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, Columbia University. 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 accounting 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 financial statement 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 asset'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-equity 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' expense. … Fundamental efficiency holds that there are no profitable trading opportunities because prices reflect fundamental value. … Text [*142] "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 cash 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 [*144] 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, Earnings Management 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 accruals 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 Balance Sheet, 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.