ARTICLE: WHY FINANCIAL APPEARANCES MIGHT MATTER: AN EXPLANATION FOR "DIRTY POOLING" AND SOME OTHER TYPES OF FINANCIAL COSMETICS

1997

Reporter 22 Del. J. Corp. L. 141

Length: 19623 words

Author: By Claire A. Hill *

* Assistant Professor of Law, George Mason University School of Law. This article was written in partial fulfillment of the requirements of the Doctor of the Science of Law in the Faculty of Law, . I wish to acknowledge helpful comments made by the participants at the Law and Economics Workshop at George Mason, particularly, Peg Brinig, Frank Buckley, Lloyd Cohen, L. Bruce Johnsen, Erin O'Hara, and Peter Letsou, Bill Lash, and participants at the Canadian Law and Economics Association Conference, particularly John Palmer. I also wish to acknowledge helpful conversations with Bernie Black, Victor Goldberg, and David Gordon. Finally, I wish to acknowledge the excellent research assistance of Sujatha Bagal and Scott Faga, both George Mason University School of Law Class of 1997.

LexisNexis Summary

… "What's more important, economic substance or appearance? Banks are voting for appearance, hands down." … The information cost structure which gave rise to the mispricing might very well continue; thus, an arbitrageur's investment might never pay off. … Debt, too, can be "managed" using beautification techniques. … No matter how visible, the effects of financial statement beautification techniques, whether relating to debt or earnings, are not costlessly translatable. … By contrast, in a pooling, the 's basis has stayed the same, resulting in higher gain on sale. … Because I am trying to explain financial statement beautification, my analysis considers only debt- swaps done for cosmetic reasons. … One money manager, in praising the accounting "aggressiveness" of Mattel, noted: "Mattel's earnings have risen for seven consecutive years, a feat that could not have been achieved without mirrors." … This should account for market neutrality as between pooling and purchase accounting, and as between leasing and debt. … Beautification would at least be earning its keep, and elicit market neutrality or perhaps even market favor, as stockholders benefitted at regulators' or lenders' . … Fundamental efficiency holds that there are no profitable trading opportunities because prices reflect fundamental value. …

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"What's more important, economic substance or accounting appearance? Banks are voting for appearance, hands down." 1

I. Introduction

1 Roger Lowenstein, A Modest Proposal to Stop ’Pooling,’ Wall St. J., May 9, 1996, at 1. Page 2 of 40 22 Del. J. Corp. L. 141, *144

Markets generally favor companies 2 with higher and more consistent earnings, and less debt, over companies with lower or less consistent earnings, and higher debt. 3 In the classic lemons 4 story, markets are well aware that companies have both the will, and the way, to mask an unflattering financial picture with financial cosmetics: 5 accounting techniques which help increase and/or smooth "earnings," and reduce "debt," without corresponding flow effects. Unless companies provide assurances that their appearances do not mask a less pleasing reality, markets will apply a lemons discount larger than all but the worst companies warrant. In this story, the aim both of companies preparing their financial statements, and market players reading them, should be full transparency. Companies using accounting techniques to

[*143] render themselves more opaque should be punished in the markets; punishment, if not immediate, should be swift and certain. This is the world the lemons story predicts. The real world is dramatically different. Financial appearances matter and they matter a great deal. Or at least many people in the financial and academic communities have acted and spoken as though they mattered for a very long time. 6 Companies select a particular accounting method, or even

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2 I use the term "company" to mean, generically, any business entity, regardless of its form. 3 This is almost a truism. One academic exploration of the desirability of consistent (smooth) earnings is Paul K. Chancey & Craig M. Lewis, and Economic Valuation Under Asymmetric Information, 1 J. Corp. Fin. 319 (1995). But cf. John R.M. Hand, Did Firms Undertake Debt-Equity Swaps for an Accounting Paper Profit or True Financial Gain?, 64 Acct. Rev. 587 (1989) (concluding that company managers may prefer smoothed earnings but that capital markets do not). Hand thinks markets might view smooth earnings as a signal that a company's earnings reports are not to be trusted, and therefore not like smooth earnings. Hand is not alone in thinking markets are suspicious of smooth earnings. See infra notes 111-12 and accompanying text. He is, however, virtually alone in thinking that markets do not like smooth earnings. Hand was studying a beautification technique that adversely affected cash flows; perhaps the cash flow effect, and the resultant signal that management cared much more about appearances than reality, was sufficient to explain the negative market reaction. 4 The word "lemons" refers, of course, to George A. Akerlof's seminal article, The Market for "Lemons": Quality Uncertainty and the Market Mechanism, 84 Q. J. Econ. 488 (1970).

5 In this area, many people, myself included, succumb to the temptation to use appearance metaphors: for instance, balance sheets may "be dressed up," "be cleaned up," "be shaped up," "get a facelift," or "use cosmetic effects." 6 See, e.g., on "managing" "earnings": James C. Freund, Anatomy of a Merger: Strategies and Techniques for Negotiating Corporate Acquisitions 484, 491, & 499 (1976) (discussing thought and effort given to obtaining pooling treatment); Chancey & Lewis, supra note 3; Michael Davis, Acquisitions Disguised as Poolings Can Lead to Misleading Improvements In Earnings, 10 J. of Acct. 99 (Oct. 1991) (some market players care more about reported earnings than cash flows; indeed, some mergers haven't occurred because pooling wasn't available); Ronald A. Dye, Earnings Management in an Overlapping Generations Model, 26 J. Acct. Res. 195 (Supp. 1988) (corporations manage earnings in part to make the firm more attractive to prospective investors); Hand, supra note 3; Robert W. Holthausen et al., Annual Bonus Schemes and the Manipulation of Earnings, 19 J. Acct. & Econ. 29 (1995) (managers manipulate to reap the maximum benefit of annual compensation plans predicated on accounting earnings); O. Douglas Moses, Income Smoothing and Incentives: Empirical Tests Using Accounting Changes, 62 Acct. Rev. 358 (1987) (earnings management is motivated by several factors, including the firm's size and bonus compensation scheme); Brett Trueman & Sheridan Tittman, An Explanation for Accounting Income Smoothing, 26 J. Acct. Res. 127 (Supp. 1988) (management has the incentive to smooth income to decrease the appearance of volatility, and receive a better price for debt). See generally Victor Brudney & William W. Bratton, Brudney and Chirelstein, Cases and Materials on Corporate Finance A1-A36 (4th ed. 1993 & Supp. 1996) (unless otherwise indicated, citations are to the 1993 text); Thomas E. Copeland & J. Fred Weston, Financial Theory and Corporate Policy 362-70 (3d ed. 1988); Ronald Gilson & Bernard Black, The Law and Finance of Corporate Acquisitions 555-87 (2d ed. 1995) (choice of accounting methods generally, with particular focus on the problem in the context of purchase versus pooling); Reed Abelson, Truth or Consequence? Hardly, N.Y.Times, June 23, 1996 at 3 (nearly all companies manipulate financial statements, and markets are influenced by the manipulated numbers). See, e.g., on reducing "debt" (mostly, "off-balance-sheet financing"): Hand, supra note 3; John R. M. Hand et al., Insubstance Defeasances: Security Price Reactions and Motivations, 13 J. Acct. & Econ. 47 (1990); Richard Dieter & Arthur R. Wyatt, Get Page 3 of 40 22 Del. J. Corp. L. 141, *144 engage in a particular business transaction or practice, to improve their financial appearance: to increase or smooth their reported earnings, or reduce their reported debt. Pooling an accounting method for mergers which keeps post-merger accounting earnings higher than the alternative method is probably the most notorious example. 7 That's why it has been referred to as "dirty pooling." 8

Some financial appearance-enhancing techniques are quite visible. Companies must, for example, disclose in their financial statements that they have accounted for a merger as a pooling. Other techniques, like accumulating and releasing reserves to smooth earnings, may be less visible: company insiders may be the only ones certain of the reality behind the pleasing financial appearance. 9 And what do companies get

[*145] for their trouble? An improved financial appearance, but not an improved financial reality: their cash flows stay the same, and in some cases, even decline. it Off the , Fin. Executive 44 (Jan. 1980) ("By getting debt off the balance sheet, the character, or quality, of the balance sheet is improved. Ratios that have withstood the test of usefulness for generations will therefore appear more favorable to the borrower."); Jeffrey Randall, Captive Finance Subsidiaries: A Method of Off-Balance Sheet Financing, 46 Secured Lender 66 (Nov. 1990) ("By removing debt from the balance sheet, a firm can present a preferable financial situation to its creditors."); Larry R. Scott, Sale-Leaseback Versus Mere Financing: Lyon's Roar and the Aftermath, 1982 U. Ill. L. Rev. 1075, 1078 (1982) ("A . . . business advantage of a sale-leaseback [a type of off-balance-sheet financing] is that it may improve the seller/lessee's balance sheet. . . . Less debt [because a company obtained funds in a sale-leaseback, rather than a borrowing] indicates a strong company, making the company attractive to potential investors."); Martha van Dijk & Ariette Dekker, Industry Faces Another Cycle When Tapping Finance Markets, 37 Pulp & Paper Int'l 23 (Sept. 1995) ("Off balance sheet financing [sale-leasebacks] enables a company to . . . shape up the balance sheet."). I use popular press sources as well as more technical sources. The popular press reports extensively on the expressed beliefs and views of the financial community about accounting and company practice; for purposes of my argument, these views and beliefs are in many cases as important as the practices themselves.

7 See Beth McGoldrick, Games, Institutional Investor, Mar. 1997, at 145. The article discusses various transactions in which pooling was obtained, sometimes at enormous cost. The article also discusses how much effort companies, , and regulators spend on pooling. Arthur Wyatt, a member of a new Standards Board task force on pooling, is quoted as saying: "If we were to assess the amount of time spent on questions of pooling versus purchase, we'd find that this is the most costly accounting issue we've ever had in the U.S." Id. See also Gilson & Black, supra note 6, at 570 (quoting Arthur Wyatt as saying that it is not atypical for a merger to be abandoned when pooling treatment is not available); Executive Update, Investors' Bus. Daily A4 (May 23, 1996) ("[W]hy all the fuss over pooling accounting? It's because investors still (incorrectly) value accounting earnings so highly."); FASB Considers Changing 'Pooling' Rule on Mergers, Wall St. J., Aug. 23, 1996, at B22 (noting that if pooling were eliminated, some mergers might not occur). See also Davis, supra note 6 ("One investment banker reports that 20 acquisitions he personally worked on in the last two years fell through because goodwill amortization would have reduced reported earnings, a risk the acquiring managers were loath to take."). Davis also notes that companies sometimes merge with other companies purely to obtain the accounting benefits of pooling. And a recent New York Times article discussed one merger that had not occurred because pooling treatment could not be obtained, and another merger that would not occur unless pooling treatment could be obtained. Floyd Norris, ADT Deal May Unravel, and Accountants Hold the Strings, N.Y. Times, July 9, 1996, at D6. See also Lowenstein, supra note 1, noting that banks were postponing or limiting stock buybacks real transactions with real economic consequences so that their mergers could qualify for pooling. However, the article also noted that banks' proclivity for pooling is motivated not only by concern for their financial appearance, but also by features of the applicable regulatory regime. I discuss this regime in infra note 163 and accompanying text.

8 See, e.g., Hai Hong et al., Pooling vs. Purchase, The Effects of Accounting for Mergers on Stock Prices, 53 Acct. Rev. 31 (1978). 9 I describe visible financial beautification techniques in infra Section III. For descriptions of invisible techniques, see, e.g., Abelson, supra note 6; Jennifer J. Garver et al., Additional Evidence on Bonus Plans and Income Manipulation, 19 J. Acct. & Econ. 1 (1995); Holthausen et al., supra note 6; Manipulating Profits: How It's Done, Time, June 25, 1984 at 50. As I discuss in infra Section II, visibility and invisibility fall along a continuum. The most visible technique can readily be seen through: its use is known, and its effect on cash flows can be computed. The least visible may be completely opaque; more likely, however, the use of the technique may be suspected, and its effects estimated within a broad range. Page 4 of 40 22 Del. J. Corp. L. 141, *145

The clash with the lemons story is clear and stark. Companies should be trying to convince markets that their financial statements are true and complete; instead, as the popular press and the financial and academic communities 10 have long acknowledged, they are notoriously, and sometimes openly, using financial cosmetics. 11 And how do markets react? They peel off the layers of makeup, as best they can, valuing beautified companies no higher or lower than comparable plain ones, so long as the makeup is tasteful, and tastefully applied. In other words, markets are neutral to the act of beautification. 12 They do not punish

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10 Most of the academic literature discusses "earnings management," which includes any type of earnings manipulation. Usually, the manipulation aims to increase or smooth earnings; sometimes it might aim to lower earnings. One common reason to lower earnings is to take a "big bath" when a smaller bath is inevitable; concentrating bad news in one period can help set the stage for a more favorable "pattern" subsequently. See infra note 58 and accompanying text. Some of the academic literature discusses particular types of off-balance-sheet financing; none of this literature, however, advances a satisfactory theory of the (cosmetic?) virtues of a cleaner balance sheet. My discussion is meant to encompass both off-balance-sheet financing and earnings management; thus, I use the more inclusive (and, I hope, more evocative) term "financial statement beautification." Another term with somewhat related coverage in the literature is "accounting choice"; "financial statement beautification" is intended to subsume accounting choice as well. As I discuss in infra Section IV.B, the end of beautification is sometimes political or regulatory; however, in a significant number of cases, it is not. My article focuses on these latter cases, where beauty is touted as an end in itself.

11 For instance, pooling has been used since the Second World War, and has survived despite periodic attempts to curtail it. Alexander J. Sannella, The Impact of GAAP On Financial Analysis: Interpretations and Applications for Commercial and Investment Banking 263 (1991). See also Davis, supra note 6; infra notes 65-66 and accompanying text. Leasing functionally resembling debt also is a long-standing practice, surviving curtailment attempts. Frank C. Minter et al., Handbook of Accounting & Auditing C8-2 (1996). See infra notes 82-84 and accompanying text.

12 Robert G. Bruman, The Debt Equivalence of Leases, an Empirical Investigation, 55 Acct. Rev. 237 (1980); Davis, supra note 6 (market neutrality for pooling); Larry R. Davis et al., The Effect of Debt Defeasance on the Decisions of Loan Officers, Acct. Horizons 67 (June 1991) ("Altering financial statements by extinguishing debt does not appear to influence the credit terms offered to a firm."); Hong et al., supra note 8 (market neutrality for pooling); Eugene A. Imhoff & Jacob K. Thomas, Economic Consequences of Accounting Standards: The Lease Disclosure Rule Change, 10 J. Acct. & Econ. 277 (1988) (market neutrality for leasing). But, as I discuss in infra Section III.B.2, when beautification expenditures are known to be high, such that negative cash flow effects are readily discernible, markets react negatively. Indeed, it seems plausible, and perhaps even likely, that part of the market's negative reaction to AT&T's merger with NCR was attributable to the excessive costs spent to obtain pooling treatment. Estimates of those costs ranged from $ 50 million to well in excess of $ 500 million. See Thomas Lys & Linda Vincent, An Analysis of Value Destruction in AT&T's Acquisition of NCR, 39 J. Fin. Econ. 353 (1995) (estimating pooling expenditures at $ 50 million or $ 500 million, depending on which expenditures are included). The article does not discuss the market's reaction to this expenditure. Rather, it notes that the market reacted unfavorably to the merger, but does not attempt to separate the effects of the merger itself from the expenditures to obtain pooling accounting treatment. But cf. Abelson, supra note 6, who says that the market may not punish even egregious cases of excessive beautification, so long as the company is profitable. For purposes of this article, I exclude the ATT/NCR pooling from the category of poolings-as-persistent-highly visible beautification techniques; the use of "poolings" may be persistent, but the notorious use of poolings costing many, many millions of dollars may not be. If the market is neutral to beautification, does this mean that beautification has no market effect? Some scholars speak as though they think so. See, e.g., Gilson & Black, supra note 6, at 570 (stating that the studies on choice of accounting method "consistently support the proposition that the capital market is efficient with respect to choice of financial accounting methods so long as financial disclosure is complete enough so that investors can compare financial statements prepared using different accounting methods"). See also Brudney & Bratton, supra note 6, at A8-A10. On my view, a negative effect might seem more appropriate, since beautification efforts seem fruitless and wasteful at best. For instance, markets should, one might think, punish companies for shunning perfectly good business combinations for appearances' sake. Thus, market "neutrality" is, I argue, in effect a market reward. Those hypothesizing that visible beautification has no market effect are, as they acknowledge, left with a difficult question: why would managers and companies speak (and, arguably, act) as though it does? See Gilson & Black, supra note 6, at 570-71 (asking this question). My approach hypothesizes a market effect which explains the beautification-seeking words and actions; I assume that markets may (slightly) reward beautification, but, more significantly, that companies might rationally fear that markets would punish its absence. Page 5 of 40 22 Del. J. Corp. L. 141, *146 companies just because the companies beautify; they do, however, punish companies who spend excessively to beautify.

Why, then, would companies beautify? Where beautification is less visible, there are some plausible explanations. Most such explanations involve someone the market, regulators, or a company's lenders or management compensation committee being fooled. 13 But where beautification is more visible, fooling seems far less plausible. In sum, the persistence of highly visible financial statement beautification poses a puzzle.

In this article, I propose an answer to this puzzle. I hypothesize a dynamic predicated on positive information costs. Verifying the

[*147] accuracy of companies' financial statements is costly. Substantial accuracy can be verified at fairly low cost; however, verification beyond substantial accuracy is much more costly. This information cost structure leads to specialization in investment strategies.

