Ask 10 accountants on the street what they think about the Sarbanes-Oxley Act, and 11 of them will probably say, "It costs way too much!" This message has been repeated so many times that no one seems to doubt it.Ask 10 accountants why their company or their clients don't report operating cash flow using the recommended direct method (instead of the virtually universal indirect method), and 11 of them will say, "It costs way too much!"
Ask 10 accountants what they think about quarterly reporting, and 11 of them will say, "It costs way too much!"
COSTS AND NO BENEFITS
The Financial Accounting Standards Board's original Conceptual Framework described a "pervasive constraint" that required the benefits from publishing useful financial information to exceed the costs. You can be sure that this language is regularly used to confront the board whenever it proposes some new standard.
Many use that point in arguing against new standards, including both managers and auditors. In effect, they claim that the costs of financial reporting all flow to them, while all the benefits flow to statement users. This assertion is, of course, patently false. The reason it seems justifiable, though, is a shortsightedness embedded into their minds by the education system and on-the-job training.
The flaw is that they're looking at only the costs that they incur in operating their generally accepted accounting principles reporting systems. Naturally, they complain when a new standard is proposed, because it would increase their compliance costs. As a result, they claim that the costs exceed their benefits, because they don't see the whole picture of what happens when they publish their statements.
We suggest that this mistaken attitude is reinforced by the responsibility for accounting systems imposed on chief financial officers and controllers. Because financial reporting does not generate revenues, their shops are surely evaluated as cost centers, not profit centers. If so, they are unfortunately motivated to resist change that would increase their costs. They are also motivated to reduce costs, such as by using the indirect method of describing cash flows or by wishing that they could report every six months, instead of each quarter.
THERE'S MORE TO IT
As managerial accounting students know, cost centers are risky, because they can lead managers away from satisfying customers. We're thinking of a decision on one of our campuses to stop preparing reimbursement checks for amounts under $50 because it "cost too much." Instead, highly paid faculty and administrators now trudge across campus bearing a petty cash form and stand in line to get paid, all in the name of reducing costs. This arrangement did not reduce costs - it merely shifted them from the treasurer's office to the people that office was created to serve. Without a doubt, it increased overall costs for the university.
That true story carries a moral for financial reporting. In particular, when CFOs compromise reporting quality, they're not saving anything. Sure, they're reducing their out-of-pocket costs, but they're creating other, much larger costs that are huge multiples of their spurious savings. They're being penny-wise but pound-foolish.
USERS' COSTS
We have observed that textbooks and some of our colleagues teach that financial accounting exists unto itself. Because it must be accomplished (by law or by contract), and because it must be done according to GAAP, the reporting process focuses on those who supply the reports, not the perspective of those who use the information, or who would use it if it were useful.
Consider again the direct method of reporting cash flow. In response to objections to its proposal in the 1980s to mandate this method, FASB fell victim to the claim that users can easily convert an indirect presentation to a direct tabulation. In response, the board allows managers to present only the indirect, a choice that 99-plus percent of public companies have made to "save money."
The indirect method's purported cost savings are spurious. We tested this popular premise in the 1990s and published results that showed it simply isn't true. By applying a computer routine to about 10,000 annual reports, we found that implementing the indirect method is more costly than conventional wisdom suggests. This outcome occurs because most companies have effects of non-operating transactions imbedded in their current asset and liability account balances. These items must be tweezed out before the indirect method can be used, and at great expense.
Our evidence documents an often-sizable disparity between working capital account changes on the cash flow statement compared to the balance sheet. This non-articulation also means that users cannot readily convert to the direct method presentation.
But even if the popular rationale were true, it would miss the point that reporting the indirect calculation doesn't reduce costs, but only shifts them from CFOs' budgets to users' budgets. Note especially that the tradeoff is between the company's cost of doing a preparation once (with full access to all relevant records) to costs incurred by a host of statement users who each must make wild-eyed guesses, because they can't tell precisely what happened. We'd venture to say that the preparers' one-time "savings" are a pittance when compared to the combined increase in all users' costs.
THE SECOND BOUNCE
As if that weren't enough, two other rebound effects occur. First, if users incur additional costs, they demand a higher return on their investments. Second, uncertainty about the quality of their estimates increases their risk and causes them to demand an even higher return.
The consequence is also two-fold. The users' higher return creates a higher cost of capital for the reporting company, which can amount to wasting literally millions of dollars. In addition, the capital markets seek a higher return by bidding down the value of the reporting company's securities.
The result could be that a CFO's stubborn insistence on reducing preparation costs by, say, $100,000, could be taking many millions out of shareholders' pockets through a depressed stock price! The solution to this problem is fairly simple, but managers will resist it because - you guessed it - it will cost too much.
HOW TO FIX IT
We think one piece of the solution is to make CFOs accountable for their companies' cost of capital. If so, they will evaluate cost tradeoffs more carefully.
Suppose a CFO is considering an innovation, such as providing clear pension footnotes or supplemental information about assets' market values, or weekly reports instead of quarterly, or classifying all investments as trading or, of course, the direct method for cash flows. If the CFO's compensation is tied to the cost of capital, and if that cost is linked to financial reporting quality, then it won't be long before quality starts to improve and stock prices start to rise because investors' risk and processing costs are being reduced. The motivating force will not be coercion from FASB or the Securities and Exchange Commission, but Adam Smith's invisible hand, leading management to gain by serving the needs of the capital markets.
The next step would be for top management to realize that they need to provide better information than their competitors. The capital markets are just as important to success as the product markets. Why would a company that prides itself on meeting customers' demands turn its back on the needs of its capital market partners? It just wouldn't happen that way if capital costs were included in compensation plans.
WILL IT BE DONE?
We used to think that reform in accounting was easy - just show people that there's a better way and they will use it. Well, it isn't so.
Shortsightedness and lethargy abound in the current management corps, as well as in the corporate and public accounting professions. Will they jump at this suggestion? Don't count on it. After all, they're used to pinching pennies while losing megabucks.
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.
