by Paul B.W. Miller and Paul R. Bahnson
Over the six years that this column has appeared in Accounting Today, our ideas about accounting and financial reporting have evolved. When it first appeared, it had a strong ethical tone because we thought a lot of problems would go away with a tougher system for bringing crooked accountants to justice.
Even then, we realized that ethics enforcement wouldn’t be sufficient to accomplish reform. Instead, it would take more political power to create new standards to force managers to change their behavior, despite their expressed inclination to withhold information and twist the truth. But, we grew disillusioned with that strategy because of the entrenched power brokers, their deep pocket books and their webs of congressional influence.
The next step for us was a quantum leap, and we trace its roots to "Financial Reporting in the 1990s and Beyond," a monograph published by the Association for Investment Management and Research, in 1993. It broke new ground by describing some of the analyst community’s frustrations with reporting practices and practitioners.
Among the topics was the cash flow statement. At one point, the AIMR committee wrote that managers ought to use the recommended but not required direct method if they wanted to build a better relationship with financial statement users.
This comment was an explosion of light because it revealed a new idea: users demand information that is not being supplied and they express that demand through the capital pricing mechanism. In other words, the better the information, the higher the stock price and the lower the cost of capital.
Virtually all at once, our perspective changed forever. No longer was the issue ethics or political power Ñ instead, it was economics. Those managers who engaged in the most reform with the greatest timeliness would reap the greatest rewards in the capital markets. By engaging in voluntary innovation without waiting for a bureaucratic process, they could enrich themselves and their stockholders more quickly and assuredly than by merely complying with generally accepted accounting standards, regardless of how well they constructed attractive but false images under those rules.
We eventually comprehended that we had experienced a classic paradigm shift, which is academic talk for a whole new way of looking at the world. From the beginning, we have used the phrase "Quality Financial Reporting," or just QFR, to identify these concepts.
Since then, we have found many new applications and new ways to explain them to others. We have written quite a few papers - more than have been published. We have also personally presented our ideas to a variety of audiences in the United States and Europe, ranging in size from only five to several hundred.
The world premiere occurred in 1997 before the members and staffs of the Financial Accounting Standards Board and GASB, and the latest presentation was an encore before the same group just last month. We have enjoyed great receptiveness, with a few exceptions, and both responses have encouraged and challenged us to perfect our ideas.
When Paul Bahnson succeeded Ed Ketz in this column, we decided that we would write more explicitly about QFR and use its concepts to analyze current issues. We have found it to be flexible and widely applicable, and we hope that your paradigm has changed as we have described its implications for such things as reporting cash flows, inventory, fixed assets, intangibles, stock options, pensions, investments and business combinations, as well as timeliness and auditor independence.
It has also helped us debunk tired and irrelevant arguments against progress presented to FASB by some corporate managers, auditors and members of Congress.
Given the apparent attractiveness of QFR, we explored the possibility of producing a book. Perhaps needless to say, the novelty was an obstacle, but we found a visionary editor, Ela Aktay at McGraw-Hill, and signed a contract in 2001. We submitted the manuscript in October, just about the same time that Enron announced its restated earnings for accounting irregularities.
Little did we (or anyone else) realize the significance of that confession, but, after three months, we pulled the manuscript out of production to add references to the disaster and a chapter describing it as the perfect example of how not to do QFR. Once the book is released on July 24, it will be available at most bookstores, including online outlets.
The book’s recurring theme is the need for managers and accountants to respond to users’ demands for greater quantities of more useful financial information. The incentives for doing so are described through four axioms: (1) more complete information creates more certainty for investors; (2) more certainty causes them to perceive less risk; (3) less risk makes them demand a lower rate of return; and, (4) a lower rate of return for them is a lower cost of capital for managers and leads to increased stock prices.
Thus, if someone wants lower capital costs and higher security prices, they should start by providing more complete information. Several chapters provide evidence in support of the axioms, including extensive quotes from financial analysts, other experts and empirical research.
Despite their simplicity and validity, ignoring these axioms has led to widespread occurrences of seven deadly financial sins: underestimating capital markets; obfuscating; hyping and spinning; smoothing; minimum reporting; minimum auditing and preparation cost myopia. Each can be remedied by acknowledging that the markets value truth and trustworthiness.
We also demonstrate how wrong it is to think that complying with GAAP is enough. After all, standards emerge from a political process characterized by multitudes of compromises. Besides, GAAP do nothing more than define minimum practices. Ironically, almost all managers stop when they reach those minimums instead of going further to really reduce uncertainty and reap the benefits.
They also miss this mark when they prefer auditors who are less than fully independent. And auditors are mistaken when they collude with clients to produce minimally informative statements or, what’s worse, to help them craft false financial images. In every case, these people are shooting themselves in the fiscal foot; in many cases, they’re unethical, too.
In addition, the book presents three checklists that managers can use to assess their attitudes and past actions to see how close they come to achieving QFR. Frankly, we expect few to be there. But, we’re not discouraged by that obstacle. Instead, as educators, we find it to be a huge opportunity.
Other chapters offer suggestions on how to achieve QFR by going beyond minimum GAAP and even beyond maximum GAAP to serve demands for useful information. One idea, for example, is to report far more often than just once every 90 days. After all, that standard was created in 1934 when information technology was relatively primitive.
Obviously, we’re excited that our ideas will be distributed more broadly. We hope that endorsements by Warren Buffett, Arthur Levitt and John Biggs, the chief executive of TIAA-CREF, as well as David Henry of Business Week and Justin Fox of Fortune, will help get our ideas out there. We really hope to convince a great many people to do things differently.
For those who regularly enjoy this column, you’ll find our ideas more fully developed in the book because we were freed from space limitations. In addition, you’ll discover many other dimensions of QFR that we have not presented here. And for those of you unfamiliar with QFR, we say, "Try it, you just might like it."