In my model, there are two types of investors. One type is money managers. They invest a large proportion of the country's investible dollars. They specialize in bulk-appraisal of many investment opportunities; for their investment strategies, substantial accuracy suffices. In this case, it may even be optimal. The other type, arbitrageurs, specialize in exploiting mispricings, 14 including those the money managers' investment strategies create or allow to persist. 15

Substantial accuracy permits of a fair measure of beautification. Markets therefore presume companies will beautify; companies do so, because the alternative, rebutting the presumption, is more expensive. 16 Indeed, companies wanting to pay less attention to appearance may face a costly battle a "public relations campaign," according to an investment banker at a major investment bank 17 to persuade markets

13 I discuss these explanations in infra Section IV.B. My arguments in that Section, as to why various fooling or outmaneuvering explanations are implausible, are not meant as death-knells. Sophisticated commercial actors are perhaps being fooled or outmaneuvered; the proposition would be difficult to prove (or disprove). My aim in claiming the arguments are implausible is partly to motivate the search for an account not relying on them.

14 For purposes of this article, I define "mispricings" as departures from fundamental value, where fundamental value is the net present value of expected future cash flows. Many, and perhaps most, scholars think that markets move towards fundamental value, but never reach it. See, e.g., Sanford Grossman & Joseph Stiglitz, On the Impossibility of Informationally Efficient Markets, 70 Am. Econ. Rev. 393 (1980). And certainly, many real world costs often assumed away, such as information costs, might impede the journey. Once positive information and other costs are taken into account, a stock that was "mispriced" relative to its fundamental value might no longer be "mispriced" on less restrictive definitions. See infra Section IV.C. But whatever a theory's definition of mispricing, it will accord to arbitrageurs an important role in moving prices towards fundamental value. (An exception may be behavioral theories, which recast, and sometimes minimize, the importance of arbitrageurs. See infra note 150.). Thus, for analytic ease, I characterize departures from fundamental value as "mispricings," and arbitrageurs as being in the business of correcting such mispricings.

15 I do not deal separately with investors who do not "correct" the money managers' mistake because they make it themselves. Some such investors also may have no reason to go beyond substantial accuracy. An important example is large pension funds. Other investors may actually mistake a company's made-up financial appearance for reality. The activities of these investors should only exaggerate the dynamic my argument hypothesizes.

16 Indeed, a recent article in quoted a financial newsletter writer as saying: "In a world where everyone plays games [manipulates earnings], you'd be a fool not to play the game." See Abelson, supra note 6. So companies play the game. One could argue that "playing the game" serves as a signal of market savvy; not playing the game might signal its absence. But this assumes the very matter at issue: that appearances are valuable for their own sake.

17 See Executive Update, supra note 7. While a merger has the same economic value whether it's accounted for as a purchase or a pooling, there can be an indirect economic impact, [Robert] Willens [managing director of Lehman Brothers Inc., Page 6 of 40 22 Del. J. Corp. L. 141, *148

[*148] that appearances are only skin-deep. 18 Markets therefore factor the effects of a normal level of beautification into company valuations. Information cost constraints of money managers' bulk-appraisal process mean that the adjustment for abnormal levels of beautification can only be substantially accurate. Substantial accuracy is more concerned with the level of beautification than whether it is visible or invisible. Money managers seeking to detect excessive beautification need valuation methodologies that aggregate visible and invisible beautification. Money managers probably can do a better job of computing the effects of visible beautification if they attempt to do so expressly. But they may be better off not doing so; they will find out more about companies at lower cost if they do not reward private applications of financial cosmetics. Companies will select a mix of visible and invisible beautification techniques that provide the most desirable appearance at least cost. In making their selection, they will consider many factors, including the compatibility of certain types of makeup with their business. But visible techniques have an important benefit, helping assure their longevity: using such techniques, companies can signal that they have little to hide. In a world where some beautification is inevitable, but excessive beautification is likely to be detected, companies applying financial

[*149] cosmetics in public may be depicting themselves as accurately as they can.

But where in this account are the arbitrageurs, ever-vigilant in searching out, and correcting, mispricings? 19 The foregoing hypothesizes a mispricing. Companies are spending money in what should be a fruitless quest; the "correct" price should reflect a market punishment, even if only for the transaction costs involved in the quest. Arbitrageurs might not find this particular mispricing worth exploiting. One possibility is that even for them, the information costs are larger than the mispricing. But even if their information costs were sufficiently small, the arbitrageurs might still not find the mispricing worth exploiting. The information cost structure which gave rise to the mispricing might very well continue; thus, an arbitrageur's investment might never pay off. The stage is set for a world in which financial appearances matter and being observed applying financial cosmetics may not. Shunning even obvious financial cosmetics for a more natural look may be perilous. a leading New York investment bank] says. Because investors still pay so much attention to accounting earnings, "a firm's stock price can take a hit when using purchase accounting." [As I discuss in infra Section IV.A.1, notwithstanding empirical studies suggesting that this "hit" may be nonexistent, the fear of such a "hit" may nevertheless be rational.] If firms are unable to use pooling accounting, "they must create public relations campaigns," Willens added. [Firms] must ask investors to "look at [the firms'] cash flows, not [their] accounting earnings." The problem is that firms have had limited success convincing the market that only cash flows count. But with pooling accounting falling into disfavor [as a result of the recent buyback restrictions, which I discuss in infra note 66], they may soon get better results. Id. Perhaps but history suggests that manipulation of cash flows soon will follow. Indeed, moves in this direction have already begun. See infra Section IV.A.3.

18 Each company would just as soon have someone else wage the campaign. A manager at Banc One was recently quoted as saying: "We love to be the second one to do something revolutionary." The manager's remark appeared in an article in the Wall Street Journal quoting two company managers. One manager worked for Wells Fargo Bank, which had recently made an acquisition accounted for using the "purchase" method. The company "has been telling investors they ought to value it according to its 'cash' earnings and disregard the lower number that results after amortizing goodwill." The second manager, of Banc One, "watching" the situation, said, We love to be the second one to do something revolutionary. Before we jump on the . . . bandwagon we've got to see what the marketplace is going to say." Lowenstein, supra note 1. The second manager apparently thinks it is cheaper to beautify than to rebut the market's presumption of beautification; certainly, the fewer who try, the more expensive rebutting the presumption will stay.

19 I discuss in infra Section IV.A.2 some new theories which hypothesize more persistent mispricings. The role of arbitrageurs in such theories is different; indeed, some "behavioral" theories seem to toy with eliminating the qualitative differences between arbitrageurs and other investors. See Werner F.M. DeBondt & Richard H. Thaler, Do Security Analysts Overreact, in Richard H. Thaler, Quasi Rational Economics 301-08 (1991); Werner F.M. DeBondt, What Economists Know About the Stock Market, J. Portfolio Mgmt. 84, 84 (Winter 1991). Page 7 of 40 22 Del. J. Corp. L. 141, *149

I am not arguing that this dynamic in which companies, encouraged by money managers, beautify, and arbitrageurs do not bother peeling off the layers of makeup is stable over the long term. Advances in accounting and financial analysis, perhaps prompted by the increasing internationalization of markets, might have some effect, 20 as might changes in the structure of money management. But the practice has shown surprising resilience: the contents of the financial makeup kit may have changed over time, 21 but the existence of a kit has not. My aim in this article is not merely to explain the puzzle of visible beautification. I also have a broader aim: to illustrate, within the context of efficient markets, how some mispricings might persist, uncorrected. The efficient capital markets hypothesis (ECMH) 22 has no difficulty with

[*150] indeed, virtually requires fleeting mispricings. 23 But when those mispricings persist, the arbitrageurs seem to be failing at the tasks the

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20 See infra note 67 and accompanying text.

21 For instance, the use of debt-equity swaps to beautify financial statements apparently all but disappeared after the Deficit Reduction Act of 1984 dramatically increased the negative tax consequences. Hand, supra note 3. Since 1984, debt/equity swaps have almost always had real economic objectives. See infra note 99 and accompanying text. Other beautification techniques have simply adapted to efforts to control them. See supra note 11.

22 For general discussions of ECMH, see, e.g., Brudney & Bratton, supra note 6, at 120-36; Copeland & Weston, supra note 6, at 330-55; Gilson & Black, supra note 6, at 137-47; and Ronald J. Gilson & Reiner H. Kraakman, The Mechanisms of Market Efficiency, 70 Va. L. Rev. 549 (1984). My article takes the ECMH as a point of departure; I should note, however, that the ECMH has been under increasing attack; many have intimated that it may warrant only circumscribed confidence, and some seem to have abandoned it altogether. See generally Brudney & Bratton, supra note 6, at 17-19 (Supp. 1996) (summarizing some of the critiques of ECMH); Gilson & Black, supra note 6, at 166-72 (summarizing some of the critiques of ECMH); Ian Ayres, Back to Basics: Regulating How Corporations Speak to the Market, 77 Va. L. Rev. 945, 967-68 (1991) (citing recent empirical studies that undermine several basic assumptions of the ECMH, but concluding that "the legal presumption of semi-strong form efficiency for stocks traded on the national exchanges may still be warranted, although the critiques clearly militate in favor of more circumscribed confidence in it"); Andrei Shleifer & Lawrence Summers, The Noise Trader Approach to Finance, 4 J. Econ Persp. 19 (1990) ("Stock in the efficient markets hypothesis at least as it has traditionally been formulated crashed along with the rest of the market on October 19, 1987. Its recovery [as of the date of the article, which is 1990] has been less dramatic than that of the rest of the market."). Shleifer and others have advanced a theory called "noise trading," according to which irrational investors' mistakes may not be fully corrected by rational investors (arbitrageurs). Another theory, from behavioral finance, comes to the same conclusion. See infra notes 150-51. Criticisms of ECMH are sometimes recast as criticisms of the underlying asset pricing model, the Capital Asset Pricing Model (CAPM). ECMH tells us that prices incorporate certain sets of information; we can only test ECMH if we have an asset pricing model that tells us how the price should incorporate particular information. See Gilson & Black, supra note 6, at 139 ("[E]very test of market efficiency is also a test of the asset pricing model used to generate the prices against which market prices are compared. If observed prices differ from the prices predicted by the asset pricing model, that could mean that the market is inefficient, the asset pricing model is incorrect, or both."). For purposes of my argument, I assume that CAPM is correct; regardless of whether some seeming market inefficiencies actually reflect flaws in the asset pricing model, it seems hard to imagine that a slight market reward for beautified stocks would be one of them. 23 Arbitrageurs must be compensated for looking for mispricings; if there were no mispricings, the arbitrageurs would stop looking. Grossman and Stiglitz solve the problem by postulating an efficient level of inefficiency mispricings sufficient to compensate arbitrageurs. Grossman & Stiglitz, supra note 14, at 393-95. See also Gilson & Kraakman, supra note 22, at 622-26. But this view does not imply that the same mispricing such as a market reward for visible financial statement beautification should persist. Indeed, in the model I describe, arbitrageurs are leaving this mispricing undisturbed; they are seeking their compensation elsewhere. More generally, Grossman and Stiglitz seem to be describing a world where particular mispricings are fleeting, but the overall level of mispricings is not. Page 8 of 40 22 Del. J. Corp. L. 141, *151

ECMH has assigned them. 24

I consider two reasons for this failure. One involves information costs. I model an information cost structure in which substantial accuracy is relatively low-cost, but additional increments of accuracy are much costlier indeed, so costly as not to be worthwhile. The other involves expectations about investor behavior. Efficient markets theories postulate two types of investors: those who may make mistakes (ordinary investors), and those who correct them (arbitrageurs). 25 Arbitrageurs do not, on standard theories of efficient markets, refrain from correcting a mistake (mispricing) because they think ordinary investors will keep making it, nor do they otherwise take what they think ordinary investors will do in the future into account in selecting investments. 26 But some recent theories hypothesize just such a dynamic: that arbitrageurs rationally take expectations about future investor behavior into account. 27 In my model, investors generally use a valuation methodology that path-dependence has entrenched. This methodology rewards beautification, including visible beautification. Switching to another methodology would be quite costly, and the costs would likely exceed the benefits, at least for a considerable period of time. Thus, arbitrageurs might expect ordinary investors to continue making the "mistake" of rewarding (or at least, not punishing) beautification, and might choose to leave this "mistake" uncorrected. Rather, they might concentrate their efforts on arbitrage more closely resembling the paradigm case: where the market's journey to the correct price that is, the price reflecting fundamental value faces less obstruction.

This article proceeds as follows. Section II discusses generally accepted accounting principles (GAAP), financial statements, and

[*152] beautification generally. Section III discusses the results of empirical work studying various visible financial statement beautification techniques. Section IV sets forth my theory of how highly visible financial statement beautification techniques could persist; it also discusses how my theory fits into the ECMH. Section V offers concluding remarks.

II. Generally Accepted Accounting Principles (GAAP) and Beautification Generally

Financial statements are the principal means by which companies depict their financial condition. Verifying the accuracy of that depiction is not costless. Some of the costs are inherent in any process of depiction; all depictions necessarily distort. But other costs reflect practical and political forces shaping accounting standards and practices. I discuss these matters below.

24 In my experience, academics and non-academics do not disagree that investors could often make (positively correlated) valuation mistakes and thereby cause mispricings. The disagreement relates to the mistake-correction process. Broadly speaking, many academics (adherents to traditional ECMH) think the process works; non-academics think it does not, at least not very well. All the non-academics I have spoken to believe that some mistakes can persist, even for a long time. Certainly, all the popular press sources I quote in this article, and all the finance and investment professionals I have ever spoken to, think market mistakes can go uncorrected for a very long time. Indeed, most of the finance and investment professionals I have spoken with think the vast bulk of the investment community is taken in by overly optimistic "stories," obvious accounting tricks, trends, and all sorts of other noise; fundamental value, I am told, is far from the first consideration.

25 See Brudney & Bratton, supra note 6, at 124-26.

26 Rather, arbitrageurs, as fully rational investors, move prices towards fundamental value. Id. 27 See, e.g., the noise trader model developed in Shleifer & Summers, supra note 22. See also Andrei Shleifer & Robert Vishny, Equilibrium Short Horizons of Investors and Firms, 80 Am. Econ. Rev. 148 (1990). As I discuss in infra Section IV.A.3, in the noise trader model, some investors may trade on "noise" that is, information unrelated to fundamental values. And arbitrageurs may not fully quiet the noise; indeed, for riskier arbitrage opportunities, it may pay arbitrageurs to heed the noise, especially if it is heard by many investors. Thus, prices might sometimes sustain, for the short term and, perhaps even for the moderate term, levels not justified by fundamental values. More generally, as I discuss in infra Section IV.C, the concept of informational efficiency accommodates an efficient market in which stock prices reflect some nonfundamental information. Page 9 of 40 22 Del. J. Corp. L. 141, *152

A. Objectives of GAAP

1. Formal Objectives

There are many ways to depict 28 the financial condition of a company. The Financial Accounting Standards Board (FASB), the standard-setting body of the accounting profession, 29 has established

[*153] standards that try to fulfill the needs of financial statement users. FASB has established as criteria relevance, reliability, and comparability. 30 These criteria seem uncontroversial; however, satisfying all three is sometimes problematic. One example involves how companies value their . Accounting rules require companies to value many of their assets at "." "Historical cost" is the amount the company paid for an asset. It is reliable because it is easily verifiable. However, historical cost is scarcely informative in comparing one company with another. Two very similar companies might seem quite different if they bought the same assets at very different times. 31 And consider, too, matters requiring judgment. A company needs to estimate the likelihood of various contingencies to determine the appropriate level of reserves. It also needs to estimate the useful life of its assets to determine the appropriate schedule. Reasonable people can differ in their judgments. In this context, different judgments can yield vastly different financial statements. Thus, even perfectly intentioned adherence to accounting rules will not provide a perfectly informative picture.

Sometimes, adherence to accounting rules is less than perfectly-intentioned, yielding, predictably, a less informative picture. As to matters requiring judgment, who is to know whether the company's level of reserves reflects its best judgment as to the matter being reserved against, or has some other purpose, such as earnings management? And companies have many other ways to render their financial statements less informative. 32 I describe these at greater length in infra Section II.B. Finally, as I describe below, accounting rules themselves may reflect

28 Underlying appearance metaphors is a worldview that a pure "reality," independent of any "appearance" or depiction, exists. But realities or truths about anything, including companies, have to be depicted somehow: what would such a reality be? (How would it look?) And the depiction will necessarily differ from what is being depicted: for instance, a photo of a person depicts that person; however, the photo is two-dimensional and the person presumably is not. Indeed, there is no depiction of a person, including a life-size replica, which does not differ in very significant respects from the person. More generally, there are many possible depictions. Which is chosen as conventional will influence how we see what they are depicting. For instance, companies "have" assets and liabilities as those terms are defined under GAAP. Our view of these as "fundamental," almost organic, attributes of companies misses the role accountants play in designing modes of depiction and, thus, of how we see what is being depicted. The depiction could have been otherwise - by cash flow streams each asset of the firm had generated, or was expected to generate, for instance. The present modes of depiction are sufficiently conventional, however, that we translate implicitly - we think of companies as "having" the attributes their depictions include (and correct depictions as including those attributes). 29 FASB's authority derives from the Securities Exchange Commission's delegation of its power to prescribe accounting practices and standards for public companies. Notwithstanding this delegation, the SEC remains involved in the process. See Louis Lowenstein, Financial Transparency and Corporate Governance: You Manage What You Measure, 96 Colum. L. Rev. 1335, 1342 (1996).

30 Statement of Financial Accounting Concepts (SFAC) No. 2, Qualitative Characteristics of Accounting Information. See generally Donald E. Keiso & Jerry J. Weygandt, Intermediate Accounting (8th ed. 1995).

31 See Lawrence Revsine, The Selective Financial Misrepresentation Hypothesis, 5 Acct. Horizons 16, 17, 19 (1991); see also Keiso & Weygandt, supra note 30, at 43-44. 32 And indeed, some of these may also be well-intentioned. By requiring companies to record assets at historical cost, GAAP sometimes perhaps often requires companies to understate the (market) value of their assets. Some companies may feel that they present a truer picture of themselves by understating the amount of their debt that is, by using off-balance-sheet financing. See Keiso & Weygandt, supra note 30, at 695. But this explanation may not explain very much. First, there is no move by companies with overvalued assets to increase the amount of their debt. And second, and more significantly, companies often Page 10 of 40 22 Del. J. Corp. L. 141, *154

[*154] opportunism, or some complex of motives incompatible with producing informative financial statements.

