Our column in the previous issue considered the Securities and Exchange Commission’s recently appointed Committee on Improvements to Financial Reporting, which has been charged with finding ways to strengthen the system. As our readers might expect, we found flaws among the premises in a discussion paper by the chair, Robert Pozen (available at www.sec.gov/about/offices/oca/acifr/acifr_discussion.htm).In this column, we look at the first five of 10 specific points in Pozen’s paper that deserve exposure and that will demand additional attention from the committee. Our next column will address the remaining five.
YES!
Listed among the bullet points of users’ desired benefits is the claim that they want: “Financial reports to reflect, to the extent feasible, actual changes in market values from period to period.” We certainly don’t dispute this point, and were gratified to find it in the paper. User groups have been asserting this claim for quite awhile, as have many others, so it’s good to see its prominence here.
However, we have these words for the reform-minded committee members: Be of good courage, because you will be told by some among your number and many others from the outside that there is no merit in moving toward “actual market values” in reports and financial statements. Your opponents will lack sound arguments, but they will make a lot of noise.
Of course, don’t be lulled by that phrase, “to the extent feasible.” Some think that feasible is synonymous with “easy.” Rather, it simply means “possible,” given current technology and the ever-present and growing demand for market value information.
Importantly, the fact that there is a cost to providing market values doesn’t mean they’re infeasible. Infeasibility happens if — and only if — all costs exceed all benefits for all parties. Managers focus only on their relatively minuscule reporting costs, completely overlooking the huge processing costs incurred by users who don’t get what they need. And managers seem to be totally unaware of how bad reporting increases their capital costs.
Somehow, we don’t think many opponents to change will address these ideas in their blind rush to provide the moribund status quo with another decade or two of life support.
OH, REALLY?
We found four other points in the paper that seemed, shall we say, a bit naive. They have been said over the years without substantiation, and Pozen includes them without any new evaluation. We hope our comments will help fill that void.
EXISTING STANDARDS
The paper says that the committee’s charter includes finding out “whether there are current accounting and reporting standards that do not result in useful information to investors.”
The answer is a resounding “Yes,” and it doesn’t take a high-powered committee to figure it out. Our position is that you can pick a number, any number, between one and 159 and come up with a FASB standard that does not provide all the useful information investors need. Of course, some standards have been replaced by others, but even the best of the new ones haven’t fixed all the failings. The same is true for all APB Opinions and Accounting Research Bulletins that are still in effect.
The fact is that these standards emerged from a political process characterized by compromises. Further, those compromises have always been away from providing users with relevant and reliable information, while giving preparers the ability to keep secrets or allowing auditors to avoid facing unfamiliar risks.
If the committee members were to really attack this charge, they would be kept busy for a long time.
STAR WARS: ONLY A MOVIE
People enjoy movies like Star Wars because they are a great escape from reality. For just a few hours (or even longer for fanatics), the imaginary world of the Galactic Empire, Jedi knights and lightsabers can be good fun. However, it isn’t healthy to escape reality for too long.
In composing the discussion paper, Pozen seems to have indulged an unhealthy fantasy when he lists this point among auditors’ wants: “Not to be later second-guessed by regulators, litigants, etc., in situations where reasonable/good faith judgments were made.” In reality, there is no way to avoid second-guessing! Baseball umpires have resisted instant replay, but football referees regularly submit to it, and hockey refs are happy to have replay to help them with tough calls on goals.
Why oh why would auditors (or preparers) imagine that they are ever going to be immune to second-guessing? This is a fact of life in the information world. If you say something is true and it turns out it isn’t, then you can expect to be challenged. If you were negligent or deceitful in making the assertion, then get ready to take heat. And if you weren’t negligent or deceitful, be prepared to experience having some high-priced law firm read your archived e-mail trying to prove that you were.
In short, committee members, don’t indulge this fantasy. You have better things to do with your time.
REASONABLE PROFIT?
Another of Pozen’s listed wants for auditors is: “To make a reasonable profit opining on financial information at a reasonable cost.” That longing is also a siren song of fertile but misguided imaginations, at least as we read between the lines. It appears to be a plea to allow auditors to continue what they have been doing while charging enough to live in the style to which they have become accustomed.
Our caveat to the committee is that auditors don’t deserve special treatment. All of us have to work hard and take risks to earn reasonable livings. We have to put in hours and sweat labor in order to put food on the table and a Lexus in the garage.
Over the years, much has been said about audits becoming interchangeable commodities. Our response is, “Well, duh!” The only thing that auditors presently accomplish is providing assurance that financial statements comply with generally accepted accounting principles, which is tantamount to confirming that they contain useless information.
Auditors need to face the fact that no one pays very much for that comfort. Thus, they have little chance of earning a reasonable return for their efforts and recrimination risk.
Instead, what the profession needs to do is figure out how to add real value to truly useful information that managers disclose over and above the minimum requirements of GAAP. Doing so will open up all sorts of revenue opportunities for them. (See the earlier comments about users’ demands for market values.)
TOO MUCH TIME?
Pozen asserts that everyone agrees that they “do not want companies to spend too much money and management time on preparing financial reports.” Alas, this statement is laughable because of what it leaves out. What’s missing here — and in many other places in the paper — is a solid assessment of management’s benefits from financial reporting that justify the time and effort.
For example, nowhere in the paper is the idea of “cost of capital” ever mentioned, which suggests to us that Pozen does not fully comprehend the wide spectra of benefits of good reporting or the costs of bad reporting. But based on some other names we see on the membership list, we’re confident this oversight will be corrected quickly and thoroughly. The ultimate result will be an assessment of costs and benefits that is not nearly as naive as saying “too much money and time.”
IN CLOSING
CIFiR clearly has potential for doing some good. It also faces the risk that it will do nothing or, what’s worse, do something that inflicts harm. Unfortunately, many signals in the discussion paper raise the possibility that the outcome won’t be positive. We’re hoping our thoughts lead Mr. Pozen and the members to think the issues through more carefully than he did in composing this discussion paper.
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors’ views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.
