Like many others, we're interested in the work of the Securities and Exchange Commission's recently created advisory Committee on Improvements to Financial Reporting. Improvement is something that everybody likes, at least if it doesn't really change very much, and certainly not the important stuff. The committee has some outstanding members, as well as others we don't expect to come up with much new because they've had other, even better, platforms for initiating change but didn't get it done in the past.The chair is Robert Pozen, the non-executive chairman of MFR Investment Management, one of seven American subsidiaries of the Canadian Sun Life Financial group. On the one hand, his affiliation with a mutual fund company is promising because it might mean that Pozen thinks like a financial statement user. However, he is an attorney by training and has been a general counsel in the industry, but never an analyst. Indeed, his present position might make him think more like a statement preparer than a user. Only time will tell which perspective he will apply, although evidence suggests the former will prevail.
Charged to explain the committee's task and lay out his views about the issues, Pozen prepared a "discussion paper" (www.sec.gov/about/offices/oca/acifr/acifr_discussion.htm). He explains, with awkward tautology, that CIFiR is charged with "examining the U.S. financial reporting system to identify ways to improve the system of financial reporting."
He goes on to say that the committee's tasks are to figure out how to "reduce unnecessary complexity" and "make information more useful and understandable for investors." So far, so good, although we're wondering just who knows which complexities are necessary, and which are not. We also scratch our heads over the ambiguity in the word "investors." Are they folks who own a few mutual fund shares, or the mutual funds themselves with their legions of sophisticated analysts? One size of reporting clearly doesn't fit all these needs, but Pozen doesn't exactly make that point clear.
From here, we could go off in several directions to critique the paper and the prospects for the committee's success. What we've decided to do is focus for now on the premises that Pozen used in forging his plan. Some are stated, but others are implied. In light of the committee's important charge, all are worthy of close examination.
A BAD PARADIGM
A person's paradigm determines what they see and think about what occurs and exists in the world. In the CIFiR paper, it's clear that Pozen's paradigm holds that the only way to have useful reports is through compelled compliance with GAAP. As he sees it, managers (like him?) report to the public only because they are forced to, and then only grudgingly and up to minimum requirements. There is no surprise here, because that paradigm describes today's management behavior.
Nonetheless, it is deficient for creating a new future, because it means that the quality and usefulness of financial reports depend 100 percent on bureaucratic processes. The problem is that those processes pose two obstacles to progress. First, they never create anything visionary and groundbreaking. Second, any guidance they do produce is compromised down to the lowest common denominator. By analogy, imagine what kind of buildings would be produced if architects merely designed them to meet code.
In contrast, what if CIFiR were to buy into a different paradigm that sees many real economic incentives for managers to improve their reporting so that they can access capital at better prices? Obviously, this other reality would produce a different analysis and outcome. Will Pozen and CIFiR see and act on this opportunity? In case you're thinking "Yes," re-read the prior paragraph.
THE STATUS QUO?
Pozen's second paragraph claims with bravado that U.S. capital markets are as good as they are "due in no small measure to the availability of relevant, reliable, readily understandable and timely financial information." Ah, if only it were so!
Reality is quite a bit different. Even if U.S. capital markets are the best in the world, they have reached that status despite the fact that GAAP statements are filled with irrelevant, unreliable, obtuse and untimely information! Given his gratuitous assessment of the status quo, it's unlikely Pozen currently sees many significant opportunities for improvement. Rather, it appears that he thinks the system is just about as good as it can get except for some tweaking. Again, if only it were so ... .
In acknowledging that different participants have conflicting goals, at least within his compelled reporting paradigm, Pozen lists several things that preparers want out of the system.
The biggest problem is his omission of the premise that the objective of financial reports is to provide managers with access to capital at a fair price that reflects real risks and returns. This would be a big change from the current management goal of trying to present such rosy pictures that they can mislead the market into producing higher stock prices. Without clarity on this overall objective, the status quo will be safe from CIFiR.
Pozen's paper also says that managers want "clear instructions on what subjects to cover." Excuse us, but would they ask the government for "clear instructions" on what features to provide in their products? This assertion sees managers as passive and powerless minions waiting for guidance from above. They are, whether they know it or not - and whether they like it or not - participants in very competitive and dynamic capital markets. Rather than working from some bureaucratic checklist, they should be trying to figure out for themselves how to build unique, long-term, productive relationships based on satisfying investors' needs better than everyone else.
He also claims managers want "flexibility" to reflect "economic reality." What kind of flexibility and whose reality? We like the general idea, but not in the existing paradigm, because both terms have been in the preparers' lexicon for decades as euphemistic justifications for income smoothing, off-balance-sheet financing and the like.
He then says that managers want to "reduce period-to-period volatility of earnings" and specifically refers to unrealized gains and losses. In other words, they want to engage in risky activity that produces unpredictable changes in assets and liabilities, but escape accountability for the volatile results.
What's missing is the idea that the only legitimate way to avoid volatile income is to make non-risky investments. It is illegitimate for managers to conceal volatility in order to mislead users. Analysts have been loud and clear in insisting that they want volatility to be revealed so they can make their own adjustments, instead of being fed pre-digested data. To the extent that fabricated smoothness hides real information, the goal of fair pricing of capital will be thwarted. Absolutely no vision here.
Pozen also claims that managers want to prepare their reports "at reasonable cost, in terms of dollars and management time." On the face of it, that claim is absurd because it doesn't include the benefits that managers would obtain from improved reporting or the costs that are incurred by users when managers cut corners.
If benefits aren't considered, this focus on costs will mean that the only improvements in reporting will be those that reduce managers' out-of-pocket expenses, without regard to their impact on capital costs. Nothing good will come from CIFiR unless Pozen, the members, and managers come to understand that lower preparation costs produce much higher processing and analysis costs that lead, in turn, to higher capital costs. Again, no vision is apparent.
Because of CIFiR's important mission, you'll see two more columns from us on this discussion paper. At the very time in history that the Financial Accounting and International Accounting Standards Boards are poised to take giant steps with regard to meaningful reform in reporting, this potentially influential committee is under the guidance of a person who does not yet seem to grasp the severe inadequacies of the status quo.
Although we always hope for a better future, right now it looks to us as if CIFiR may not initiate needed significant reforms. If not, a great deal of high-powered talent (and a golden opportunity) would be wasted. Based on what we've seen so far, it doesn't look so good.
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 firstname.lastname@example.org.
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