2. Accountants' Objectives

Companies prepare their own financial statements; independent accountants the statements for compliance with GAAP. 33 It is presumably unnecessarily costly for independent accountants to prepare the financial statements themselves. The company already has accountants in its employ. The independent accountants' more important role is likely rental of their reputations for independence. 34

But independent accountants need to get, and keep, clients. To this end, accountants might want standards that permit them to compete for

[*155] business by touting their comparative laxity. Accountants reportedly fear that if they refuse a client's request for a particular accounting treatment, the client will find another willing to comply. Indeed, accountants are commonly viewed as favoring accounting standards that permit discretion. 35 They may lobby the FASB to adopt or retain standards promoting their interests in maximizing client harmony. 36 And the FASB itself may be somewhat of a captive of the accounting profession, advancing the profession's interests over the interests of the "public" it is intended to serve. The chairman of the Securities Exchange Commission, Arthur Levitt Jr., apparently holds this view. Levitt recently negotiated a change in the membership of FASB's governing body, the Financial like having lower asset values on their books (whatever the market values of their assets); such values raise their "return on assets," and lower their depreciation . See infra note 54 and text accompanying notes 84-85.

33 The review (audit) is required by SEC rules applicable to some companies. See, e.g., The Securities Act of 1933, Schedule A (25) - (27), 15 U.S.C. 77aa (filing of audited financial statement prior to registration of a new stock issue); The Exchange Act of 1934 12(b)(1)(J) - (L), 15 U.S.C. 781(b)(1)(J) - (L); 12(g)(1), 15 U.S.C. 781 (g)(1) (filing of audited financial statements prior to listing securities on an exchange); 13(a)(2), 13(b), 15 U.S.C. 78m(a)(2) (filing annual reports); 14, 15 U.S.C. 78n (filing of audited financial statements in connection with proxy and information statements); Regulation S-X, 17 C.F.R. 210 (1983) (prescribing qualifications of accountants and the contents of the accountants reports that must be submitted with corporate financial statements). Independent accountant also are required by most loan agreements. They also may be required or expected for other purposes. Indeed, few, if any, companies of appreciable size do not have financial statements prepared in accordance with GAAP and audited by an independent accounting firm. As part of their audit, the accounting firm provides a letter, which is appended to the financial statements. The letter describes what the accountants did in their audit, and contains the following language: We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of [name of company] as of [date of the statements] and the results of its operations and its cash flows for the year ended [date of the statements], in conformity with generally accepted accounting principles. The letter also may include explanations and qualifications if the accounting firm deems it necessary, and the company is unable to convince them otherwise.

34 See Ronald J. Gilson, Value Creation by Business Lawyers: Legal Skills and Asset Pricing, 94 Yale L. J. 239, 291 (Dec. 1984). [I]t is a common occurrence for companies about to make an initial public offering to switch to a Big Eight [now Six] auditor. Since the previous audit firm apparently satisfied management's need for information, the discovery of systematic switching when the company is, in effect, to be sold to the public, strongly suggests a reputational explanation. Id. Gilson is referring to the reputation of Big Six accounting firms versus that of "lesser" firms; however, his remarks are equally applicable to the reputation of an outside accounting firm versus the inside accounting department. 35 But the matter is more complex, as is discussed in Revsine, supra note 31, at 19. For example, Revsine notes that the desire for client harmony can sometimes impel auditors to want rigid standards, or standards that are flexible yet have "rigid computational metrics" (such as historical ). 36 Id. Page 11 of 40 22 Del. J. Corp. L. 141, *155

Accounting Foundation; the aim was to reduce the Foundation's ties to the accounting profession, and give a larger role to members representing the "public interest." 37

3. Company Managers' Objectives

There is some evidence that company managers, too, lobby FASB to obtain flexible accounting standards. Such standards may benefit company managers in several ways. First, if companies benefit from the beautification such standards assist, so should their managers. But the managers also may benefit at the expense of their companies. Compensation measures are often pegged to accounting results, and flexible accounting standards may facilitate achieving higher results. 38

[*156]

I argue in infra Section IV.B that opportunities for company managers to benefit at the expense of their companies should be limited where the beautification is visible. Increased compensation might be an impetus, however, for company managers to seek accounting standards that permit more visible beautification if the same standards also permit more invisible beautification.

B. Financial Statements and Beautification Generally

A company's financial appearance historically has been revealed by its financial statements 39 and, primarily, its and balance sheet. 40 The income statement reveals a company's "bottom-line income" or "earnings," while the balance sheet reveals a company's debt. Financial statements are prepared in accordance with GAAP. 41 GAAP allows companies and their accountants considerable latitude. Beautification involves using that latitude to produce the most flattering financial statements possible.

Attempts to beautify financial statements most often focus on earnings. Debt, too, is a common focus of beautification efforts. 42 Both earnings and debt are important numbers in themselves, and for the computation of financial ratios. Financial ratios are the chief tools used for financial analysis. They measure a company's liquidity

37 A race to laxity by accountants presents an analytic problem on lemons grounds. Reputational capital for nonlaxity would seem more likely. See Gilson, supra note 34. The "Big Six" accounting firms have most of the outside accounting business for larger companies. Expertise in accounting is not rare; yet, there is no move towards admitting additional firms to the Big league, even firms staffed with Big Six alumna. Big Six firms should thus have an interest in not being deemed captives. Id. But the views of SEC Commissioner Levitt and many others suggest this interest is at least sometimes overridden. See Steve Burkholder, SEC, FAF Agree on Changes to FAF Board, 28 Sec. Reg. & L. Rep. (BNA) 875 (1996); Jay Mathews, Levitt Wants Accounting Board to be Reorganized: SEC Chief Pushes for More Independent Panel, Wash. Post, June 1, 1996, at c1; Trustee Plan in Accounting is Approved, NY. Times, July 9, 1996, at D6; Former GAO Official Bowsher Invited to Join FASB's Parent Body, 28 Sec. Reg. & L. Rep. (BNA) 1268 (1996). See also Revsine, supra note 31. 38 In one case, company managers lobbied against a requirement that companies reduce their earnings by the costs of executive option grants. The managers apparently thought earnings reductions would chill option grants. A compromise was reached. No reduction of earnings was required in the financial statements so long as the reduction was disclosed in the footnotes. FASB 123.045. Can company managers think that the forces wanting to limit their compensation won't read footnotes? Are they right? Empirical work revealing the effect of disclosure practices on compensation might reveal the answer. See generally Lowenstein, supra note 29, at 1344. See also Revsine, supra note 31. 39 See generally Sannella, supra note 11 (GAAP requires companies to publish a balance sheet, an income statement, and a , as well as full disclosure of pertinent information in footnotes). 40 More recently the third major financial statement, the statement of cash flows, has taken on more importance. But as market players have touted cash flows as ways to see beyond manipulated earnings, some accounting firms reportedly are now developing, and marketing to companies, ways to manipulate reported cash flow numbers.

41 See James Cox, Financial Information, Accounting and the Law 6 (1980).

42 See supra note 6. Page 12 of 40 22 Del. J. Corp. L. 141, *156

(how quickly the company's assets can be made available to meet its liabilities) and activity (how much business the company is doing). Ratios also measure a company's leverage, profitability, and market value. 43 Among the most widely used ratios are the price/earnings ratio (a company's stock price

[*157] divided by its earnings) and the debt/equity 44 ratio (a company's debt divided by its equity). 45 Other important ratios are return on assets (earnings divided by assets) and earnings per share (earnings divided by the number of shares outstanding 46 ). As I discuss in infra Section IV.A.1, these ratios, particularly the price/earnings ratio and, to a lesser extent, the debt/equity ratio, are accorded an important role in markets' appraisal processes; they naturally become the focus of companies' beautification efforts. 47

Earnings beautification efforts often involve the computation of expenses. Expenses reduce earnings; all else equal, the lower the expenses, the higher the earnings. 48 The computation of expenses affords companies considerable discretion. 49 One important example involves diminutions in the value of a company's assets. Value diminution reflecting wear and tear is popularly known as "depreciation."

[*158]

Accounting rules, like tax rules, require companies to reduce their earnings by some amount for depreciation. However, tax rules mandate a particular depreciation schedule; accounting rules do not. 50 Accounting rules permit

43 Joel G. Siegel & Jae K. Shim, Dictionary of Accounting Terms 164, 334 (2d ed. 1995) [hereinafter Dictionary]. 44 A company's equity is computed by subtracting its debt from its total assets.

45 Dictionary, supra note 43, at 113. See also Benjamin Graham & David L. Dodd, Security Analysis 199 (1951) (discussing the price/earnings ratio); Gary J. Previts et al., A Content Analysis of Sell-Side Financial Analyst Company Reports, 8 Acct. Horizons 55 (1994) (noting frequent mentions of price/earnings ratios and other measures involving ratios in analyst reports). 46 One controversial, and short-lived, proposal by companies to improve their earnings per share was to reduce the number of shares outstanding for purposes of the earnings per share computation. Companies would issue "unbundled stock units" in exchange for some of their shares. The units would consist of a bond, a preferred share, and a warrant. The units were ostensibly created to exploit a clientele effect: they subdivided share ownership into its constituent parts, such as rights to income and rights to appreciation. However, unlike the shares for which they were being exchanged, the units would not be considered "outstanding" for purposes of the computation of number of shares outstanding; thus, earnings per share would increase because the denominator, the number of shares, had decreased. (Indeed, according to one published account, the principal inventor of the units "thought the accounting treatment was an important benefit for the companies.") The SEC's chief accountant refused to permit companies to compute outstanding shares without including the unbundled stock units; after, and purportedly because of, his refusal, the concept was quickly abandoned. See generally Floyd Norris, SEC Objection Dooms 'Unbundled Stock Units,' N.Y. Times, Mar. 29, 1989, at D6. The SEC's position was adopted as a result of a recommendation by a professor of finance, Chuck Trzcinka, who was then Senior Economist at the SEC. Professor Trzcinka's advice to the SEC's chief accountant was that the unbundled stock units "quacked like a duck, walked like a duck" and hence should be treated "like a duck" (that is, like outstanding stock for all purposes, including the computation of shares outstanding). Professor Trzcinka believes that there were actually very few buyers for unbundled stock units, and that the SEC position provided a face-saving pretext for abandoning them.

47 See, e.g., Keiso & Weygandt, supra note 30, at 694. 48 Earnings are computed by subtracting expenses from . Revenues are the amounts flowing into the company; expenses are the amounts the company had to spend to obtain those revenues.

49 Minter et al., supra note 11, at C2-30.

50 See Sannella, supra note 11, at 71. Indeed, the tax depreciation schedule tends to provide for far quicker depreciation than companies tend to select for accounting purposes. Id. at 33. Page 13 of 40 22 Del. J. Corp. L. 141, *158 a company to select a schedule in accordance with a company's reasonable estimate of the asset's useful life. 51 The longer the schedule selected, the longer the company can spread out the depreciation expenses on its financial statements.

Value diminution also can occur due to damage, destruction, or some other extraordinary event. In accounting terminology, such events are called "write-downs" or "write-offs." A company has considerable discretion in determining when such a diminution is reflected as an expense against its earnings. 52

Companies have another important tool available to control expenses reflecting diminutions of value of an asset. This tool also helps increase gain if the asset is sold. The amount at which any asset is recorded on a company's financial statements the "value" the company places on the asset for accounting purposes is called the asset's "basis" or "book value." When a company acquires an asset, it typically must record a basis equal to the acquisition price. However, in certain circumstances, including some mergers, asset bases are not adjusted, and remain at their previous (and likely, low) level. 53 All else equal, the lower an asset's basis, the lower its depreciation expenses will be, and the higher the company's earnings will be. Or, if the asset is sold, the higher the book gain will be. For example, an asset with a book value of 10, a fair market value of 15, and a useful life of 5 years will generate 2 of expenses every year to be deducted from earnings. If the asset is sold at its fair market value, 5 will be added to earnings. That same asset, with a book value of 5, will generate only 1 of expenses or, if sold at its fair market value, 10 of earnings. 54

[*159]

Another important example of discretion afforded by GAAP involves reserves. The most familiar of these is the "bad debt reserve;" another example is the reserve for future litigation. Companies can add to and release amounts from these reserves as they deem appropriate.Amounts added to reserves are subtracted from earnings; amounts released from reserves are added to earnings.

In some cases, use of these techniques can be quite visible. Visibility means that the beautification can be recognized as such, and translated, within some fairly narrow range, into unbeautified numbers. For instance, markets often have their own estimates of the rate at which companies' assets diminish in value, and will compare the companies' reports with those rates. 55 But some of these techniques may be less visible, or their effects harder to translate. Markets may have their own estimates of an appropriate level of reserves. However, much of the information needed for an adequately informed estimate may be private, making translation into unbeautified numbers difficult. 56

51 Id. at 33. 52 See supra note 10.

53 I am referring here to "pooling" accounting treatment for a business combination. Pooling is discussed at length in infra Section III.A.1.

54 Lower asset bases offer an additional benefit. "Return on assets" is a common measure of a company's profitability. All else equal, a company with fewer, or lower-valued, assets will have a higher return on assets. This is sometimes cited as an additional benefit of leasing; the asset is leased rather than owned, so the return on assets is higher, since the earnings (that is, the return) are not affected.

55 See Stephanie Strom, Double Trouble at Linda Wachner's Twin Companies: Warnaco's Chief is Under Fire for Her Merger Plan, N.Y. Times, Aug. 4, 1996, at 3-1 (Warnaco capitalized its store openings over a non-standard period of time. Analysts have re-examined Warnaco's reported earnings using a more standard depreciation schedule to obtain a more accurate earnings picture.). See also Jerry Knight, Called to Account, Wash. Post, Oct. 30, 1996, at C12 (discussing an accounting professor's criticism of America Online's "legal but financially aggressive" practices, including spreading out expenses over a long period of time, and taking a large charge against earnings "to get bad news out of the way in one big chunk").

56 In other words, a company with smooth accounting earnings might really have "smooth" earnings. However, the company might have timed a discretionary release from its reserves (an accounting entry with no effect on cash flows) in order to smooth Page 14 of 40 22 Del. J. Corp. L. 141, *159

Using these and other techniques, companies can manage their earnings. They can keep their earnings high by minimizing depreciation, amortization, and other expenses. They can smooth their earnings by adding to reserves in more prosperous times, and releasing amounts in less prosperous times. 57 They can concentrate all their bad results in a

[*160] quarter that's already bad (a "big bath"), setting the stage for a consistent upward trend later on. 58 Debt, too, can be "managed" using financial statement beautification techniques. The practice is known as "off-balance-sheet financing." The techniques involve changing "debt" obligations into obligations that need not be recorded on the balance sheet as debt. A company has a variety of methods available, including structuring payment obligations as "lease" payments rather than debt payments; depositing in a trust funds sufficient to repay the debt; or repurchasing the debt with newly-issued equity. 59 The latter two also serve as means of managing earnings. Indeed, the earnings management function may be as important, if not more important, than the debt-minimization function. All types of off-balance-sheet financing are quite visible. The obligation, however couched, appears on the financial statements or the appended notes, and is readily recognizable as a debt obligation. 60 No matter how visible, the effects of financial statement beautification techniques, whether relating to debt or earnings, are not costlessly translatable. Indeed, for some techniques, estimates may only be possible within a broad range. And no matter how good or effortless the translation, the transaction costs associated with the technique fees paid to professionals who structured the transaction, for instance will usually be invisible.

[*161] III. Beautification Techniques and Market Reaction

out its "real," "lumpy," earnings smoothing via accounting entries. Complicating matters, the company might have timed actual expenditures (such as research and development expenditures) to smooth its earnings smoothing via actual expenditures that are reflected in accounting entries. I do not dwell on these intricacies because they relate only to invisible beautification. 57 Accumulation and release of reserves as an income-smoothing technique has been considered in, e.g., Holthausen et al., supra note 6; Maureen McNichols & G. Peter Wilson, Evidence of Earnings Management from the Provision for Bad Debt, 26 J. Acct. Res. 1 (1988 Supp.) (firms use discretionary accruals to manage earnings); and Jennifer J. Garver et al., Additional Evidence on Bonus Plans and Income Manipulation, 19 J. Acct. & Econ. 1 (1995) (managers use discretionary accruals to effect a smooth income stream). See also Manipulating Profits, supra note 9 (referring to practice of "squirreling away" reserves, or keeping them in a "corporate sugar bowl"). Germany is famous for giving companies discretion to choose appropriate levels of reserves. See Jonathan P. Charkham, Keeping Good Company, 31-32 (1994) ("A book on accounting practice in Germany would need to be called Accounting for Survival and would show the various ways in which profits are concealed for a rainy day."). See also Lowenstein, supra note 29, at 1341 (discussing German corporations' use of "hidden reserves." "Daimler Benz reversed provisions and reserves totalling DM1.8 billion in the first half of 1993, creating a German-style 'profit' at a time when its operations experienced a reality-style loss.").

58 See Abelson, supra note 6. Abelson notes that companies use write-offs, which are supposed to reflect extraordinary events, in a strategic way to take a "big bath" that is, report all foreseeable negative information at once. This enhances the firm's subsequent ability to paint a favorable picture of its regular operations. See also Mahendra R. Gujarathi & Robert E. Hoskin, Evidence of Earnings Management by the Early Adopters of SFAS 96, 6 Acct. Horizons 18, 21 (1992).

59 A financing transaction structure that also achieves off-balance-sheet treatment is securitization. There is an enormous transaction volume, with billions of dollars' worth of new transactions done each year. There are anecdotal accounts that off-balance-sheet treatment may motivate some securitization transactions. However, because the accounting treatment requires no effort beyond what the transaction structure itself requires, the extent to which securitization is used to limit on-balance-sheet debt is hard to measure.

