Our previous column kicked off a series on the Financial Accounting Standards Board's new project to update the 25-year-old conceptual framework by proposing that it explain that the mission of financial reporting is to promote the efficiency of capital markets and, in turn, economies. Among other things, this modification would inject a new criterion into the board's decision process as it frames, analyzes and considers issues.
This shift would, we think, tilt financial statements toward serving the public's needs instead of the narrow needs of the board's competing constituents. This column picks up that theme and applies it to the objective of financial reporting.
According to SFAC 1, issued in 1978 after several years of due process, "Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions."
This definition seems innocuous and obvious, but the historical record shows that not even 40 percent of the comment letters on the exposure draft supported this objective! It makes one wonder what these respondents thought. At the time, then-FASB project manager Diana Willis said, "Who, for heaven's sake, would argue that financial reporting should provide useless information?"
Even though we would not change anything in this definition, we would clarify its meaning and implications for the standard-setting process.
We have come to realize that useful financial information is like a two-mile run every morning, or cod liver oil, or other elixirs that promote good health. Although they're good for you, they can be unpleasant. On any given day, it's tempting to skip a jog or a dose, but in the long term, it's much better to stick with the discipline.
In the same way, it's good to develop the habit of publishing genuinely useful financial statements. It takes resolve to forgo the illusory benefits of optimistic reporting. In the long run, though, it's wiser to supply capital markets with complete, reliable and timely information in order to have lower capital costs.
Politics of standard-setting
The reporting world is more complicated than we used to believe, especially back when the framework was created. It's clear that reporting occurs in a political context that is currently characterized by competing individual interests, thus making it difficult to achieve win-win solutions.
Instead, issues are framed in such a way that standard-setters must choose who wins and who loses. These decisions are difficult because it is likely that the collective welfare of all constituents won't align with what seems to be the welfare of any one constituent, individually or as a group. Most important, standard-setters must resist caving in to the most vocal or obnoxious participants.
The three big constituents in the current mix are: managers, auditors and statement users.
Traditionally, most managers approach standard-setting defensively, fighting all proposals for change so that they can avoid revealing something that they would rather keep to themselves. It's safe to say that they want to protect their ability to look good so they can achieve some other goal, like keeping their jobs or producing a higher stock price. If you need proof, see how many of the 31 APB opinions and 150 FASB standards force managers to stop recognizing expenses and liabilities or require them to recognize larger revenues or make them put more assets on the balance sheet. None.
In fact, standards are always pushing managers in the opposite direction, over their objections. Their attitude is understandable, but it is intolerable when it causes standards to fail to provide useful information that would make the markets and the economy more efficient. This resistance to change is actually self-defeating in light of the inflated cost of capital paid by managers who are unwilling to provide more informative reports that would reduce users' risk.
It's more challenging to characterize what auditors are doing. In the beginning, standard-setting was the province of the auditing profession, but that leadership role has been sacrificed to the competitive drive to placate existing clients or attract new ones. As we observe history, auditors have used the political process to create safety for themselves by avoiding retribution from disgruntled (and litigious) statement users while not upsetting clients. This attitude is also counterproductive. If information is not useful for making financial decisions, then all auditors can do is attest to its uselessness, and no one gets rich providing that service.
What about statement users? On the whole, they lay low in the process. The CFA Institute has elevated this group's visibility, but the record shows that participation by users has been sparse, even very sparse, and generally not very effective. Reasons suggested by an Association of Investment Management and Research committee include claims that users trust the accountants, don't have the technical capacity to participate, or simply don't have time.
On one level, their abdication is counterintuitive - after all, shouldn't users be calling for more disclosure? However, imagine that you're a sophisticated user with private sources and proprietary analytical techniques that provide unique insights. Why would you fight for new public information that takes away your information advantage? This protective attitude is understandable, but society is not well served when it is indulged. The free flow of information is much to be preferred because it enhances market efficiency.
As we said, the political process flounders if it tries to accommodate each group's interests. The unfortunate truth is that FASB seems to have attempted to do just that, and its activities are characterized by political struggles at every turn.
Although the due process was conceived as a way to find and fix errors before standards are issued, it has become a battleground for competing selfish interests such that, we think, the board's main goal is crafting palatable answers that will satisfy disparate interests, soothe vocal opponents and otherwise compromise away the best answers. How else did we get SFAS 123, which recommends reporting options expense but permits footnote disclosure?
We welcome the resuscitation of the CFW project as a golden opportunity to restore and reform the due process.
Collective vs. individual
The solution lies in grasping that decision usefulness is collective. In any given situation, what is good for the collective whole will likely go against what individual preparers, auditors and even users might want.
For example, moving toward market values in financial statements may upset managers who don't want to reveal these secrets, auditors who think that the numbers will be difficult to verify, and users who have developed effective estimation methods. Nonetheless, it will be good for society if market-based information pervades the capital markets, because managers will make better decisions, auditors will add genuine value to relevant information, and users will compete using their ability to predict the future instead of just getting good at figuring out the present.
Of course, the ultimate beneficiary of this progress will be the collective public, which will harvest the fruits of more efficient capital markets and more productive economies.
The good news is that the route to this better world does not require that the CFW objective be rewritten - in fact, it's fine the way it is. The key is getting the board and its constituents to comprehend that the public interest must trump all self-interests. The litmus test for acceptability is not whether the majority of constituents agrees with an answer, but whether it enhances the capital markets.
All of us must get comfortable with the fact that doing what is right for society will always displease certain constituents. This political paradox is what makes standard-setting so challenging. However, a steady focus on the greater public good will give standard-setters and others a better rationale for disregarding claims by contentious constituents.
Bottom line, we encourage FASB to proclaim that useful information is seldom popular with its constituents, but that it is nevertheless good for them and the public at large.
Bring on reform; let's even make it a revolution. There's no time to lose and plenty of usefulness to be gained.
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
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