However, because of the constraints of space, a discussion of balance sheet manipulations is outside the scope of this chapter.
  3. Companies that are not expected to generate positive future cash flows may be valued on a ‘liquidation’ or break-up basis, which assesses the value the company’s assets could achieve were they to be sold separately rather than their combined cash generative capacity.
  4. IFRS define a provision as ‘a liability of uncertain timing or amount’, where a liability is ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.’
  5. The company will begin to amortise these capitalised costs once the product starts to earn revenue. These amortisation expenses will reduce the company’s reported profit. Capitalisation therefore defers, rather than prevents, the recognition of development costs through the income statement.
  6. US GAAP also allows for the capitalisation of certain costs associated with the development of software under certain conditions.
  7. Anonymous, 2010. A Guide To Window-Dressing (1883). Edition. Kessinger Publishing, LLC, p. 11.
  8. In some cases the vendor may commission due diligence and provide the results to the purchaser. It is then for the purchaser to decide whether it wishes to rely on the vendor’s due diligence or commission further due diligence of its own.
  9. It is also possible to calculate multiples by reference to the company’s performance in the current financial period. These ‘current multiples’ may include both historical and prospective financial information.

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