60 See, e.g., Sannella, supra note 11, at 140, 320. Page 15 of 40 22 Del. J. Corp. L. 141, *161

Market reaction to several visible beautification techniques 61 has been measured. The following describes these techniques, and the market reaction.

A. Earnings

1. Accounting for Business Combinations: "Pooling" Versus "Purchase"

One well-known technique to increase earnings involves accounting for business combinations (mergers). Two methods of accounting may be available: "pooling" or "purchase." If company A's financial state-ments are pooled with those of company B, both sets of assets are included on the "pooled" company's balance sheet at their then-book values. By contrast, if the transaction is accounted for as a purchase by company A of company B, company B's assets are adjusted (typically upwards) to their fair market value on company A's post-acquisition financial statements. Moreover, the difference between the fair market value of company B's assets, and the price paid by company A to acquire company B (likely a large, positive amount) is included on the new company's balance sheet as "goodwill." In a pooling, there is no goodwill, because both companies' items are simply combined; the fact that the purchase price for company B is higher than the fair market value of its assets is not reflected. 62

Purchase accounting reduces accounting earnings. "Goodwill" is "amortized" according to applicable accounting rules; the more goodwill, the greater the reduction. In the not-uncommon situation where the acquisition price far exceeds the fair market values of the assets, goodwill and the associated earnings- reduction effect caused by amortization can be a very large number. And the upward adjustment of the assets' bases yields higher bases and, thus, higher depreciation deductions and lower earnings. As discussed in supra Section II, the "expense" associated with owning an asset that will wear out in 5 years is greater if the asset is valued at 10 than if it is valued at 5. Finally, if the asset is sold, the gain is measured as the excess of the sales price over the

[*162] book value. In a transaction accounted for as a purchase, the asset's basis likely has been increased; the higher the basis, the lower the gain on sale. By contrast, in a pooling, the asset's basis has stayed the same, resulting in higher gain on sale. 63 All these effects are pure accounting effects, with no corresponding effects on underlying cash flows.

Pooling's potential to "inflate" earnings has long been notorious. 64 In 1970, the accounting profession responded to criticism that pooling was being used "abusively" by adopting Accounting Principles Bulletin (APB) 16. APB 16 made pooling treatment considerably more difficult to obtain. 65 A recent SEC rule has made obtaining pooling still more difficult. 66 There is some discussion about increasing that difficulty, or perhaps abolishing pooling altogether,

61 As discussed in supra note 9, I characterize as visible financial statement beautification techniques whose use to enhance appearance is known, and whose direct effect on cash flows can be estimated within a relatively narrow range.

62 Sannella, supra note 11, at 262. 63 Id. at 264. 64 See Davis, supra note 6.

65 See Sannella, supra note 11, at 264-65. 66 In poolings, the consideration paid in the merger must be shares of stock. Pooling rules have long restricted share repurchases following mergers accounted for as poolings. If a newly-merged entity can freely repurchase its stock, the difference between pooling and purchase all but evaporates. And, left to their own devices, companies would have ample incentive to make liberal repurchases. In the pooling, they issued new shares of stock: they can effectively reverse that issuance, amplifying pooling's earnings-increasing benefit, by repurchasing some number of shares. Thus, with a pooling and stock repurchase, a newly merged company could get the best of all worlds: earnings from the two companies, no reductions for goodwill, and a minimum number of shares among which to "divide" the earnings for purposes of the earnings per share Page 16 of 40 22 Del. J. Corp. L. 141, *162 as part of the increasing internationalization of financial markets. 67 Indeed, the prevailing view outside the U.S. is that pooling "inflates" earnings, and ought not to be permitted. 68

"Inflated" earnings do not, however, inflate stock prices: an empirical study found that mergers accounted for as poolings had slightly, but not significantly, abnormal negative returns. 69 Nevertheless,

[*163] transaction volume has stayed large. 70 The effort expended in this area is significant, 71 not only in structuring transactions to obtain pooling, 72 but also in shunning or abandoning transactions where pooling cannot be obtained. 73

2. Changes in Accounting Method: LIFO to FIFO

Another way for a company to manage its earnings is to change its accounting method. 74 The most common change involves . 75 Earnings are supposed to reflect a company's revenues less the expenses incurred in obtaining those revenues. The computation of expenses tries to match the costs associated with computation. Before the rule, companies had interpreted the prohibition against post-merger share repurchases quite liberally. In March of 1996, the SEC adopted a rule significantly restricting post-merger repurchases; too many repurchases will preclude pooling treatment. SEC Staff Accounting Bulletin No. 96. See generally Executive Update, supra note 7; Alert on Pooling, Mergers & Acquisitions 7 (May/June 1996).

67 Steve Burkholder, FASB Advisory Council Open to Writing New Rules for Business Combinations, 28 Sec. Reg. & L. Rep. (BNA) 901 (1996); see also FASB Considers Changing 'Pooling' Rule on Mergers, supra note 7 (FASB is considering changes that would restrict the use of pooling.). See also McGoldrick, supra note 7, ("At this point, most observers think that FASB will end up adopting the international standard of allowing poolings only in the case of a merger of equals.").

68 See Davis, supra note 6. 69 The leading study is Hong et al., supra note 8. See also Roberta Romano, A Guide to Takeovers: Theory, Evidence and Regulation, 9 Yale J. on Reg. 119, 127 (Winter 1992) ("Studies [citing Hong], however, show that the market sees through the accounting conventions to the firm's economic earnings."). But see also supra note 12 and accompanying text (discussing the amounts paid by AT&T to obtain pooling treatment in its merger with NCR, and the market's negative reaction to the merger). Another related question is whether acquirors have paid higher acquisition prices (that is, premiums) in pooling transactions than in purchase transactions. The results of these studies conflict. See Gilson & Black, supra note 6, at 569 (discussing a study which found no pooling premium); Davis, supra note 6 (discussing studies finding a pooling premium). Note, however, that Gilson & Black themselves acknowledge that the study they discuss "may be based on a false premise." There may, thus, be more support for the existence of a pooling premium. And see supra notes 7 and12, describing various examples of pooling premia. Note, too, that a pooling premium will affect the post-pooling return on the stock, so that the two phenomenon, and their measurement, overlap.

70 A search on LEXIS of various SEC and current news databases for the last several years revealed numerous mentions of pooling transactions being considered or consummated.

71 While accounting treatment itself does not affect cash flows, tax treatment, of course, does. The interplay between accounting and tax for business combinations is extremely complex. Some efforts involved in structuring a transaction to qualify for pooling may be necessary for the transaction to obtain the desired tax treatment. However, the incremental efforts to achieve the desired accounting treatment are sizeable.

72 See, e.g., Freund, supra note 6; McGoldrick, supra note 7. 73 See, e.g., supra notes 7-8.

74 Morton Pincus & Charles Wasley, The Incidence of Accounting Changes and Characteristics of Firms Making Accounting Changes, 8 Acct. Horizons 1, 2 (1994). Some accounting changes are voluntary. Other changes are mandatory, but a company has discretion as to when to effect the change. The authors note that companies seem to have used the discretion to change methods, and the discretion to select when they would adopt a mandatory change, to manage their earnings. 75 Id. Page 17 of 40 22 Del. J. Corp. L. 141, *163 particular transactions. presents an obvious conceptual problem. When a company has 100 widgets and sells 10, which 10 did it sell? The first ten it made ("first-in-first-out," or "FIFO"), when labor and other costs were (typically) lower, or the last ten ("last-in-first-out," or "LIFO"), when such costs were (typically) higher? If the widgets "cost" the company less, their sale

[*164] generates more gain, and higher earnings. If the widgets "cost" the company more, their sale generates less gain, and lower earnings.

A company's choice of inventory accounting method will affect its accounting earnings. Often, FIFO yields higher earnings. But if FIFO yields higher earnings, it also yields lower cash flows: Tax rules require that companies use the same inventory valuation method for tax as they use for accounting. By contrast, most accounting choices, including those involved in other beautification techniques, do not constrain tax choices: a company typically can select the most advantageous accounting choice without adverse tax consequences. 76

There are likely reasons other than earnings management why a company might choose FIFO in the first instance. 77 However, a switch to FIFO is likely an earnings management technique: an increase in reported earnings is its most notable effect. Such switches are rare and not surprisingly, since companies must pay for the higher earnings with higher taxes. Companies may recognize the imprudence of increasing reported earnings at the expense of cash flows. Empirical evidence shows that markets react negatively to switches to FIFO. 78

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B. Debt

1. Leasing Instead of Borrowing

Leasing is probably the most common type of off-balance-sheet financing. 79 A company incurs an obligation to pay lease payments rather than debt (re)payments. This ability to recast a loan as a lease is well-known.

76 See Lowenstein, supra note 29. See also Sannella, supra note 11, at 77. Indeed, before the Tax Reform Act of 1986, accounting and tax choices were even less linked than they are now. One of the few efficiency accounts of earnings management, Chancey & Lewis, supra note 3, argue that cosmetically smoothed earnings are a good signal of "real" earnings; one crucial assumption for their argument is that higher accounting earnings are closely linked to higher tax earnings, and hence higher tax payments. This assumption is true in the context of inventory accounting methods; in many, perhaps most, other contexts, it is not.

77 However, one puzzle is why more companies do not use LIFO. Many companies which could use LIFO instead use FIFO even when it raises their tax bills. There have been various attempts to solve this puzzle, none fully satisfactory. See Patricia J. Hughes & Eduardo S. Schwartz, The LIFO/FIFO Choice: An Information Asymmetric Approach, 26 J. Acct. Res. 41 (1988 Supp.); John Fellingham, Discussion of the LIFO/FIFO Choice: An Asymmetric Information Approach, 26 J. Acct. Res 59 (1988 Supp.). Hughes & Schwartz identify three "conundrums" where market reaction to choice of inventory method, or switches in method, may not accord with expectations: "that a large number of firms continue to use FIFO, foregoing billions of dollars in tax savings; second, that firms which switch to LIFO appear to do so slowly; and a third, that LIFO adoptions may be accompanied by either a positive or a negative stock price change." Hughes & Schwartz, supra, at 41. While LIFO switches may not be as frequent or quick as they perhaps "should" be, they are nevertheless among the most common discretionary accounting method changes. LIFO switches are most common in periods of high inflation, when the tax benefit is largest. However, concern for earnings appearances may play a role even in switches to LIFO. A study found that companies switching to LIFO tended to have higher-than-average accounting earnings before the switch. In other words, companies taking this accounting earnings "hit" were sufficiently above-average in beauty that the switch would not render them ugly ducklings. See Pincus & Wasley, supra note 74, at 20.

78 See Copeland & Weston, supra note 6, at 365. 79 For example, many airlines, including ones that declared bankruptcy, have, at certain times, had significant percentages of their fleets financed in leveraged leases or another similar type of transaction, sale-leasebacks. As to the frequency of Page 18 of 40 22 Del. J. Corp. L. 141, *165

Accordingly, accounting rules specify when a company will be treated as a lessee under a lease, or a borrower under a loan. However, the accounting rules simply draw the line between leases that can be treated as leases (called "operating leases") and those that must be treated as loans (called "capital" or "finance" leases). 80 Leases often are drafted to fall, just barely, on the "operating lease" side of the line. Many practitioners and commentators consider such leases as capital in "spirit," albeit not in fact. 81 Before 1976, virtually all transactions nominally structured as leases could be treated for balance sheet purposes as leases and not as debt. The rules adopted in 1976, FASB 13, were intended to make off-balance-sheet treatment harder to achieve. However, in large measure, they simply provided the impetus, and a roadmap, for restructuring many leases into "operating" leases. 82 (I will call leases that

[*166] are technically operating leases, but capital in spirit, "operating" leases.)

The technical requirements for a finance lease are: (i) that it transfers ownership of the asset to the lessee at the end of the lease term, for no or nominal consideration, (ii) that the lease term is at least 75% of the useful life of the property, or (iii) that the present value of minimum lease payments is at least 90% of the of the property. If any of these requirements is met, the lessee must reflect on its balance sheet a liability (and an asset the asset being leased) equal to the present value of future lease payments. The transaction is treated as though the "lessee" had borrowed money and purchased the asset; the "lease payments" are the repayments on the borrowing. 83

Operating leases are treated differently. One year's worth of lease payments are reflected on the balance sheet as a current liability, and the aggregate remaining amounts of payments are disclosed only in a note to the financial statements. 84 These leases can have very long terms (74.9% of the asset's useful life), during which cancellation generally is not permitted: The lessee is required to lease the asset for the entire term, with certain very limited exceptions. Thus, the payments owed under the lease, but omitted from the balance sheet, may be quite large.

All else equal, a lessee under an operating lease has less debt on its balance sheet than a lessee under a finance lease. But the operating lessee also has fewer assets. At first blush, it might seem that off- balance-sheet financing has beautified one part of the balance sheet the liability side, but only at the expense of the other side the asset side. However, because of the relationships the standard ratios measure, a company is much better off with no asset and no liability than an offsetting asset and liability. Some ratios include only liabilities and not assets; also, leasing in the airline industry, see Richard D. Gritta et al., Lease Capitalization and the Effect on the Debt Ratios of the Major U.S. Airlines, 22 Transp. L.J. 1 (1994). Both leveraged leasing and sale-leasebacks involve an asset being "financed." In leveraged leasing transactions, the asset being financed is acquired from a party who then leases it to the lessee; in sale-leaseback transactions, the asset is acquired from a party who then becomes the lessee (that is, who then "leases back" the asset). 80 Statement of Financial Accounting Standards No. 13 (Fin. Accounting Standards Bd. 1980) [hereinafter SFAS No. 13].

81 See Sannella, supra note 11, at 330; Gritta et al., supra note 79; Eugene A. Imhoff, Jr. et al., Operating Leases: Impact of Constructive Capitalization, 5 Acct. Horizons 51, 51-52 (Mar. 1991). 82 See supra note 11 and accompanying text. See also Imhoff et al., supra note 81, at 51. The popularity of leasing is due . . . to management's ability to keep the leased asset and its associated financial obligation off the balance sheet. Evidence from around the time of the adoption of SFAS 13 [the statement of financial accounting standards governing accounting for leases] suggests that the terms of most capital leases were restructured to avoid the new capitalization requirements. Id. But changes recently have been proposed which would eliminate the operating lease/capital lease distinction, and capitalize that is, include on the balance sheet all long-term leases. Steve Burkholder, Capitalization Approach is Focus of Rulemaker's Lease Accounting Report, 28 Sec. Reg. & L. Rep. (BNA) 959 (1996).

83 SFAS No. 13.

84 Id. Page 19 of 40 22 Del. J. Corp. L. 141, *166 all else equal, "return on assets" is larger, and hence more desirable, for a company which leases, rather than owns, its assets. And ownership of the asset would have negative effects on the income statement as well: an operating lessee would not need to reduce its earnings to reflect depreciation of the asset, whereas a finance lessee would.

The major impetus behind these types of transactions is often tax: the tax benefits of ownership are sold to a higher-valuing user. 85 Tax and

[*167] accounting standards are similar. However, there is a sizeable increment of effort involved in meeting both sets of standards, and meeting the parties' commercial aims as well. 86 Thus, while there is a cash flow benefit to these transactions, that benefit is achievable at lower cost if off-balance-sheet treatment is not also sought. The empirical evidence is consistent with market neutrality to leasing: markets seem to "capitalize" (that is, treat as debt) both capital leases and "operating" leases. 87

C. Earnings and Debt

1. Dedicating a Repayment Source: In-Substance Defeasance

Companies can reduce their balance sheet debt and, often, increase earnings using a transaction called "in-substance defeasance." The company dedicates funds to the debt's repayment. Properly structured, the transaction can permit the company to take the liability entry reflecting the debt off its balance sheet. There should be an earnings management effect as well: when interest rates are rising, the securities needed to defease the debt will be available at prices lower than the debt's book value. The difference is an accounting "gain" that increases earnings; however, there is no immediate cash flow effect. 88 (Companies initially attempted to reflect the book gain as part of their "operating" income; the FASB rejected this characterization, and insisted that the gain be reflected as "extraordinary" income. 89 For this reason, in-substance defeasance is somewhat less useful for managing earnings. It can increase present earnings, but not expectations about future earnings.)

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85 The lessee often cannot fully use the tax benefits of owning the property. (For instance, airlines frequently are lessees in leveraged lease transactions. The assets they use in their business - aircraft - generate sizeable depreciation deductions; various constraints, including the size of their respective incomes, prevent them from using all of those deductions.) Thus, the transaction is structured so that someone who can use the benefits becomes the owner for tax purposes. If the lease were treated as a finance lease for tax purposes, the lessee would be treated as the tax owner of the property, and thus entitled to the tax benefits of ownership. The lessor would be treated as a lender. If the lease is an operating lease for tax purposes, the lessee is, for tax purposes, just a lessee, and the lessor is the owner. See generally Michael D. Rice, Asset Financing 493-511 (1989). In sale-leaseback transactions, the impetus often also includes a realization, for accounting (and economic) purposes, of the asset's appreciation. See Tony Kontzer, More and More Users Leasing, Not Buying, Computer Equipment, Bus. J., June 20, 1994, at 7.

86 My experience in doing these types of transactions, as well as my conversations with many professionals in the field, supports this statement. 87 See, e.g. Alexander J. Sannella, The Capitalization of Operating Leases: The Discounted Cash Flow Effect, 72 J. Comm. Bank Lending 49 (1989). But there are several methods for valuing (capitalizing) long-term operating leases; the methods should produce similar, but not identical, results. Id. See also Gritta et al., supra note 79.

88 Sannella, supra note 11, at 138-39.

89 Keiso & Weygandt, supra note 30, at 685. Page 20 of 40 22 Del. J. Corp. L. 141, *168

The company must purchase government securities sufficient to repay the debt, and deposit the securities and the debt being defeased into an irrevocable trust; the trust repays the debt as it comes due. 90 Balance sheet beautification is likely a sufficient motivation for many of these transactions. 91 Indeed, I have heard of finance courses that describe the transaction as "a means to manipulate ratios."

