by Paul B.W. Miller and Paul R. Bahnson
When we talk about Quality Financial Reporting and its potential to bring real change to financial reporting, we’re often challenged to show how managers receive a payoff from providing more information to users. We’re not dismayed at all; in fact, we were pondering the same objection when the idea for QFR first leapt into our brains for the first time.
With apologies to ophthalmologists, we think those who get hung up on the costs of making good reporting choices suffer from three impairments to clear vision: preparation cost myopia, enterprise astigmatism, and proprietary cost hyperopia. (They could also have presbyopia, but that’s another story.)
Fortunately, all are treatable with a little common sense.
- Preparation cost myopia. Over the years, we have concluded that actual preparation costs are often the sole focus of management attention when they should be only a small consideration.
What have we discovered that others have overlooked? Here it is: There is another cost factor that escapes nearsighted managers who can’t spot the connection between the quality of reported information and the additional cost of capital that they incur for leaving the markets uninformed. This cost, called the “information risk premium,” is imposed on the firm (and its shareholders) because the markets are not as informed as they would like to be.The information risk premium is part of a company’s cost of capital, just as much as compensation for the time value of money and the business risk faced by investors and creditors. When financial statement users lack useful or complete information, they perceive more risk and demand a higher return through discounted stock prices.
We have come to see that the cost of this risk effect is just as real as, but much larger than, the amounts managers would pay to produce truly useful information. Any rational comparison of the costs and benefits of financial reporting simply has to include it, but we reckon that few managers actually do.
When implemented, Quality Financial Reporting reduces the information risk premium. Of course, not even QFR can eliminate the unavoidable risk created by the inability to predict the future. Only time can do that. The reporting issue faced by managers is whether to reduce investors’ risk by incurring higher preparation costs to provide full and transparent reports, or to suffer a higher cost of capital by choosing myopic minimum compliance with generally accepted accounting principles. Either way, costs are going to be incurred, so the question is, how much of which kind?
For example, consider the voluntary supplemental reporting of asset market values recommended by the Financial Accounting Standards Board in SFAS 89. While the money used to prepare this information should be thoughtfully spent, the analysis of whether to spend it must include the savings in capital costs generated by reducing information risk. All too often, CFOs only compare spending the money with not spending it, and decide to not spend it. No surprise there! But, if the additional information meets users’ needs, certainly the resulting capital cost savings will exceed the relatively low preparation costs. (In this case, how can these costs not be low? After all, what good management doesn’t already know the market value of its assets?)
Even though these capital cost savings are hard to see, their obscurity doesn’t make them unreal or insignificant. As we have watched over the last few years, there is growing research evidence that high-quality reporting produces lower capital costs. In light of the staggering market caps for public companies, even shaving off only a few basis points justifies more complete financial reporting.
Here is a fundamental truth: The extra costs of well-executed financial reporting are good investments that reduce capital costs. By squinting and not seeing beyond out-of-pocket preparation costs, managers and accountants miss the obvious point that cheap financial statements are way too costly.
- Enterprise astigmatism. This second malady somehow keeps people from clearly seeing important things, even when they’re right in front of them. For example, accountants are conditioned to view businesses as separate and distinct from their owners, to the point that the entities are thought of as having profits, assets and the like.
However, this poor habit obscures the important point that companies are simply conduits of ownership for investors. The fact that profits and assets belong to the owners has an important implication for the costs of preparing financial reports. If the owners want information about some aspect of the business that isn’t provided in the statements, they have to spend more of their own money to get it from less reliable sources. These additional costs (paid to money managers and analysts) greatly outweigh the relatively small preparation costs that would have been incurred inside the firm.By not providing what users need, management pays twice. First, the money paid to the outside advisors is money not invested in the firm — it’s simply taken off the table. In addition, managers’ refusal to report sends a signal to the capital markets that they are unresponsive to their owners at best and disdainful at worst. Adding insult to injury is the fact that many dollars are diverted by the owners to getting outside help, when the managers could have spent a few dimes to provide the same information more quickly and reliably.
Just in case someone is thinking about it, we insist that it’s impossible to reap rewards by faking QFR. Any rewards will be short-lived at best, and will be followed by a slam. Half-hearted efforts and cut corners aren’t credible either. The markets quickly figure out that they either have to spend money to learn the truth or take their money some other place where the information is better.
The bottom line: Money spent on deception is money down the drain.
- Proprietary cost hyperopia. Another knee-jerk reaction to proposals for more open disclosure is the objection that doing so will reveal too much to competitors. Some say that the information might divulge secrets about the company’s strengths and weaknesses. We concede that releasing some information would create commercial disaster, but it would be things like product formulas, source codes, new product specs or pricing strategies, to name a few.
But what do the markets really want to learn from the financial reports? Nothing but facts about past performance and current conditions. While they’d love to know trade secrets, they also know that the secrets wouldn’t be secret if they could figure them out that easily. Besides, anyone who can glean trade secrets from public financial statements, even QFR statements, would put Sherlock Holmes to shame.Finally, QFR is voluntary, and any managers who decide to keep financial secrets can just keep them. However, they can’t expect to be rewarded with lower capital costs.
We often draw a parallel to advertising: You can’t inform customers about your products without also informing your competitors. In the same way, you can’t inform the capital markets about your financial results without also informing your competitors. You won’t reap the benefits of promotion if you don’t advertise, and you won’t get lower capital costs if you keep secrets from the markets.
To summarize, those who use these kinds of cost-based arguments to resist progress are misguided. It does no one any good to produce cheap but useless statements, to force markets to gather information for themselves, or to keep silly secrets. No matter how much is saved in lower preparation costs, it is lost many times over through the resulting huge discounts in stock prices.
The solution for correcting management vision is actually quite easy. One way lies in changing how chief financial officers are evaluated. We think that most CFOs are graded on their ability to minimize preparation costs, but doing so inevitably encourages them to publish less useful reports. If, on the other hand, they were to be evaluated on the basis of lowering overall reporting costs, including the information risk premium, we think that the changeover to Quality Financial Reporting would be rapid and complete, all without government regulation or any action by FASB.
We trust that you can see our points clearly.
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 email@example.com.
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