In The FASB: The People, the Process, and the Politics, a book that we published under the McGraw-Hill imprint in 1998, we presented a brief discussion of what we called "a new perspective" that unveils the futility of many of the beliefs and actions of managers and others who have not yet grasped how the capital markets get and use information. We recently came across it and thought it would make an interesting column.Traditionally, accounting theory, practice and standards-setting have all focused on the flow of information from companies to the capital markets, under the assumption that this information is used by those markets to make investment and credit decisions. In effect, attention has been directed to the public financial statements moving between statement preparers and the capital markets (see box, "In theory").
Of course, a great deal of useful information can flow along this path, and accountants have been justified in focusing attention on the contents of public financial statements. However, it is not valid to focus exclusively on this flow as if it is the only source of information that the capital markets have. In fact, the situation is more completely and usefully represented by the bottom figure (see box, "In reality").
It shows that capital market participants (investors and creditors) also have access to other sources of information in addition to the public financial statements.
This concept is important because it shows that much of the political resistance to new financial accounting standards has been misplaced. For example, this perspective shows that preparers' opposition to putting stock options expense on the income statement was based on the assumption that the capital markets would not have access to other private information about its existence and amount.
Earlier, the Financial Accounting Standards Board encountered great difficulties in passing a new pension accounting standard because the preparer community exerted great effort to keep the board from requiring them to report new public information about their pension obligations to their employees. They seemed to assume that users would not try to find information from other sources if it wasn't presented in the financial statements. They were so intent on managing the image of their companies that they ignored the reality that the capital markets will do what they must in order to be adequately informed.
If this situation exists, some might suggest that public financial statements are not needed. After all, couldn't the capital markets generate all the information they need on their own? Of course they could, but the real issue is the total cost of relying on the private information to the exclusion of the public.
It is instructive to consider what costs are incurred when public financial statements are incomplete or otherwise less than fully informative. There are at least three different costs:
* First, users incur costs of producing and processing the private information. Thus, they demand a higher rate of return from these investments. The higher rate of return is a higher cost of capital for the company, which in turn produces lower prices for its securities.
* Second, the users are not able to attribute a great deal of reliability to the information, because it is based on estimates and conjectures developed from relatively unreliable sources. If the information lacks reliability, the capital markets face more risk, which means they demand a higher rate of return, which in turn means a higher cost of capital and lower security prices.
* Third, the presence of these costs and reliability problems means only a relatively few users know the private information. Because fewer investors are interested in the stock, there is less demand for it. In turn, this condition leads to lower security prices, resulting in a higher cost of capital for the company.
In addition, society incurs excess costs when information flows to the markets along the private channel, instead of the public one. In particular, each user has to pay for the information, which means substantially higher costs are incurred than would be incurred if a preparer develops the information one time and then publishes it for everyone to use if they wish. Furthermore, preparer-generated information can be more reliable because it comes from a well-informed source and has fewer estimates and conjectures. It also can be subjected to an audit that can greatly increase its reliability.
Despite the simplicity of these ideas, the history of standards-setting is full of efforts by preparers to keep information out of the financial statements in order to report higher earnings or to present better-looking balance sheets. We are convinced that this effort is so fruitless as to be futile.
This futility is also encouraged by the fact that obvious efforts to keep useful information out of the statements lead investors and creditors to believe that they cannot trust management to keep them informed. This lack of trust creates more uncertainty, which means (again) that the markets demand a higher rate of return that produces a higher cost of capital and lower security prices.
Thus, an assumption by managers that the capital markets are concerned only with the contents of public financial statements leads them to do things that hurt themselves if they own stock or hold options, that harm their stockholders, and that help perpetuate capital market inefficiencies.
Alas, despite the passing of nearly 10 years and numerous descriptions of Quality Financial Reporting, it's apparent that the old paradigm is hanging tough. For example, when FASB proposed amending SFAS 87 on pensions and SFAS 106 on post-employment benefits, numerous managers launched a letter-writing campaign that begged for using the smaller accumulated benefit obligation measure, while pleading for the board's understanding that recognizing the debt would throw them into violation of long-standing covenants with their creditors.
Of course, if the markets prefer the projected benefit obligation, reporting the ABO would only frustrate statement users, because they would then have to change the reported numbers to suit them. The point is that the driving force in the decision should have been what users want and need, not what managers are willing to report.
With regard to the covenant issue, apparently it never occurred to the managers that their pleas were essentially public confessions that they had knowingly broken their agreements. We are hard pressed to understand how they would think that their creditors would be oblivious to the true state of affairs.
So, one more time, we have returned to a recurring theme - there is nothing that adds value to financial reporting quite like candid and complete disclosure of the truth. We are confident that some day the gaping chasm between truth and generally accepted accounting principles financial statements will start to close.
Moreover, we think that the greatest accelerant for that closing will be the adoption of our new QFR perspective, which shows that it does no good to withhold information from the capital markets. They'll get it, one way or another, so management might as well present it themselves and reap the benefits of lower capital costs and higher stock prices.
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.