There were a spate of in-substance defeasance transactions when the interest rate climate was favorable (that is, when interest rates were decreasing), but negative publicity followed. The interest rate climate became less favorable, and the transaction volume plummeted.An empirical study conducted after the first spate of transactions found significant negative stock market reaction. 92 A contemporaneous unpublished study found market neutrality. 93 More recently, in another favorable interest rate climate, there has been another spate of transactions. 94

2. Debt/Equity Swaps

Another way for companies to move debt off their balance sheets and perhaps increase their earnings is to turn some of their existing debt into equity. In a debt/equity swap, as the name implies, the company swaps some of its outstanding debt for equity. The liability representing

[*169] the debt is removed from the balance sheet, and an amount equal to its book value is added to the stockholders' equity amount. Before the Deficit Reduction Act of 1984, the transactions enabled companies to record an accounting gain 95 without a commensurate tax gain. 96 Indeed, the technique was sometimes touted as a way to remove debt from a company's balance sheet, 97 or increase or smooth earnings. 98 The Deficit Reduction Act made any gain on these transactions taxable; anecdotal evidence suggests that the transactions are now used for

90 Statement of Financial Accounting Standards No. 76 (Fin. Accounting Standards Bd. 1983).

91 Relief from onerous covenants in the agreement governing the defeased debt cannot be a motivation. Because the debt is not actually repaid, the covenants remain in place. Another possibility is that the trust serves to bond the managers to repay the debt. But managers whose bonding is most valued would presumably be ones whose companies were most precarious. More precarious companies are more likely to become bankrupt and in that event, there is no assurance that the trust would not be available to the company's creditors. For a discussion of when trusts a company creates or holds become part of its bankruptcy estate see generally Collier Bankruptcy Manual 541.06 (3d ed. 1995). See also Sannella, supra note 11, at 138 ("[I]t is . . . not certain if the trust [created in an in-substance defeasance transaction] would survive intact in the event of bankruptcy of the corporation.").

92 Hand et al., supra note 6.

93 P.F. Roden & I. Karafiath, In-substance Defeasance and Shareholders' Wealth (1986) (unpublished manuscript, North Texas University). Hand criticizes these results because the authors measured stock price reactions on the date of defeasance, not the date the defeasance was announced. 94 Hand, supra note 6, never attempted to explain how these transactions could persist probably because he thought they would not. On my account, too, the transactions should not persist. How, then to explain the recent spate of transactions? Perhaps the market or company and money managers has forgotten what it had previously learned, but will remember once its memory is jogged by a sufficient transaction volume?

95 See Marilyn Much, Passing Fancy; Companies Find Way to Boost Balance Sheet, Ind. Wk., July 26, 1982, at 78 (describing how debt/equity swaps can produce a "book" gain when the debt for which the equity is being swapped has a market value lower than its book value). 96 Hand, supra note 3, at 588-89.

97 See Much, supra note 95 (Among the purposes of debt/equity swaps are: elimination of debt from the balance sheet and improvement of a firm's interest coverage ratio (a leverage ratio, measuring its ability to meet its debt obligations).).

98 Hand, supra note 3. Page 21 of 40 22 Del. J. Corp. L. 141, *169 noncosmetic reasons, principally restructurings of troubled companies. 99 Not surprisingly, empirical studies have found negative market reactions to these transactions. 100 For healthy companies, foregoing the "tax shield" the debt offers should reduce cash flows. For troubled companies, the tax shield may be worth less. However, the transaction may signal bad news about the company. Debtholders generally know more about the company than do the stockholders. If they and the company are both willing to engage in the debt/equity swap, it seems likely that the debt has declined in value that the debtholders doubt the company's ability

[*170] to pay. 101 Because I am trying to explain financial statement beautification, my analysis considers only debt-equity swaps done for cosmetic reasons.

D. An Explanation for the Empirical Results

Empirical investigation of market reaction to beautification has been difficult, whether the beautification is invisible or visible. With invisible beautification, the existence of the beautification must be inferred. And market reaction may only be measurable against a rough estimate of the true, unbeautified, numbers.

Market reaction to visible beautification should be easier to measure. But even there, the difficulties are substantial. For instance, the most persistent types of beautification, pooling and leasing, have effects lasting many years. Indeed, some analysts think markets see through pooling initially, but soon forget. If this is true, market reactions to pooling would need to be measured over a long period and the longer the period, the more

99 Id. Hand said that debt equity swaps virtually disappeared after 1984. However, his article was published in 1989 and, in any event, dealt only with public transactions. My conversations with practitioners, and searches of various business databases on LEXIS/NEXIS such as NEWS/ASAPII, reveal numerous references to debt/equity swaps after 1984; these transactions typically involved restructurings for troubled companies. See, e.g., Kara Glover, Wherehouse to Seek Debt-Equity Swap, 17 L.A. Bus. J., No. 24, June 12, 1995, at 1. Other troubled companies engaging in debt/equity swaps have included TWA (mid-1995) and Greyhound (late 1994). Anne B. Fisher, TWA Channels: The Spirit of St. Louis, Fortune, Mar. 18, 1996, at 19 (TWA); Casinos, Mergers, Workouts Rule Year End Junk Action, 5 High Yield Report 1 (Jan. 9, 1995) (Greyhound). Indeed, judging again from anecdotal evidence, it appears that debt-equity swaps were always used by troubled companies, and for noncosmetic purposes. However, for a period ending when gain on such transactions became taxable, cosmetic uses also were frequent. The cosmetic uses were often the brainchildren of investment bankers, who would buy a company's debt from third parties, and swap it with the company for equity, earning fee income for their trouble. Soon thereafter, the investment bankers would sell their stock on the open market. Hand, supra note 3, at 589. 100 Hand, supra note 3. See generally Copeland & Weston, supra note 6, at 519-23. See also Robert M. Hull & Richard Moellenberndt, Bank Debt Reduction Amounts and Negative Signalling, 23 Fin. Mgmt. 21 (June 22, 1994). 101 Hull and Moellenberndt, supra note 100, speak generally about debt reduction. They contrast reduction of bank loans with reduction of nonbank loans: the negative signal seems stronger when bank loans are reduced since banks are more likely to have inside information. (I would note additionally that bank loan reductions seem likelier than nonbank loan reductions to have been at the behest of the lender.) In the case of debt/equity swaps, however, the debtholders are the ones obtaining the equity, and the transaction will almost certainly require their consent; thus, in their access to information, they will more closely resemble banks than nonbanks. (It might seem, too, that reduction of bank debt should signal a worse company than a debt/equity swap. After all, the bank is walking away from the company altogether. But presumably, it is not walking away empty-handed: the debt, or at least some portion of it, must have been paid off. By contrast, where a lender, bank or not, takes equity in exchange for its debt, the signal may be that the alternative was to walk away empty-handed.) By contrast, the (pre-1984) transactions described by Hand, supra note 3, were often arranged by investment bankers accumulating the company's debt on the open market to obtain fee income; the negative signal seems more muted (and perhaps nonexistent) in these cases, since the parties engaging in the swap, and especially the investment bank-debtholders, have motives other than avoiding losses on the debt. See also Copeland & Weston, supra note 6, at 519-23 (negative market reaction to leverage-decreasing transactions). Page 22 of 40 22 Del. J. Corp. L. 141, *170 other events would need to be filtered out. 102 And leasing, too, presents similar difficulties. Finally, a more general caveat applies for both visible and invisible beautification: if beautification is pervasive, the effect of particular beautification techniques may be difficult to discern. In this regard, in 1990, Professors

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Bruns and Merchant concluded that short-term earnings were being managed in many, if not most, companies. 103

But, as discussed above, some empirical work has been done. 104 Studies have found market neutrality for pooling and leasing, and market punishment for debt-equity swaps. A study of the switch from LIFO to FIFO found market punishment. One study of in-substance defeasance found market punishment; another (unpublished) study found market neutrality. 105

One explanation, consistent with market neutrality for pooling and leasing, and market punishment for debt-equity swaps, FIFO switches, and in-substance defeasance, is that negative, and easily quantifiable, expected cash flow effects elicit negative market reaction. 106 Effects that are harder to quantify may not, especially if they are either small or particularly hard to quantify. The change to FIFO improved accounting earnings at the expense of a higher tax bill. In-substance defeasance required the company to buy a low-yielding investment to repay debt: a wealth transfer to bondholders, whose debt had been made less risky. And expectations about future cash flows may very well have decreased, with the company's willingness to make such a low-yielding investment signalling that its other investment opportunities were poor. 107 Debt-equity

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102 For instance, the leading study on pooling did not measure market effect beyond the first annual earnings announcement after the merger. See Hong et al., supra note 8.

103 William J. Bruns & Kenneth A. Merchant, The Dangerous Morality of Managing Earnings, Mgmt. Acct. 22 (1990) ("In practice, it appears that a large majority of managers use at least some methods to manage short-term earnings.").

104 Much of the work has studied invisible types of beautification. See, e.g., Holthausen et al., supra note 6; Trueman & Tittman, supra note 6. Inferring that beautification has occurred is one important aim of this work. Such work helps show how pervasive beautification is, but is otherwise of limited use in studying visible beautification. A world where company managers think detection and quantification of their beautification efforts is costly and difficult is very different from one where detection is sure and quantification within some fairly narrow range is feasible at reasonable cost. 105 See supra notes 92-93. 106 As I discuss in supra note 12, it seems plausible that pooling with large negative, and sufficiently quantifiable, cash flow effects might also elicit negative market reaction, although such a reaction has not been confirmed empirically.

107 See Hand, supra note 3. Hand considers, too, whether a (seemingly healthy) company engaging in a debt/equity swap might be signalling that it is reaching its covenant limits under its loan agreements, and is therefore in bad financial health. The force of such a signal would seem weak. First, as I discuss in infra note 165 and accompanying text, many loan agreement covenants in fact do cover off-balance-sheet financing of various types. Second, if the agreement covenants do not cover off-balance-sheet financing, a company preserving its flexibility by favoring such financing might be seen as savvy and aggressive rather than approaching dire financial straits. But, of course, for troubled companies, debt-equity swaps are a signal of deteriorating financial health. As I discuss in supra notes 99-101 and accompanying text, these swaps are not being used for beautification. Indeed, quite the contrary: these swaps are tantamount to an announcement that the company is uglier than it may appear. An admittedly anomalous feature of my account is that I am ascribing different reasons why the same transaction might have had the same effect for different companies: In all cases, the market didn't like debt-equity swaps. Why shouldn't the swaps always signal bad news? My response is as follows. We know that the swaps work differently in the two cases. First, the healthy companies benefit more from the tax shield (benefit), and suffer more from the tax gain (burden) than do the troubled companies. Second, that the troubled companies are signalling bad news is obvious; the construction of a bad signal by the seemingly healthy companies is more obscure, and the tax effect seems sufficient to explain the negative market reaction without resort to the signalling explanation. Page 23 of 40 22 Del. J. Corp. L. 141, *172 swaps, too, may have raised the company's tax bill by lowering the tax shield offered by the deductibility of interest payments, especially if the company substituted (non-deductible) dividend payments. Where the tax- increasing effects were smaller, the negative market effects might reflect a negative signal: well-informed debtholders were preferring equity, suggesting that debt repayments might not be forthcoming. 108

By contrast, the choice of accounting method for a merger does not affect expected cash flows in a large and readily quantifiable way. Transaction costs are small, and difficult to quantify. And the costs of foregone mergers, while perhaps not small, should be particularly difficult to quantify. 109 For leasing, the cost involved is the increment over the structuring costs for the non-accounting aspects of the transaction; this is likely not large, and also not readily quantifiable. In both cases, market neutrality reflects that the market has quantified what it readily can. In the case of pooling, it has reversed the cosmetic enhancements, so as to treat purchase and pooling equally. 110 In the case of leasing, it has treated the lease payments as debt. The beautification itself is not being punished, nor is it being greatly rewarded. The only reward may be catching the market's eye, thereby earning a second look.

There have been various studies of invisible earnings management techniques and practices, though few measuring market reactions. One intriguing exception is a study by Bitner et al. This study found that

[*173] markets favored smoother earnings, even when they likely knew the effect had been achieved cosmetically. The same study found, too, that markets preferred naturally smooth earnings to cosmetically smoothed earnings. 111 Indeed, some, and perhaps many, market players view all smooth earnings with suspicion. One money manager, in praising the accounting "aggressiveness" of Mattel, noted: "Mattel's earnings have risen for seven consecutive years, a feat that could not have been achieved without mirrors." 112

In sum, the empirical evidence seems generally consistent with market neutrality for visible beautification with no large or readily quantifiable negative effects on expected cash flows, and market punishment for visible beautification with such negative effects. In other words, at best, the act of beautification elicited market neutrality. So why do companies bother beautifying? They bother because they fear market punishment if they do not beautify. I explore how this fear could be rational in the next Section.

IV. How Highly Visible Financial Statement Beautification Might Persist

A. The Model

I model a game with three players: money managers, arbitrageurs, and companies. Money managers have the largest role. Money managers invest a large proportion of the country's investible dollars. With so many dollars to

108 See supra note 101.

109 See also Gilson & Black, supra note 6, at 570 (discussing the "real costs" of earnings-maximizing accounting choices). See also Robert W. Holthausen & Richard Leftwich, The Economic Consequences of Accounting Choice: Implications of Costly Contracting and Monitoring, 5 J. of Acct. & Econ. 77 (1983) (discussing the difficulties of measuring the effects of accounting choice, and expressing skepticism that (then-current) techniques could detect economic consequences of choices with small wealth effects). But see supra note 12, discussing a case where transaction costs to obtain pooling were quite large.

110 Stern Stewart [a corporate finance advisory firm] goes so far as to undo any goodwill amortization resulting from a purchase merger. . . . Conversely, when analyzing a pooling, the firm determines the deal's purchase price 'based on the value of the buyer's stock.' Purchase and pooling deals can then be compared on an 'apples-to-apples' basis." Executive Update, supra note 7.

111 Larry N. Bitner & Robert C. Dolan, Assessing the Relationship Between Income Smoothing and the Value of the Firm, 35 Q. J. Bus & Econ. 16 (1996). The authors used as indicators of market knowledge changes in accounting choices, and research and development expenses.

112 Abelson, supra note 6. Page 24 of 40 22 Del. J. Corp. L. 141, *173 invest, they need many investment opportunities. They thus specialize in bulk appraisal. For their investment strategies, substantial accuracy suffices. And substantial accuracy permits of beautification, so long as it is not excessive. 113

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Arbitrageurs specialize in exploiting mispricings, including those the money managers' investment strategies create or allow to persist. However, arbitrageurs don't arbitrage away mispricings attributable to visible and persistent beautification. There are two possibilities. One possibility is that doing so is not worthwhile, even for them. This particular mispricing is smaller than the information expenditures necessary to exploit it. The other possibility is that arbitrageurs expect the information cost structure facing the money managers, and the money managers' investment and appraisal strategies, to persist; the arbitrageurs' payoff for a bet to the contrary would thus be uncertain, and distant.

Unlike many accounts of beautification, my account does not give company managers an independent role. Most other accounts address invisible beautification: their universe is one in which company managers might hope to fool the company's stockholders, and markets generally, and thereby benefit at stockholders' expense. The more visible the beautification, the less plausible is an account that depends on fooling. My account has no one fooled. Rather, company managers do as their principals, the companies, would have them do: they beautify, because money managers may reward beautification, and, perhaps more importantly, may punish its absence a prisoner's dilemma. 114

1. Role of Money Managers and Companies

I first model money managers' investment strategies to show how and why substantially accurate financial statements could suffice. I then explain how the strategies assure no less, but also no more, than substantial accuracy. Finally, I explain how such strategies could be optimal.

Money managers manage many of this country's investible dollars. They pool individual investors' money. They promise diversification and economies of scale (and perhaps scope) in research and transaction costs well beyond what the investors otherwise can achieve; they often offer substantial liquidity as well, permitting redemptions on short notice. The investors (customers) want low expenses; the money managers want high compensation. The way to achieve both is a large fund, 115 such that

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113 To simplify the analysis, I lump together beautification that is quantitatively excessive with beautification whose excessiveness is more qualitative. An example of the former is a company's beautification of its earnings to turn huge losses into gains; an example of the latter is beautification using questionable interpretations of accounting rules. The analysis works a bit more cleanly for the former set of cases: aggregating visible and invisible beautification makes sense if the aim is to detect "too much" beautification. But detecting "the wrong kind" also can be assisted by aggregation; the more familiar the beautification techniques are, whether the particular uses are visible or invisible, the easier the detection of unfamiliar and perhaps fraudulent techniques becomes.

114 I am not the first to model beautification as a prisoner's dilemma. See Jeremy C. Stein, Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior, 104 Q. J. Econ. 655 (1989). Stein's account focuses mostly on invisible beautification. But he also notes that relaxing the assumption of fully rational traders makes beautification stable even with perfect information. Id. at 668. 115 I use the term "fund" generically to include mutual funds, pension funds, and other managed pools of funds. Page 25 of 40 22 Del. J. Corp. L. 141, *175 expenses can be spread among more investors. Money managers like larger funds for other reasons as well. Money manager compensation is often computed as a percentage of a fund's assets. 116 And a money manager's importance is in part determined by the size of the fund she manages. 117

The more assets a fund has, the more investments it likely needs. Excessive exposure to any one company would increase the fund's riskiness and decrease its liquidity. One approach is to appraise a great many investments using an abbreviated (bulk) appraisal process. Such an approach might do an adequate job appraising many investments fairly cheaply; it might not, however, do a flawless job ferreting out the intricacies of each investment. Flawless jobs might be better done by someone else. Consider clothing: there are many clothing designers producing perfectly adequate clothing using mass-production techniques. There are only a few haute couture designers, producing many fewer clothes by hand. The two specialties are different. One involves making an adequate product; the other involves making a flawless product. Even corporate law has comparable specialists: the simple transaction specialist and the complex transaction specialist. The simple-transaction specialist provides adequate services for many; the complex-transaction specialist provides flawless (?) services for a few.

