Why Financial Appearances Might Matter: An Explanation for 'Dirty Pooling' and Other Types of Financial Cosmetics
Claire A. Hill
University of Minnesota, Twin Cities - School of Law
Delaware Journal of Coporate Law, Vol. 22, No. 1, 1997
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.
Number of Pages in PDF File: 47
Keywords: accounting, dirty pooling , financial appearance, financial cosmetics
JEL Classification: G38, K22, M41Accepted Paper Series
Date posted: March 10, 2003
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