Okay, we'll admit it up front: We are inveterate wordsmiths who love using words to make our points. Over the previous 15 years that we've produced this column, we've even invented a few to describe some financial reporting issues, such as "pfooling of interests," "volatilaphobia" and, more recently, "duh-preciation."
In this column, we want to make a significant point to those involved in financial reporting by focusing on two common words that everybody uses hundreds of times a day. Specifically, it matters whether someone thinks the capital markets exist for their benefit or to their benefit.
To start, we ask for whose benefit do capital markets exist?
The answer is simple: everyone. Their role in a free market economy is to efficiently connect those who demand capital with those who supply it. If market efficiency exists, then capital is priced optimally, reflecting expected future returns and the associated risks. Without efficiency, economic activity, growth and stability are all jeopardized. With it, though, a society's economic system more readily fulfills its functions of generating and distributing wealth.
One main factor that created and sustained the Great Depression was inefficient capital markets that had no liquidity, trust or useful information. Because people lacked confidence in the markets, those with capital were unwilling to supply it and those who needed it could not obtain it. We think the same sort of friction may very well exist in today's economy.
In short, the purpose of the capital markets is to help the economy contribute to society's overall well-being.
TO THEIR BENEFIT?
Within that context, it takes an intricate and balanced interplay among four main participating groups to make the capital markets work for society's benefit. Because the groups gain from their contributions, it's true the markets work to their benefit. In a sense, society rewards them for services rendered.
Consider managers who issue public securities. The system allows them access to fresh capital in primary markets, enabling companies to come into existence or expand, as the case may be. They use their shares as currency for buying assets and even other companies, and, of course, as compensation. The secondary markets create liquidity and establish the securities' value as well. Thus, markets benefit shareholders and help managers retain their jobs and prosper.
The markets also sustain auditors by providing them with a livelihood in exchange for contributing a valuable service to society. Specifically, completing their task of adding credibility to managers' self-representations gives them above-average income and a great deal of respectability.
Third, financial statement users, including investors and financial analysts, can access many different investment opportunities with an endless array of returns and risks. This diversity promotes wise investing and greater income for themselves and their clientele. These people are, in effect, the main mechanism for creating efficiency as they pore through reams of data to find the best investments for their goals. They put every security in play and enable equilibrium prices to be reached quickly. Their obvious reward is a chance to accumulate substantial wealth.
Fourth, there are regulators, including standard-setters. Like auditors, the markets provide them with a respectable and satisfying livelihood, primarily by creating and enforcing regulations that aim to reduce risk by building confidence in the markets' fairness. In return, they are admired for their integrity and can take pride in contributing every day to society's prosperity. Former SEC Chief Accountant Walter Schuetze once explained that he felt it was his duty each day to cradle the capital markets like a delicate crystal vase that he was to carefully protect from harm.
There are, of course, many others who make the markets work, such as brokers, exchange managers, investment advisors, mutual fund managers and marketers, bankers, venture capitalists and media pundits. We'll focus on only the above four because of their direct involvement in financial reporting.
Unless they adopt a broad perspective, all these people see only their little part of the system through the lens of their self-interest and come to believe they're entitled to use their power, wealth and position to get what they "rightfully" deserve. Like spoiled adolescents, they may literally think the markets exist for their benefit, instead of grasping that they are only bit players in a bigger game in which they are allowed to participate to their own benefit only because of their unique contributions to the greater good.
Lamentably, the reality is that many, and probably even most, participants do indeed see the markets as existing for their benefit, unfortunately to the detriment of everyone, even themselves.
Because they can, managers wheel and deal with other people's money like there's no tomorrow. They think nothing of shading the truth to pull down insane compensation. At times, they're so intent on feathering their nests that they forget everything else, including common decency and even the law.
We're afraid auditors have also become sufficiently self-absorbed to the point that they tend to resist any change that would cause them to audit new information and expose them to what they see as unacceptable risks. What they miss over and over again is that their defense of the status quo prevents useful information from reaching the markets. By auditing only GAAP financial statements, their opinions are not particularly valuable because they merely affirm that the reports present mostly useless information. We think auditors also fail to see that being paid by clients diminishes the essential trust factor.
As for investors and analysts, many mistakenly think it's perfectly fine to engage in self-serving deals that weaken the markets' contribution to society's overall benefit. They focus, for example, on forecasted and reported GAAP earnings per share as if they mean something, when all should know that they're basically worthless. The consequence is a lot of market friction when "earnings season" rolls around every quarter. Their shouting about this meaningless statistic destroys market efficiency, even if it makes some analysts wealthy. Other misbehaviors are "pump and dump" and short-selling while bad-mouthing a stock.
Regulators are not immune to this effect. Sometimes, for example, they get so focused on finding acceptable and enforceable rules that they forget they exist only to ensure that the markets are fairly informed and operated. We think of pension accounting as an example of how compromise was injected into GAAP 25 years ago but remains unchanged because the regulators don't want to go through a tough due process to fix it.
In effect, all these parties operate at cross purposes, not only among themselves, but also contrary to society's interests in efficient capital markets.
THE NEED FOR AN EPIPHANY
What we see is a crying need for a massive epiphany. If markets really exist for society's benefit and participants can earn great rewards with integrity by serving those broader societal interests, then they will be better off working toward that goal.
For managers, it would mean focusing on what they should do best, which is managing enterprises to generate wealth through innovation and serving demand for their goods and services. I
f they do a good job, it follows that they will be honestly (and handsomely) compensated without crossing a line. A key realization will reveal that the best way to increase their securities' value is providing useful, complete and timely information. No obfuscation, no truth-bending, no withholding bad news, no propaganda, just the truth, the whole truth, and nothing but the truth, so that all can understand.
For auditors, an epiphany would lead to verifying the actual truthfulness of managers' reports. Much more value is added to financial reports by affirming their truthfulness and trustworthiness than in merely saying that they comply with arcane, compromised, outdated and otherwise ineffective principles. Auditors should also recognize that their opinion is helpful only with true independence. For now, they insist that the one and only way to operate is by client fees, missing that others see that ambiguous arrangement as a source of bias.
For statement users, we envision a new setting in which they do what they do best - namely, use truthful information to assess the amount, timing and uncertainty of future cash flows. Their minds should not be wasted digging through deceptive reports that devious managers craft within GAAP with their auditors' blessing. Instead, risk created by untrustworthiness would be dramatically reduced through truthful reports attested by independent auditors.
For standard-setters, the epiphany would lead them to encourage all parties to escape bad habits through innovation. Regulators can also help by calling on all to embrace the epiphany while consistently dropping heavy hammers on those who act like the markets are their personal sandboxes.
IS THIS POSSIBLE?
We know, we know. These ideas sound like they came from an ivory tower. In fact, they have, because we're not caught up in taking anything from the markets for ourselves. Our goal is to put an intense new spotlight on obstacles that keep markets from reaching their full potential.
It's often said that humans use less than 10 percent of their brain power. We think the same is true for markets, except that the percentage may be even lower. For sure, no one has yet seen what can be accomplished when great minds from all four market sectors come together to seek their individual interests in the context of serving society.
Until this epiphany occurs, inefficiency will reign and no one will come close to helping the markets create value up to their potential until participants understand that the markets operate to their benefit, not for it.
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 authorsâ€™ views are not necessarily those of their institutions. Reach them at email@example.com.
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