On this view, money managers are specialized in providing an adequate mass-production service. 118 The service is stock selection. The first step is a simple screening test, using price/earnings ratios and other

[*176] common financial ratios, to winnow down investment possibilities. 119 In the second step, the final selections are made using more rigorous and tailored, but still somewhat mechanical, tests.

For each money manager, adopting such a process makes sense. The process uses readily available raw materials and technology: in this case, financial ratios and financial analysis. Indeed, information needed to make appraisals using such a process is readily, and inexpensively, available. For instance, companies' financial ratios are easy to obtain from many popular databases. And the more the financial community uses ratios (and financial statement numbers generally), the better they get at using them: at understanding what the ratios and numbers actually measure (and predict?). 120 Each money manager will develop his own methodology, if only to tell

116 2 Tamar Frankel, The Regulation of Money Managers 255 (1978). According to Frankel, this compensation structure is favored under the applicable regulatory regime. Such a structure, it is thought, gives money managers more appropriate incentives. 117 I am, of course, not suggesting that there is no limit to the size fund a money manager prefers. Indeed, when funds become very popular, they are sometimes closed to new investors; beyond a certain point, size becomes a disadvantage. And I am also not suggesting that all money managers prefer larger funds. 118 Michael Lewis, the author of Liar's Poker (a popular book about bond salesmen on Wall Street), recently wrote that the activity of making money from money "belongs forever to the socially undifferentiated mass of services provided by people not bright enough to be movie stars. To see why, all you have to do is open the C section of The Wall Street Journal. Along with stock prices, futures prices and the like, there are now three pages or so of highly detailed mutual-fund listings. The number of fund managers has skyrocketed; the skill has become ordinary." Michael Lewis, The Death of Sherman McCoy, N.Y. Times Sun. Magazine, Aug. 18, 1996, at 18, 20. Although the words apply expressly to the activity of making money from money, it seems more aptly directed at the not-so-smart money, such as the money managers with whom this article is concerned. I do not think, for instance, that would be considered either to be providing a socially undifferentiated service, or to not be bright enough to be a movie star.

119 A money manager might, for instance, only consider that is, screen for companies with a price/earnings ratio below x, and a return on assets above y. Companies passing the screening test would be winnowed down further using a more tailored analysis.

120 See, e.g., Edward I. Altman, Corporate Financial Distress and Bankruptcy: A Complete Guide to Predicting and Avoiding Distress and Profit from Bankruptcy (2d ed. 1993); see also Virginia M. Kahn, Tweedy Browne Avoids the Hot Spots and Hunts for Value, N.Y. Times, Aug. 4, 1996, at 6, sec. 3 (quoting William Browne, a principal at the Tweedy Browne Company, an investment adviser: "The stocks the firm likes also often have low debt-to-equity ratios and have gone through significant price Page 26 of 40 22 Del. J. Corp. L. 141, *176 investors why to invest with him rather than someone else. But the overall design is common to the community, and establishes an industry standard. Of course, not everyone follows even the industry standard; however, enough money managers do that it retains its mantle.

Money managers benefit in various ways from an industry standard. Money managers are commonly ranked by their performance relative to other money managers. Falling significantly behind other money managers, even briefly, can be perilous: witness the ranking information almost inevitably given in advertisements for mutual funds. Money managers need a way to stay within the pack; 121 this task is made much easier if there is an industry standard to follow. (Of course, each money manager would prefer to beat the other money managers. Such

[*177] a result is, however, impossible to assure. Staying within the pack is, by contrast, much easier.) Moreover, each individual money manager might rationally reason that if other money managers are following the industry standard and will continue to do so, she should as well, or at least not shun the standard. In the aggregate, common use of the industry standard should exert considerable price pressure towards the standard-favored investments. 122 And a money manager might find it easier to justify bad results to labor markets, customers, and courts and regulatory agencies if she followed such a standard. 123 Indeed, the common ratios, and particularly, the price/earnings ratio, are frequently touted as reliable and conservative indicia of company value. For example, a declines. 'These characteristics are all associated with above-average rates of return.'"); see also Keiso & Weygandt, supra note 30, at 1318 ("Some limited evidence on credit granting activities by bank loan officers suggests that reasonable predictions of business failure can be made using only certain key ratios.").

121 Of course, money manager behavior is far more complex than my stylized description captures. Money manager behavior has been extensively studied in the literature. See, e.g., Keith C. Brown et al., Of Tournaments and Temptations: An Analysis of Managerial Incentives in the Mutual Fund Industry, 51 J. Fin. 85 (Mar. 1996) (finding that lower ranked money managers are more likely to alter their fundamental investment strategies than higher ranked money managers). However, these complexities do not affect my analysis.

122 Anecdotal evidence (as well as strong intuition) supports the view that money managers generally heed what other money managers are doing. One anecdote, about "technical analysis," is discussed in Marcia Stigler, The Money Market 462 (3d ed. 1990). The book's subject is the money market, not the stock market; nevertheless, the anecdote is apt, since technical analysis is used by traders in the stock market as well. Technical analysis holds, in direct contradiction to even the weak form of the efficient capital markets hypothesis, that future price movements can be predicted in part by past price movements. Stigler quotes a trader on Wall Street as saying: "Whether you assume that technical analysis, in and of itself, has any merit is irrelevant. It is followed by so many traders that, whether you believe the message you get from a chart or not, enough people do so that charts have an effect. There is no fundamental reason for charts to be correct. Still, I could not imagine doing business without the technical analysis our firm has." See also Graham & Dodd, supra note 45, at 637. An early, and notorious, pronouncement as to money managers' views that doing their jobs meant anticipating each other is Keynes' famous beauty contest model: "Professional investment may be likened to those newspaper competitions in which the competitors have to pick the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view." John M. Keynes, The General Theory of Employment, Interest and Money 154-56 (1936). In Keynes's model, these "professional investors" actually set prices. By contrast, later theorists often separate investors into two types; one type may make mistakes, such as looking to what other investors are doing, and the other type corrects mistakes, and sets prices. Like such theorists, I hypothesize the same two types of investors. I liken Keynes's "professional investors" to the money managers in my model, who can make mistakes; I use his description to show one way such mistakes could be compounded. I discuss in infra Section IV.A.3 what would happen if the mistake-correctors started acting more like the mistake-makers.

123 See, e.g., Department of Labor, Pension and Welfare Benefits Advisor, Notice of Proposed Exemption, 60 Fed. Reg. 58,651 (Nov. 28, 1995); and, more generally, Employee Retirement Income Security Act of 1974, as amended, 29 U.S.C. 1001(b), 1004 (1990) (requiring pension fund trustees to act reasonably and prudently in managing their funds). Page 27 of 40 22 Del. J. Corp. L. 141, *177 recent article in the Washington Post was entitled: "For safety, try low p/e stocks" [that is, stocks with a low price/earnings ratio]. 124 More technical accounts

[*178] expressly acknowledge financial ratios' limitations, but also acknowledge that ratio analysis is a logical, and perhaps necessary, starting point for financial analysis. 125

This industry-standard appraisal process can, and likely often does, achieve substantial accuracy.After companies pass the screening test, there are more rigorous and tailored tests. The tests likely reverse many of the effects of visible beautification. This should account for market neutrality as between pooling and purchase accounting, and as between leasing and debt. This also should account for market punishment for in-substance defeasance, debt/equity swaps, and switches to FIFO. The second-stage tests are perfectly capable of computing cash flows; except for transaction costs, there should be no difference between those in a pooling or a purchase, or in a lease or a loan. And there should be no negative cash flow effect. 126 But there are negative cash flow effects for the other three transactions effects which the second stage tests detect, and which markets, appropriately, punish.

But the process likely does not achieve complete accuracy. Even the most visible beautification is not transparent. And there are transaction costs, and in the case of pooling, there are also the costs of foregone mergers. These costs are not necessarily inconsistent with market neutrality; they may be too small or difficult for markets to profitably measure. 127 Most importantly, one effect of beautification cannot be reversed: the effect of passing the screening test. A company which passed the screening test by beautifying is differently (that is,

[*179] better) situated than an otherwise identical non-beautified company that did not.

Substantial accuracy, thus, permits of some beautification; indeed, it sometimes offers beautifying companies the reward of a second, closer look. But, as evidenced by the market reaction to in-substance defeasance, debt/equity swaps, and LIFO/FIFO, it does not permit of beautification with clear, negative effects on cash flows. In these cases, companies are (or were) incurring higher expenses, such as higher taxes, or making a low-yielding investment (signalling, too, the lack of good investment opportunities) in the cause of beautification. 128 Markets punished accordingly.

124 James K. Glassman, For Safety, Try Stocks that pass a P/E Test, Wash. Post, June 23, 1996, at Hl. 125 See, e.g., Keiso & Weygandt, supra note 30, at 1301-21 ("As analytical tools, ratios are attractive because they are simple and convenient. But too frequently, decisions are based on only these simple computations. The ratios are only as good as the data upon which they are based and the information with which they are compared."). Id. at 1316; Dictionary, supra note 43, at 165-66; see also Graham & Dodd, supra note 45, at 199, one of the seminal texts in its field. Graham & Dodd counsel that an analyst's first step should be to determine the company's true operating earnings. But they note that price-earnings ratios, per-share data, and a few other measures enjoy widespread use. 126 But see supra note 12, discussing a pooling with large transaction costs. 127 The techniques' effects can be estimated with some, but not complete, accuracy. For instance, money managers may know that a company has long-term operating leases that resemble debt; their estimate of the debt-equivalent may be close, but it likely will not be perfect. See supra note 87. Similarly, money managers may know that a company has merged with another in a transaction accounted for as a pooling, but they lack sufficient information to compute the pooling's full effect. Indeed, the publisher of Analyst's Accounting Observer was quoted in the Wall Street Journal as saying: "With a pooling, you don't know what the acquiror paid for the other company." See also Lowenstein, supra note 1. See generally Gilson & Black, supra note 6, at 509-16. But errors in estimating a technique's effects could be in either direction. 128 I distinguished earlier between debt-equity swaps done for cosmetic reasons and those done for noncosmetic reasons. See supra note 99 and accompanying text. Page 28 of 40 22 Del. J. Corp. L. 141, *179

And punishment may go beyond negative market reaction. Companies caught beautifying excessively for example, turning huge losses into huge earnings or obscuring huge liabilities, or treading into the province of fraud 129 may pay a reputational price, and suffer more rigorous scrutiny as well. 130 A recent account of one company's fall from Wall Street favor noted that analysts had become "less eager to give [CEO Linda Wachner] a break, and [were] re-examining the quality of Warnaco's [the company's] earnings." 131 This may apply with more force to invisible beautification; however, analysts may also be "less willing to give a break" to companies using techniques that openly and quantifiably reduce cash flows to no good economic end.

Companies may have another reason to shun excessive beautification. If many companies engage in such beautification, a radical revision of the accounting and reporting system might result. Companies would have to expend significant resources to learn the new system, including its beautification techniques, yet gain nothing for their trouble. 132

[*180]

Companies' fears about the consequences of excessive beautification may constrain their beautification activities, and thereby establish a ceiling. But, I am arguing, companies' fears about the consequences of too little beautification should establish a floor. Companies not beautifying believe they will be punished by a too-low ranking relative to their beautified competitors. A too-low ranking might deny them that all- important second look. Indeed, widely used databases of financial information and ratios such as Dun & Bradstreet, Value Line and Compact Disclosure do not routinely adjust for the effects of at least one type of financial statement beautification, off-balance sheet financing using "operating" leases. 133

An appraisal process, thus, may most cheaply achieve substantial accuracy by factoring in both a floor, and a ceiling, for beautification. Indeed, doing so accords with rational presumptions about what companies are doing. 134 The ratio screens effectively establish a floor, by not specifically adjusting for beautification's effects. The spectre of detection the various market punishments establish the ceiling.

129 See generally Abelson, supra note 6.

130 See Strom, supra note 55. But see Abelson, supra note 6, discussed in supra note 12. 131 See Strom, supra note 55. 132 In other words, in a world with positive information costs, companies benefit from a moderate-term equilibrium of upper and lower bounds of beautification efforts. Consider the alternative. If enough companies were exceeding the upper bounds, the payoff to rocket scientists' efforts to detect and undo particular beautification schemes would increase. Markets would invest in more precise detection. Developers of beautification techniques might see an increased demand for their services, as the only upper bound became staying one step ahead of the market's detection techniques. Such a world would presumably be worse for both companies and markets. Each would be expending considerable resources, but mostly to defeat the others' efforts. See Revsine, supra note 31 ("Some reasonably close correspondence between economic events and accounting messages must predominate in order to instill confidence in affected parties."). 133 To quote: "Although the concern over off-balance sheet financing via operating leases has long been recognized by financial analysts . . . widely utilized databases of financial information and ratios such as Dun & Bradstreet, Value Line and Compact Disclosure do not routinely adjust for its effects." The authors also note that "[b]y avoiding capitalization of their leases, [company] managers improve their firm's reported performance and leverage ratios." Imhoff et al., supra note 81 at 51-52. My discussions with several investment professionals confirm that databases and analyst screens still do not "routinely adjust" for beautification's more visible effects; indeed, such adjustments are the rare exception. 134 In this regard, studies have found that company managers within a particular industry all seemed to have the same target debt/equity ratio. Furthermore, there was negative market reaction to capital structure changes away from the target, and positive market reaction to changes towards the target, suggesting that departures from the target were viewed as negative signals. See Randall S. Billingsley et al., Simultaneous Debt and Equity Issues and Capital Structure Targets, 17 J. Fin. Res. 495 (Dec. 1994). More generally, it seems likely that market presumptions (and company practices) are somewhat industry-specific. After all, many opportunities for beautification are industry specific: users of heavy equipment may, for Page 29 of 40 22 Del. J. Corp. L. 141, *180

The foregoing describes appraisal processes money managers might use. It further describes how, in a world with positive information costs, these processes might permit, and entrench, a dynamic of beautification. But surely, whatever may be the case about invisible beautification, money managers can do better at correcting for the effects of visible

[*181] beautification for instance, by adjusting their ratio screens to treat "operating" leases as debt, and ignore goodwill generated in mergers accounted for as purchases. Why don't they?

My answer is as follows. While money managers can do better in correcting for the effects of visible beautification, it may not make sense for them to do so. First, perhaps distinguishing between excessive and nonexcessive beautification, as the appraisal processes do, conflicts with distinguishing between invisible and visible beautification. Whether a company's use of financial cosmetics warrants heightened scrutiny would seem to turn more on the size of the cash flow effects than whether it is visible or invisible. If markets have to choose and, I am arguing, it is plausible that they do they are better off concentrating their resources on detecting aggregate levels of beautification than they are discouraging visible beautification. Indeed, if markets were to begin punishing visible beautification, beautification efforts might shift more towards invisible efforts. Those being punished might end up being the money managers, as their costs to verify substantial accuracy of a company's financial statements increased.

How do companies behave in such a world? Companies choose the optimal mix of visible and invisible beautification techniques which show them to best advantage. Both types of techniques have their costs and benefits. Companies will take many factors into account. Some factors will favor more invisible techniques; other factors will favor more visible techniques. Among these factors are the compatibility of certain types of makeup with a company's business. For instance, companies which use more capital equipment should find "operating" leasing easier than those which use less. Only companies involved in acquisitions and mergers can consider pooling. A company with shaky debtors or frequently-threatened lawsuits may find manipulation of reserves easier than another company with more established debtors and few lawsuits. One important factor will favor more visible techniques: companies applying their financial cosmetics in public can signal more accurately their true, unbeautified financial appearance.

Market expectations for particular companies will reflect these factors; companies, in turn, will assess market expectations in determining which financial cosmetics to apply.And indeed, companies' makeup kits apparently do include cosmetics for visible, and invisible beautification techniques. In my account, both types of techniques have a continuing role.

[*182]

A world with beautification may offer money managers benefits unavailable in a non-beautifying world. 135 Money managers want to look as though they can predict the future; in a world with beautification, a company manager is freer to depict his company's financial appearance to conform to the money manager's and the company manager's "prediction." 136 Companies willing to beautify are signalling that they have a stake in looking good, and instance, find it easier to enter into "operating" leases that are functionally equivalent to debt. Money managers often use ratio screens to select the top performers within a particular industry; the accuracy of the rankings yielded may be substantial indeed.

135 See Previts et al., supra note 45, at 61. Previts notes that some analysts characterize companies with "conservative" reserves as having higher quality earnings. The intimation is presumably that these companies can release reserves to smooth fluctuations.

136 Indeed, analysts considering covering a company sometimes ask the company to provide projections; when the projections are later "confirmed," they reward the company with favorable coverage. One plausible interpretation is that by asking the company for projections, the analysts are inviting the company to signal its willingness to beautify if necessary; by meeting the projections, the company is accepting the invitation. Page 30 of 40 22 Del. J. Corp. L. 141, *182 making money managers who predicted good results for the company look good as well. Highly visible beautification may be a particularly good signal of this, as may a pattern of "smooth" earnings. 137 Smooth earnings are earnings which change (generally, increase) at a constant rate over time. For every period in which the pattern continues, the pressure increases for the next period's earnings to continue the trend. Which CEO would want to preside over a company during its first "down" quarter in recent memory? And markets might presume that a company unable to continue the pattern must be signalling really bad news: the company presumably would have managed to continue the pattern if at all possible. 138 Indeed, one money manager's use of a one-quarter decline in reported earnings as a "sell" trigger 139 can be seen in this light as more sensible than hasty. But such a trigger, especially reported publicly, can scarcely help but perpetuate beautification. The conventional wisdom is that markets prefer smooth earnings, 140 but also that markets believe smooth earnings are often due in some measure to beautification. 141 This perspective that smoothing signals companies' ability and willingness to help money managers look good may help reconcile these two apparently conflicting beliefs.

In sum, money managers may, for some purposes, take companies at face value. They do so as part of an industry-standard bulk-appraisal process that helps them appraise many investments at low cost.

