by Paul B.W. Miller and Paul R. Bahnson

In virtually all of our writings about financial reporting and accounting, we tend to focus on the negative effects on the capital markets when they are provided with information that is not useful.

False and misleading public information may cause the stock price to go too high and then too low as users figure out that they were misled.

As a change of pace, we want to think about what happens to managers who are swayed into believing their own manipulated financial statements. As Warren Buffett said in his “Owner’s Manual” for Berkshire-Hathaway’s stockholders: “The CEO who misleads others in public may eventually mislead himself [or herself] in private.”

Certainly, the still-continuing series of accounting scandals has raised serious questions about many aspects of corporate governance, including the role and independence of corporate boards.

In several frauds, including Enron, boards were apparently duped by management, thus casting suspicion on all directors’ competence and diligence. In other instances, including Tyco, board members seem to have willingly conspired in perpetrating the fraud.

The fallout from all these failings has been a wave of governance reforms, including Sarbanes-Oxley, new SEC rules, modified stock exchange requirements, and self-imposed policy amendments. Collectively, these changes are intended to assure the public that corporate boards will function as tenacious investor representatives asking tough questions about management actions and plans, not as wielders of the rubber stamp.

While we politely applaud these reforms, we are led to a deeper reconsideration of financial reporting in terms of how it can promote good corporate governance. As we said, thinking about financial reporting first stirs thoughts about the information needs of investors and creditors. Deciding what to report involves this fundamental question: Will the information inform investors and creditors and lead to better decisions? If so, it should be reported.

This question is a sound platform for shaping reporting policy and is consistent with the Financial Accounting Standards Board’s conceptual framework. It is also the basis for Quality Financial Reporting, our new perspective for taking on the issues.

However, financial reporting can do more - much more, in fact. For one thing, it can help hold management accountable for its actions. In an ideal world, this constraint would not be necessary because managers would exercise self-discipline and always make decisions in the long-term best interests of shareholders. Unfortunately, self-interest kicks in and takes control unless the personal interests of the managers are somehow aligned with those of investors and creditors.

We believe that financial reporting can contribute a great deal to achieving this alignment. The fact that financial statement numbers matter to executives causes alignment to happen naturally when the balance sheet and income statement usefully report the consequences of management’s past decisions and actions. The statements are the scorecards used to assess management performance, both explicitly and tacitly. This scorecard effect is behind executives’ strenuous objections to FASB proposals that will report less income, increased leverage, or both.

Consider what can happen when assets, liabilities and expenses are kept off the books. In the face of their absence, where is the managers’ incentive to control them carefully and appropriately? If a manager can take on an obligation without reporting it as a liability, the item received in exchange seems to be free. What assurance do shareholders have that management struck the best deal possible in obtaining it?

For example, who can assess whether the asset acquired through an operating lease is earning an appropriate return in excess of the cost of unreported debt? Not shareholders, and probably not even management.

This flaw is magnified when the obligation is not due for many years (e.g., pensions). It also balloons when the managers are a party to the transaction (e.g., stock options). Without accountability in the financial statements, managers surely find it much more tempting to make extravagant promises.

Despite FASB’s efforts, many financial obligations are still purposefully left off the books, whether it be liabilities, pensions, special purpose entities or option obligations. Required disclosure in the footnotes for pensions and options helps investors understand that the obligations are really there, but it does little or nothing to overcome the incentive problem.

Without financial statement depiction, management can choose to act as if these debts don’t exist. Failing to account for any real expense on the income statement (or any real asset or liability on the balance sheet) will not motivate managers (or directors) to make wise decisions.

Whether these transactions are legitimate or not, the fact remains that defective generally accepted accounting principles cause them to be incompletely and inaccurately portrayed, and do not inspire management to exercise stewardship.

Of course, the real issue is whether the missing items are, in fact, free, economically speaking. If so, there should be no income statement expense. If they are not free, then they should not be reported as if they are, not just to give statement readers complete information but also to provide managers with incentives to use the costly resources appropriately.

To illustrate, we want to look at options one more time: Are they free or costly? This question was extensively (and fruitlessly) debated when FASB took it on in the 1980s and again in the 1990s (some are still debating it). Some were fond of arguing that options do not have a cash cost. This may be technically true if the issuer has adequate unissued shares to cover the option exercises.

However, there can be substantial cash cost when the shares have to be repurchased in the markets. Furthermore, the cash flow model for financial reporting was long ago rejected because it does not faithfully represent financial performance.

In essence, the act of granting options commits the company to sell its stock at an unknown date in the future at today’s value. If the stock value rises, the options will be exercised at a price less than what would come in if the shares were sold to anyone else.

This real cash discount is the ultimate cost of issuing the options. Any time a company issues shares without receiving full market price, all other shareholder claims are diminished. But if managers don’t report an expense upon issuing the options (or grossly underreport the expense using the SFAS 123 preferred method), there is no formal accountability for the dissipated wealth.

If accountability is to exist, Fictional Financial Reporting must give way to Quality Financial Reporting. As we see it, FFR doesn’t really fool anyone, but it costs shareholders plenty. They face added risk from making decisions based on incomplete information, and they suffer lower returns from the incentive problems described above. The combined consequence is low stock prices and high capital costs.

Greater accountability is another reason to believe that there is a great unmet demand for timely and transparent financial reporting. It really is as simple as this: Tell the truth, the whole truth, and nothing but. Anything less is pointless and costly self-deception.

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