Why Financial Appearances Might Matter: An Explanation for 'Dirty Pooling' and Other Types of Financial Cosmetics

Abstract:     
Companies openly and notoriously use accounting techniques (financial "cosmetics") to improve their financial appearance. They have been doing so for a very long time. Common examples include the use of "pooling" accounting in mergers, and the use of long-term leases that are functionally debt. The former increases earnings; the latter reduces debt. Both higher earnings and lower debt make for a more pleasing financial appearance. Companies' open and notorious use of financial cosmetics presents a puzzle. Financial vanity should be punished; expenditures on cosmetics applications divert from more worthwhile (that is, more profitable) pursuits. Yet the practice persists. I propose an explanation. Companies fear that markets, attracted by beautified companies' luster, might shun plainer ones. This fear is rational: Proclamations that financial appearances matter are loud and constant. So long as the cosmetics are tastefully applied (that is, the techniques do not adversely affect cash flows), markets seem indifferent; in short, there's nothing to drown out the proclamations. Why not? I argue that markets, trying to minimize aggregate information costs of unmasking beautification, concentrate their resources on discouraging and detecting makeup that masks a company's true appearance. They are indifferent to, and may even prefer, open and notorious makeup applications. The more openly a company applies its makeup, the more markets know about how the company really looks underneath. And a company applying its makeup in public may be signalling that it has little to hide.

JEL Classification: G38, K22, M41

working papers series