[*183]

Companies respond by putting their best faces forward. A dynamic of beautification is created, and persists.

In my model, the market reaction to visible persistent beautification 142 is neutral. Neutrality has a certain intuitive appeal, if only on account of beautification's persistence, and the almost-universally expressed sentiments of companies, and many, if not most, market players that markets would punish companies whose financial appearances lacked sufficient luster. 143 The empirical work (scant as it is) helps bolster the case.

But in my model, lack of market punishment reflects a mispricing relative to fundamental values. 144 How could visibly beautified stocks be persistently mispriced? My argument suggests that money managers might exert upward price pressure on all beautified stocks, up to the point of market neutrality (that is, enough to compensate for transaction costs and, perhaps, the negative signal of vain companies 145 ). But the existence of even a large

137 Of course, smooth earnings are obtainable through both visible and invisible means of beautification (and indeed, without the use of beautification at all).

138 Note, though, that this assumes that companies feel constrained not to excessively beautify. 139 See Kahn, supra note 120. 140 See supra note 3. 141 See Abelson, supra note 6; supra text accompanying note 112; Hand, supra note 3.

142 I have generally characterized pooling as being among the "persistent" beautification techniques. However, I have also suggested that the market might have reacted negatively to AT&T's use of pooling in its merger with NCR. As I discussed in supra note 12, AT&T's use of pooling in this case cost so much, and was known to cost so much, as to be qualitatively different from most other poolings.

143 My model argues for, but basically assumes, market neutrality. As I discuss in supra Section III.D, there is empirical evidence to support this view, but not a great deal of it. My main evidence for neutrality is the practices' persistence in the face of visibility, coupled with lack of strong evidence inconsistent with neutrality. 144 As I argued in supra note 16 and infra note 160 and accompanying text, accounts of beautification as a positive signal seem implausible even for invisible beautification; such accounts seem even less plausible for visible beautification. Another theory under which there is no mispricing is that certain types of beautification signal market savvy; in supra note 16, I reject this theory as circular.

145 Unless we have some account of why markets would like beautification, the default view is presumably that companies who engage in such a fruitless quest are "vain," and that vanity in this context is undesirable. And indeed, it might seem that the correct price for beautified stocks, particularly those reflecting "poolings," should in some cases reflect a large penalty for the Page 31 of 40 22 Del. J. Corp. L. 141, *183 number of investors who trade on the basis of information not relevant to a stock's fundamental value ("noise") 146 should not keep prices away from fundamental values for very long. Indeed, a small number of arbitrageurs should be sufficient to return prices to

[*184] fundamental values. That's what arbitrageurs do: they make their money by ferreting out and correcting mispricings. As a result, visibly beautified companies' stock prices should be lower, and clearly so, and money managers who favor beautification, and companies that practice it, should lose ground to beautification-avoiding purists. But visible beautification persists. Why?

2. Role of Arbitrageurs

One possibility is that even for arbitrageurs, the (information) costs exceed the benefits. The mispricing is not large. Money managers have computed everything easy and cheap to compute. What's left to compute is transaction costs, and, in the case of pooling, the costs of foregone mergers these are either small, hard to compute, or both. Arbitrageurs have more profitable opportunities elsewhere.

Another possibility is that there is an arbitrage opportunity, and the arbitrageurs simply aren't taking it. Why not?

An answer is suggested in recent work on the ECMH. ECMH posits a world in which some investors may make mistakes, but mistake-correctors arbitrageurs correct them. 147 Recent work has suggested that sometimes, arbitrageurs may play a different role: they refrain from correcting mistakes, and may even reinforce them. 148 One article discusses arbitrage involving assets that may take a long time to return to fundamental values ("long-term assets"). Such assets may be more mispriced in equilibrium than short-term assets: each arbitrageur prefers strategies that pay off more quickly, because his financing sources will provide cheaper funding once he can demonstrate his ability. Thus he shuns arbitrage opportunities in long-term assets unless the mispricing is sufficiently large. 149 Furthermore, some theories have suggested that

[*185] squandered resources involved in seeking pooling treatment and shunning mergers where such treatment wasn't available. The appropriate-sized penalty would be very difficult to compute; however, no one even seems to try. But see supra note 142. My account can explain the small mispricing of not taking transaction costs into account; it has more difficulty with these larger costs. Perhaps these larger costs are incorporated into a general discount applied by markets to reflect the expected general level of beautification. See Bruns & Merchant, supra note 103, and accompanying text.

146 See Shleifer & Summers, supra note 22, at 22. 147 As discussed in supra note 23, mistakes are not completely corrected, to preserve a return to the activity of arbitrage. Still, even in a world with an "efficient level of inefficiency," the persistence of particular mispricings needs explanation.

148 See, e.g., Shleifer & Summers, supra note 22. See also infra notes 151, 153 and accompanying text. 149 Shleifer & Vishny, supra note 27. In this article, Shleifer and Vishny distinguish between "long-term" and "short-term" assets. "Short-term" assets are those which cannot be mispriced for long: fundamental uncertainties will be quickly resolved, investor misperceptions will be quickly corrected, and arbitrage will rapidly drive the price to fundamental value. Long-term assets, by contrast, can be mispriced for a long time; the journey to fundamental value is slower, and probably less direct. Stocks are typically long-term assets. Sometimes, however, they may be short-term assets. One example is the stock of a company involved in a takeover battle; in a finite, and short, period of time, uncertainties associated with the battle, and its effect on the stock price, should be resolved. Shleifer and Vishny argue that long-term assets are more mispriced in equilibrium. Long-term arbitrage is riskier than short term arbitrage; thus, an arbitrageur's financiers will care greatly about an arbitrageur's ability, and will limit financing except to arbitrageurs able to demonstrate their superior ability. The arbitrageur wants to make such a demonstration as soon as possible; thus, she will favor opportunities involving short-term assets. And the preference is self-fulfilling, as the increased arbitrage activity in short-term assets shortens even further the return to fundamental value. Page 32 of 40 22 Del. J. Corp. L. 141, *185 arbitrageurs may sometimes rationally spend time predicting, and even emulating, the trading activities of less rational investors 150 ("noise traders"). Indeed, an important risk of arbitrage, particularly arbitrage involving long-term assets, is that investor mistakes causing a particular mispricing will persist, and even proliferate, thereby delaying the return to fundamental values. 151 Thus, intuition suggests that appraisal of an

[*186] arbitrage opportunity might sensibly incorporate expectations about future investor mistakes. 152 In this regard, Shleifer and Summers, in a leading article on noise trading, 153 one of the most important of these theories, say,

150 Shleifer and his co-authors do not consider extensively why investors might make mistakes. Shleifer & Summers, supra note 22; Shleifer & Vishny, supra note 27. Some recent work in behavioral finance looks to cognitive psychology to explain investor mistakes. My account looks instead to a cost structure that reflects positive information costs. But my story still works even if some sort of cognitive bias or other psychological (irrational) force, such as those postulated in behavioral theories, explains beautified financial statements' allure: There are positively correlated investor mistakes, and arbitrageurs do not correct them. In noise and behavioral theories, as well as my story, arbitrageurs may be outnumbered (really, out-traded) by irrational investors, and decide to refrain from trading. And behavioral theories sometimes contemplate a more radical possibility: arbitrageurs rational investors may be making "irrational" mistakes as well. DeBondt and Thaler look in vain for rational investors in what they consider likely places. They study security analysts and economists, and conclude that both display the same sorts of (irrational) biases found in "naive undergraduates." DeBondt & Thaler, supra note 19, at 308; DeBondt, supra note 19, at 84. DeBondt and Thaler imply that if it's that difficult to find rational investors, the role of rational investors in setting prices, and indeed, such investors' very existence in the real world outside of financial theory, might be open to question.

151 See Shleifer & Vishny, supra note 27, characterizing this risk as "noise trader risk." Noise trading theories assume that persistent investor mistakes can prevent some prices from returning to fundamental values, perhaps for the moderate-to-long term. See also Frederic Palomino, Noise Trading in Small Markets, 51 J. Fin. 1537 (1996) (Noise traders' misperceptions cannot be forecasted by arbitrageurs and may persist over the long term, denying arbitrageurs any profit opportunity.). Noise trading models are not alone in hypothesizing that noise traders can affect prices. In behavioral finance models, too, "irrational" investors (DeBondt and Thaler call them quasi-rational investors), making positively correlated mistakes reflecting cognitive biases and other psychological forces, can sometimes affect prices; the presence of rational investors is not sufficient to make a market efficient. See Thomas Russell & Richard H. Thaler, The Relevance of Quasi Rationality in Competitive Markets, in Richard H. Thaler, Quasi Rational Economics 239-57 (1991). See also DeBondt, supra note 19; DeBondt & Thaler, supra note 19. In these articles, DeBondt and Thaler account for various market "anomalies" that is, effects ECMH cannot readily accommodate using behavioral models. See DeBondt, supra note 19; DeBondt & Thaler, supra note 19. See also Copeland and Weston, supra note 6, which discusses the "rational expectations hypothesis," in which prices are formed on the basis of expected future payout of the assets, including their resale value to third parties. They recount an experiment (with a small group of individuals making simulated trades) whose results were more consistent with that hypothesis than with various competing hypotheses, including the "intrinsic value hypothesis" and the "speculative equilibrium hypothesis." The former ties stock prices purely to their "intrinsic" (that is, fundamental) value; the latter seems to tie stock prices purely to their resale value to third parties. Id. at 339-43.

152 An interesting article arguing that arbitrageurs may refrain from arbitrage if they cannot depend either on other arbitrageurs or on (predictable or likely?) market forces to complete the correction is James Dow & Gordon Gary, Arbitrage Chains, 49 J. Fin. 819 (1994) ("An informed trader with a limited [time] horizon will not trade on his information if he believes that tomorrow's price, when he must sell the stock, will not reflect the information."). The authors argue that rational traders may sometimes not engage in arbitrage because irrational traders may drive prices even further from fundamental values within the rational traders' time horizon. Arbitrage can only exist if there is a "chain of arbitrageurs" who essentially carry the rational position forward through individual horizons.

153 Shleifer and Summers describe their noise trader theory as an alternative to efficient markets. Shleifer & Summers, supra note 22, at 19. Certainly, if "noise trader moves" can generate many profitable investment strategies, the challenge to ECMH is direct. However, a more modest claim, that a noise trader model best explains anomalies that the pure form of ECMH is hard pressed to explain, but that the model's explanatory powers far exceed its ability to generate profitable trading strategies, leaves ECMH largely intact. Much the same can be said of behavioral finance theories: the challenge to the theory of ECMH is likely far greater than the challenge to its usefulness as a default model, and point of departure. See DeBondt, supra note 19; Page 33 of 40 22 Del. J. Corp. L. 141, *186

"[n]ot only do arbitrageurs spend time and money to predict noise trader moves, they also make active attempts to take advantage of these moves. . . . When they bet against noise traders, arbitrageurs begin to look like noise traders themselves." 154

Whether arbitrageurs incorporate expectations about future investor mistakes in selecting arbitrage opportunities has been extensively debated in the literature. 155 But surely, the strongest case when such behavior would be rational is a small, but persistent, mistake. 156 Persistent visible

[*187] financial statement beautification, as I have described it, is such a case. The cause of the mispricing the appraisal methodology which slightly favors beautified stocks is entrenched: money managers will likely continue to use screens that take beautified (and unbeautified) companies at face value; their appraisal processes will go much beyond appearances, but traces of the cosmetics will remain. Thus, the price pressure away from fundamentals should be enduring; an investment exploiting the difference between the prices of beautified company stocks and such stocks' fundamental values might not pay off for a long time. Indeed, there would be no natural triggering event to correct the mispricing. Companies can continue beautifying their financial statements for a very long time, perhaps forever. And during this time, the upward price pressure away from fundamental values would likely continue. Arbitrageurs might prefer to concentrate their resources elsewhere. 157

DeBondt & Thaler, supra note 19; Russell & Thaler, supra note 151. Further consideration of this point is beyond the scope of this article. 154 Shleifer & Summers, supra note 22, at 19. 155 See sources cited supra note 150. See also Brudney & Bratton, supra note 6, at 17-19 (Supp. 1996) (discussing the debate between noise traders and advocates of traditional ECMH).

156 Ordinary language definitions of arbitrage do not need to take investor misperceptions into account separately because there is no reason to suppose such misperceptions will persist; indeed, there is every reason to suppose they will not. Consider the familiar example of a stock overpriced relative to the equivalent option package. The arbitrage (mistake correction) is riskless the equivalent of a $ 20 bill on the floor. The first person who saw the $ 20 presumably would pick it up. (An aside: according to a famous, but perhaps apocryphal, story, a University of Chicago economist and a student were walking together. The student saw $ 20 on the floor, and pointed it out to the economist, remarking "Look! There's $ 20 on the floor. Aren't you going to pick it up?" The economist's response, purportedly, was to say "Naah; there can't be a $ 20 bill on the floor. Somebody would have picked it up," and continue walking, without even glancing down. (The story does not discuss whether or not the student picked up the $ 20.)) Similarly, the first person computing the disparity between a stock and an equivalent option package presumably would sell the overpriced stock short and buy the equivalent option package. Unless the world changes drastically people stop honoring their contracts, or a $ 20 bill is no longer valid currency the arbitrageur makes money correcting the mistakes. In other examples, especially those involving "long-term assets," the intuition that investor misperceptions are important seems rather stronger. After all, an arbitrageur's return often comes from anticipating an investor consensus (at fundamental value) that corrects the prior misperception; thus, the arbitrageur has some interest in when (and indeed, whether) those misperceptions are corrected. 157 Arbitrageurs' returns to correcting mispricings often come when the market price reaches the "correct" price the price reflecting fundamental value. Of course, in most cases, the market price should reach fundamental value. Fundamental value is anyone's best guess; but what if there were cases where a better guess was possible? There might, for instance, be some long-lasting investor sentiment adversely affecting the demand for particular types of stocks. In such cases, why would arbitrageurs want to bet on a move towards fundamental values? After all, investor consensus would likely not converge at fundamental value any time soon. See Dow & Gary, supra note 152. Indeed, such a convergence might never occur. There are probably very few of such cases. After all, it is not just in the sale of a stock that an investor can realize her return; for instance, a reliable dividend stream is a fine substitute. But the possibility exists. And, I am suggesting, persistent visible financial statement beautification may be such a case. Page 34 of 40 22 Del. J. Corp. L. 141, *187

In any event, the mispricing arbitrageurs are shunning reflects only small transaction costs and hard- to-quantify costs of misallocations of time and effort. 158 Relative to its size, the mispricing is expensive to quantify. The dynamic is quite different for beautification which openly and quantifiably reduces cash flows, to no good economic end.

[*188]

Arbitrageurs should find unmasking such beautification worthwhile. But there may not be much to unmask: as discussed above, money managers have likely gotten there first.

3. Role of Others

Some market players likely gain from the beautification industry. Financial professionals, such as analysts, accountants, and investment bankers, all gain from touting their skills as beautification-kit- creation and detection experts. They compete in part through their financial savvy and creativity, which beautification techniques give them an opportunity to display and profit from. Wherever appearance counts, there's a market for makeup artists. Indeed, accountants sometimes promote themselves to companies as understanding how Wall Street really values companies, and how they can help the companies achieve higher values. Analysts are giving more emphasis to cash flows? All the better: the accounting firm will tell the company how to beautify its cash flow numbers. And just in time: the accounting firm has already told the company's competitors how to beautify their cash flow numbers.

B. Other Explanations?

The dynamic I describe need not be the exclusive explanation of visible beautification. Opportunism that someone is fooled or outmaneuvered is the most common explanation for financial statement beautification. 159 But this explanation is generally given for invisible beautification. 160 For visible beautification, it seems far less

[*189]

158 Cf. supra note 145.

159 See Robert W. Holthausen, Accounting Method Choice: Opportunistic Behavior, Efficient Contracting, and Information Perspectives, 12 J. Acct. & Econ. 208, 217 (1990). Holthausen says that most explanations of accounting choice involve opportunism; the characterization of opportunism stories as involving fooling or outmaneuvering is mine. 160 Indeed, models of persistent financial statement beautification generally have been predicated on invisibility. See, e.g., Dye, supra note 6; Holthausen et al., supra note 6; Trueman & Tittman, supra note 6. While the more typical models involve fooling or outmaneuvering, signalling models have also been advanced: the beautified financial statement numbers signal to markets the company's real numbers or financial well-being. See Chancey & Lewis, supra note 3. See also Hughes & Schwartz, supra note 77, at 42. These models assume that higher accounting earnings translate into higher tax payments. The signal is thus costly and credible. But, as the discussants to the Hughes & Schwartz article note, why should expenditures on taxes be especially good as signals of a firm's financial health? Fellingham, supra note 77. As one discussant suggested, perhaps a better signal might be for the firm's CEO to burn cash outside the corporate headquarters. On a less facetious note, the discussants suggest alternative signals of "money to burn" such as charitable contributions. Another possibility might be a well-publicized, expensive contract with a "celebrity" spokesperson. In any event, while higher accounting earnings attributable to the FIFO choice do translate into higher tax payments, higher accounting earnings attributable to many, if not most, other accounting choices and practices do not. See infra notes 76-77 and accompanying text. One article that considers more visible beautification is Stein, supra note 114. Stein's account is mainly concerned with invisible beautification. He also notes, however, that if there are investors who are not rational, beautification can exist even with perfect information. In my account, there is never perfect information, even about visible beautification; however, there is very good information, and certainly, better information than the persistence of visible beautification would seem to imply. Page 35 of 40 22 Del. J. Corp. L. 141, *189 plausible. We know that markets are not fooled. 161 And it seems unlikely that anyone else could be fooled. Candidates include compensation committees who set company manager compensation, lenders, regulators, and interest groups. 162 But each of these knows, or can easily learn, at least as much as the market; compensation committees and lenders, and perhaps regulators, may know considerably more.

Outmaneuvering may be more plausible. Here, regulators and lenders are the prime candidates. Beautification would at least be earning its keep, and elicit market neutrality or perhaps even market favor, as stockholders benefitted at regulators' or lenders' expense. Outmaneuvering regulators regulatory arbitrage is clearly part of the story for both invisible and visible beautification. Regulators have a rule triggered (or not) by financial statement numbers; companies seek to avoid application of the rule by manipulating their numbers. Industries in which regulatory arbitrage is a motivation for beautification include financial services and regulated utilities. 163 But regulatory arbitrage cannot be the whole story. Even the industries in which regulatory arbitrage is possible have beautification regulatory arbitrage does not explain. Moreover, outside such industries, beautification is also

[*190] common.

Outmaneuvering lenders is another possibility. 164 Lenders might mistakenly fail to include beautification techniques in their covenants. As a result, companies could operate closer to the "edge" than the lender contemplated, and than the loan's interest rate reflected. But why would lenders make this mistake more than once? Loan agreements do not last forever; certainly, a lender who had been "burned" once (even if only by finding out that the company had used visible beautification techniques) would make sure it didn't happen again. Perhaps the borrowing company might not be "caught," and the beautification might stay undetected. However plausible this may be for invisible beautification, it seems far less likely for visible beautification. The first generation of lenders may have been outmaneuvered. But, in a dynamic parallel to the one I have hypothesized for markets, lenders now seem to factor beautification techniques into their covenants. 165 The result is to further entrench beautification.

An outmaneuvering story also can be told about compensation committees. In such a story, company managers, who play no independent role in my account, would be outmaneuvering the companies and their stockholders to obtain higher compensation. Compensation committees may compute compensation using accounting measures,

161 See, e.g., Hand, supra note 3; Hand et al., supra note 6; Hong et al., supra note 8. To be "fooled" by beautification would be to take the beautified company at face value.

162 See Moses, supra note 6. A company could, of course, benefit in many ways if it could fool people into uncritically accepting its financial depictions of itself. For instance, it would presumably benefit, in the form of lower interest rates or a more favorable loan agreement, if it could fool its lenders into thinking that it had less earnings volatility than it did. 163 For instance, banks are required to maintain "capital" equal to some percentage of their "assets." Therefore, the higher the value of a bank's assets, the more capital it needs to keep. Minter et al., supra note 11, at E1-35. In a merger accounted for as a purchase, the purchased company's assets are revalued, typically upwards, and an additional asset, "goodwill," is created. In pooling, by contrast, assets are not revalued, and no goodwill is created. Purchase accounting, thus, creates higher asset values and the need for higher capital levels; this is one reason why banks often prefer pooling treatment. As to other regulated industries, the applicable statutes and regulations may use accounting numbers as measures. Gilson & Black, supra note 6, at 577.

164 See, e.g., Randall, supra note 6; Trueman & Tittman, Randall, supra note 6. 165 I base this statement on my review of loan documents as a corporate lawyer, and discussions with professionals in the legal and business community. Many loan documents expressly address particular beautification techniques. For instance, one covenant might restrict a company's ability to incur debt; another might restrict its ability to enter into long-term operating leases or sale-leasebacks. Or there might be no explicit mention, but beautification would be addressed implicitly. For instance, all loan documents include some measure of "fixed charges" a company can incur; the definition of fixed charges will likely include long-term lease payments. And, as some financial professionals have suggested, the actual financial ratios included in a loan document may very well be more conservatively stated to take into account some expected level of beautification. Page 36 of 40 22 Del. J. Corp. L. 141, *190 thus motivating company managers to beautify financial statements. There is much anecdotal, and some empirical, evidence supporting the existence of accounting-based compensation measures; company managers' incentive to increase their own compensation can safely be presumed. 166 But, in the case of visible beautification, this explanation seems a bit strained. 167 The implausibility of an outmaneuvering dynamic for lenders

[*191] seems to apply with equal, if not greater, force for compensation committees. Both have considerable access to inside information about the company, information that goes well beyond publicly reported financial information. And both interactions are relational, with multiple iterations. More likely, then, as with lenders, a certain level of beautification is built in, further entrenching the beautification dynamic.

Compensation measures that reward beautification have been explained not just as manifestations of manager agency costs, as described above, but instead as attempts at minimizing such costs, by aligning the managers' incentives with those of stockholders. Because of difficulties measuring performance and detecting beautification, compensation measures rewarding beautification might be the best we can do. 168 But compensation committees have powerful incentives to do better. Compensation committees need to know the company's real financial picture; they should want to establish measures that, to the extent possible, encourage accurate reporting by company managers. Because of information asymmetry, they probably can't eliminate company manager ability to "inflate" earnings, but they can limit it; an easy place to start is visible techniques. And the compensation committees often have something to bargain with. The compensation computation may include an allocation for the company's overall expenses; company managers will want the allocation to be as small as possible, and may be willing to trade off tighter compensation measures for a smaller allocation. Finally, company managers might find it difficult to argue for compensation for earnings increases attributable to visible beautification techniques.

The foregoing has considered some explanations commonly given for beautification. I argued that whatever their plausibility for invisible beautification, most are implausible for visible beautification. Exceptions, though, are regulatory arbitrage, and a dynamic, parallel to the one my

[*192] model depicts for markets, for lenders and compensation committees. The two dynamics are not only parallel they are also complementary. In both, beautification is presumed. The effect is cumulative: the more beautification is presumed, the costlier (and less worthwhile) it will be for any company to rebut that presumption. Banc One, watching Wells Fargo's attempts to convince investors to "value [Wells Fargo] according to its "cash" earnings" was not irrational in wanting to be second in doing something revolutionary: classic collective action and free rider problems make few companies good candidates for being the first. An exception may be Warren Buffett's

166 See Holthausen et al., supra note 6; Moses, supra note 6. See also Revsine, supra note 31, at 17: "Virtually all U.S. companies have management compensation plans tied to reported earnings numbers."

167 But cf. Samuel Laibstain et al., Managing Off-Balance-Sheet Financing, Mgmt. Acct. 33 (July 1988) ("[M]anagement compensation plans are tied to ratios or reported earnings that are affected favorably by off-balance-sheet financing [that is, a visible beautification technique]."). Of course, if the popular view that markets are fooled by beautified financial statements is right, (and the economists' view, and the empirical evidence, to the contrary, is wrong), increased compensation could motivate company managers to use even visible beautification techniques. See McGoldrick, supra note 7 ("Not surprisingly, in a financial world where CFOs are judged (and often compensated) on stock appreciation, pooling, which, unlike purchase accounting, avoids the dreaded goodwill, has become very popular.") (emphasis added). But my model assumes that markets are neutral towards the act of beautifying, and to the bulk of the pleasing effects achieved by visible beautification in other words, that stock prices do not increase from an application of visible financial cosmetics. Accordingly, compensation increases pegged to stock price increases could not motivate company managers to use pooling or other visible beautification techniques.

168 See generally Richard A. Lambert, Income Smoothing as Rational Equilibrium Behavior, 59 Acct. Rev. 604 (1984). Page 37 of 40 22 Del. J. Corp. L. 141, *192 company, Berkshire Hathaway. 169 Buffett's reputation for rectitude may be unrivalled. But his is a niche that few companies profitably can occupy.

C. Implications for the ECMH: Fundamental Versus Informational Efficiency

I now consider how my explanation accords with the Efficient Capital Markets Hypothesis. 170 There is no universal formulation of ECMH; rather, there are species and sub-species. All species of the ECMH hold that, with respect to a given information set, there are no profitable trading opportunities 171 using information from that set. 172 The species differ in specifying the information set; the information set for the most commonly considered form of ECMH, semi-strong ECMH, is publicly available information.

Within each of the three species, sub-species have been distinguished. Definitions vary, but one common set of distinctions is between fundamental and informational efficiency. Fundamental efficiency holds that market prices reflect all fundamental information about a stock. Fundamental information is information relating to net present value of future cash flows. Informational efficiency holds that

[*193] market prices reflect all relevant information about a stock. The set of fundamental information is a subset of the set of "relevant" information; there is much "relevant" information that is nonfundamental. 173

In fundamental efficiency ECMH, a stock is mispriced if it does not reflect the present value of its future cash flows. In informational efficiency ECMH, the indicia of mispricing is less clear. A stock's price reflects, tautologically, all "relevant" information; there is no independent specification of what information is relevant. In fundamental efficiency ECMH, the role typically accorded arbitrageurs is to correct mispricings; in informational efficiency, the arbitrageurs' role is (largely?) the same. However, in a fundamentally efficient market, the correction process is smoother: prices would be at fundamental values but for a (fleeting) mistake, which arbitrageurs stand ready to correct. By contrast, in an informationally efficient market, the price at any point in time may reflect fundamental as well as nonfundamental information. Thus, the strategy of moving towards fundamental values should still be each arbitrageur's best guess; however, the guess may not be as good in an informationally efficient market as in a fundamentally efficient market. 174

Given the open and notorious nature of visible beautification, the market reaction I hypothesize neutrality, where fundamental values would dictate market punishment is, at first blush, a puzzle under both fundamental and informational efficiency, because some "relevant," "fundamental" publicly available information is apparently not reflected in stock prices. I have tried to show how the puzzle might be solved. As I discuss in more detail below, my

169 But even Warren Buffett apparently sees the allure of beautified financial statements, and in particular, of "pooling" accounting, judging by the pro-pooling arguments he has made to Berkshire Hathaway shareholders. See Calvin Johnson, Accounting in Favor of Investors, 18 Cardozo L. Rev. (forthcoming 1997). 170 For purposes of my analysis, I assume that ECMH has escaped its noise trading and behaviorist critics sufficiently to remain at least a default model and point of departure. See supra note 153.

171 The more formal (and more precise) term for "profitable trading opportunities" is "abnormal returns." With respect to any stock, the "normal return" is the market return times the company's sensitivity to the market (that is, its systematic risk). Any return that deviates significantly from the normal return is an "abnormal return." An abnormal return can be positive or negative. See generally Gilson & Black, supra note 6, at 194-95. 172 As to ECMH generally, see supra note 22.

173 See generally Ayres, supra note 22, at 969-73; Lawrence A. Cunningham, From Random Walks to Chaotic Crashes: The Linear Genealogy of the Efficient Capital Markets Hypothesis, 62 Geo. Wash. L. Rev. 546, 564-65 (1994); Jill E. Fisch, Picking A Winner, 20 J. Corp. L. 451, 464 (1995).

174 See supra note 173. Page 38 of 40 22 Del. J. Corp. L. 141, *193 first explanation a persistent mispricing smaller than the information costs needed to exploit it accords with both fundamental and informational efficiency. However, my second explanation, that arbitrageurs take future investor mistakes into account, may not accord with fundamental efficiency; in a world of fundamental efficiency, the arbitrageur should have no reason to refrain from moving prices towards fundamental values.

My first explanation was that the information costs exceed the size of the trading (arbitrage) opportunity. I explained how appraisal methodologies have developed and are used, and how they have come to accommodate, and thus effectively require, an equilibrium level of beautification. I argued that given this history, markets and companies

[*194] cannot do any better.

Neither "fundamental efficiency" nor "informational efficiency" is challenged by such an explanation. Fundamental efficiency holds that there are no profitable trading opportunities because prices reflect fundamental value. Allowing for positive information costs, a fundamentally efficient market might nevertheless leave uncorrected mispricings smaller than the costs to exploit them. Informational efficiency, too, can easily accommodate a mispricing reflecting positive information costs. For both fundamental and informational efficiency, the payoff to obtaining information must be larger than the cost, or the information will not be obtained.

My second explanation related to the risks involved in arbitrage of long-term assets, and arbitrageurs' responses to those risks. My explanation posited that arbitrageurs are, in some cases, best off not correcting a particular mispricing. Here, fundamental efficiency has some difficulties. In fundamental efficiency models, barring information cost constraints, correcting mispricings should always be worthwhile, because the market should, and quickly will, move to fundamental value. Either the fundamentals will quickly win out by themselves, or arbitrageurs will hasten the process. Informational efficiency, by contrast, hypothesizes that nonfundamental information is reflected in prices; it is thus possible to imagine a rational investment strategy incorporating expectations about nonfundamental information's effect on future stock prices.

But visible beautification itself poses no serious challenge to the underlying tenets of ECMH. Visible beautification offers no profitable trading opportunities. Markets reverse most of its effects: they do not take companies at face value, but instead, peel off much of the makeup. What they do not peel off is thin, and adheres rather more closely; removal would be costly, and the payoff small, uncertain, or both. Prices reflect information up to the point where the benefits exceed the costs.

I offer different accounts of why the peeling process stops where it does; in any event, it does not stop too soon for the markets to get a substantially accurate picture of companies. In an ideal world, the amounts spent on beautification, both by companies and markets, would be better spent on more efficient activities. But that is not our world. In our world, path dependence and positive information costs combine to produce companies' and markets' best strategy: to perpetuate an equilibrium level of beautification.

[*195]

V. Conclusion

I began this article asking why appearances financial statement appearances should ever matter. There is very strong evidence that many people think such appearances matter. And, I have argued, they are not wrong: not because the market is fooled, but because it rationally has concluded that everyone will try to look their best. Companies who do not beautify may act at their peril; they are ranked in a world where their peers do.

Might we be better off in a world where no one beautified? Probably yes. But, at least at present, a beautification-free world doesn't seem imminent. Page 39 of 40 22 Del. J. Corp. L. 141, *195

It is hard to gage how likely change is. Several indications that change may be possible come from the internationalization of markets. Different countries' accounting practices are being compared; the competition may produce a result that incorporates the best of each. And re-examination can permit revisiting, and perhaps discarding, an entrenched rule or practice. Indeed, pooling has come under much scrutiny, and the U.S. is almost alone in permitting it. Leasing, too, is being reconsidered as part of the international harmonization initiatives.

Other developments could constrain beautification. There have been proposals to make radical changes in the way financial information is prepared and disseminated. 175 And the new composition of the Financial Accounting Foundation could trigger tightening of rules that now allow flexibility. As a result, beautification may be constrained, or its form significantly altered.

But the dynamic has proved very resilient. The techniques change, but the dynamic remains. As noted in supra Section IV.a.3, some accounting firms have responded to recent analyst shifts from earnings models to cash flow models by creating and marketing cash flow beautification techniques. It has shown great geographic resilience as well. Canada, for instance, has a quite similar beautification dynamic. Canadian press reports often bemoan companies' beautification efforts, and the difficulties these pose for investors trying to ferret out the truth. In short, they sound remarkably like their counterparts in the . 176 And Canadian GAAP is similar too. An important item in their

[*196] makeup kit is leasing, just as in the U.S. 177 Indeed, internationalization, at least as regards the U.S. and Canada, has caused what some would term a race to the bottom. Pooling treatment is much more difficult to obtain in Canada. 178 Nevertheless, companies are increasingly attempting to obtain it; 179 many claim its absence disadvantages them in cross-border transactions.

175 Rick Telberg, GAAP Be Damned: Accounting Moves Beyond Money, Acct. Today, Dec. 13, 1993, at 12 (discussing proposals to effectively replace financial statements with a searchable database containing financial information that users could access to fulfill their particular disclosure needs).

176 See, e.g., Douglas Cameron, AC Opts for Export Credit; Airlines Now Use Export Credit, Operating Leases to Obtain Aircraft, Airline Bus., May 1992, at 31 ("The primary aim [of a particular operating lease transaction] is to provide Air Canada with off-balance-sheet financing, rather than to take advantage of current operating lease rates."); Bruce Gates, Canada: Leasing Gives Strapped Firms New Lease on Life, Fin. Post, Oct. 6, 1992 (Keeping debt off the balance sheet by using leasing is an advantage to companies worried about their debt-to-equity ratios. The article notes, however, that sophisticated lenders may not fooled.); Lisa Grogan-Green, CBC's Innovative Borrowing Raises Eyebrows, Fin. Post, Dec. 11, 1993. (Ottawa is attempting to mask its deficit through the use of off-balance-sheet financing.); Philip Mathias, Why Accounting Standards Aren't Standard, Fin. Post, Apr. 2, 1994 (The article notes that critics say Canadian GAAP are not only flexible but easily manipulated. One major problem with management's financial reporting is "[w]ilful prettying up of financial results by some companies, acting within the law." The article also notes that Canadian GAAP is more flexible than U.S. GAAP, and that "some corporate accountants are using GAAP's suppleness to cast their companies in a rosy light.").

177 Price Waterhouse, Accounting Principles and Practices in Canada and the United States of America 1995/96, Significant Differences 27 (1995). See also Cameron, supra note 176; Gates, supra note 176.

178 In Canada, pooling can only be used in the rare instances where the acquiror cannot be identified. Price Waterhouse, supra note 177, at 3.

179 There have been a few poolings in Canada in recent years. Examples include: Anderson Exploration Ltd. and Home Oil Company, in 1995, discussed in Anderson Exploration Ltd. Announces Fiscal 1995 Operating Results Including the Effect of a Business Combination with Home Oil Company Limited, Canada Newswire, Financial News Section, Nov. 23, 1995; Viceroy Resource Corporation, Loki Gold Corporation, and Baja Gold, Inc., in 1996, discussed in Viceroy-Loki-Baja Merger, Canada Newswire, Financial News Section, Mar. 27, 1996. Cross-border poolings between Canadian companies and U.S. companies have included Tim Hortons and Wendy's International, Inc., in 1995, discussed in Wendy's Posts Another Record Year; Merger with Tim Hortons Creates $ 5 Billion, 5,900 Unit Chain, Canada Newswire, Financial News Section, Feb. 22, 1996. Page 40 of 40 22 Del. J. Corp. L. 141, *196

In sum, financial appearances continue to matter. In the financial world, like the rest of the world, appearances don't always reflect reality. But making an initial judgment on the basis of appearances may be all but inevitable even, it seems, in the world of markets.

Copyright (c) 1997 Delaware Law School of Widener University, Inc. Delaware Journal of Corporate Law