One origin of "The Spirit of Accounting" was concern over the lack of ethics in financial reporting. Eleven-plus years later, the same concern is alive and, unfortunately, thriving.Despite collapses of corporations and an accounting firm, perp walks, and prison sentences, we still encounter situations that make us cringe. We feel that way when we see how far some managers go to produce pretty pictures in their statements, and that their auditors don't stop them.
Our concern doesn't end there, as we contemplate why regulators are content with existing generally accepted accounting principles that are nothing more than political compromises that create or perpetuate practices designed to suppress, obscure and otherwise intentionally misrepresent truth.
We also question the academic community for tolerating GAAP's deficiencies for far too long. The fact is that promotion, tenure and prestige come from publishing articles in research journals that are more often than not about refining sophisticated methodologies than making practical recommendations for improving financial reporting. In fact, to many academics, normative prescriptions are out of bounds.
The unfortunate outcome is that many professors are unaccustomed to criticizing GAAP, and don't pass this important perspective along to their students. If practicing accountants aren't trained in college to question, it's no wonder that so many of them assume that GAAP compliance automatically yields useful financial reporting.
In contemplating these situations, we have tried to figure out exactly what causes this behavior to survive, despite evidence that it's dysfunctional.
THE TWIN ROOTS OF EVIL
Besides obvious ethical failings that promote bad practices or merely allow them to endure, we believe that most shortcomings in financial reporting can be traced to two character flaws. The first is unbounded ignorance and the second is shameless arrogance. In a sense, these problems are also ethical failings, because experts should be both well-informed and diligent.
* Unbounded ignorance. To be clear, there are differences between ignorance and lack of intellectual capacity. There are a lot of smart people who are woefully ignorant about a lot of things. For example, most people are ignorant about nuclear physics, opera and how cell phones actually work. Fortunately, that ignorance doesn't keep them from comprehending that power can be generated with a reactor, that certain opera passages are awesome, or that cell phones are useful for reaching others even if you don't know where they are.
The key point is that general ignorance on these areas has virtually no impact on others. But that is not always the case. No one would tolerate reactor designers who don't understand nuclear physics, opera musicians who have no clue how to present the composer's words and music, or cell phone engineers who don't know how to build wireless networks. To get more personal, our readers expect us to understand more than they do about financial reporting and the things we write about. In other words, it's OK to be naive and uninformed about many things, but inexcusable when you're an expert, because errors on your part will negatively affect others.
In light of this conclusion, we think that managers, auditors, regulators and educators act as they do because they are ignorant of two things that are well within the realm of their professional expertise: the broader purpose of financial reporting, and how capital markets work, especially when they are presented with incomplete information.
The purpose of financial reporting is to help improve capital market efficiency by supporting decisions by participants; in turn, this efficiency benefits all of society by making the economy more productive. The free enterprise system allows or even forces managers who need capital to compete with each other to get it from investors.
Like all others, the capital markets experience imbalances between supply and demand. Unlike others, these markets are not under the domination of any one entity, in that investors are totally free to invest or not invest in any company according to their assessment of the amount, timing and uncertainty of the cash flows from various investments. Further, investors' incentives drive them to make careful analyses of future cash flows, or to hire someone who can do it for them. Importantly, no one can be compelled to invest in any company.
When financial reports are more informative, investors face less uncertainty and have a higher demand for the reporting company's securities; in turn, this lower risk leads to higher prices. The opposite happens when reports are poorly constructed and otherwise uninformative. It happens with great gusto when management is known or even just perceived to have produced deliberately misleading reports, even when they've complied with GAAP.
In other words, the inevitable reaction to useless information in financial statements is downward pressure on stock prices.
Managers who are ignorant of these economic facts must somehow believe that they can con others into paying more than they would pay if they knew the truth. Auditors ignorantly aid and abet these perpetrators because they are more concerned with the process of constructing the statements than with their contents and impact on users and stock prices.
The unavoidable consequence of all this is depressed security prices and auditors who earn little from audits because they don't add much value to GAAP statements that are known to produce useless information. Regulators enforce empty rules and professors train instead of educate.
* Shameless arrogance. Compounding the ignorance is the prevalent shameless arrogance that compels many managers to believe that they really know more than anyone else. As described in the book about Enron by Bethany McLean and Peter Elkind, they seem to think they are the smartest guys in the room. Well, they aren't.
To explain: Capital markets are pretty efficient, especially in penetrating flimflam reports constructed using loopholes in GAAP. In the face of still-mounting evidence of efficiency (albeit less than complete efficiency), virtually every management team seems to think that they will be the one in 10,000 that actually fools the markets into paying too much for their stock. They also think that they can then maintain the ruse for the long term.
If they weren't so deathly intent on using GAAP to produce rosy pictures, it would be downright silly. As it exists, this arrogant game is nothing short of pathetic. It is also ironic that it produces inefficiency, where simply telling the truth with clarity and completeness would produce the results they are seeking: higher long-term stock values.
Once the problem is articulated in this way, part of the solution seems pretty clear. First, management education needs to wipe out the antiquated thinking that sophisticated capital market participants look only at published financial statements and take them at face value, bidding stock prices higher and higher as the pictures get rosier and rosier. For those who are already the victims of a poor past education, it's never too late to learn something new. They need to trade their naive ignorance for thoughtful knowledge that the markets are driven by real information, not propaganda.
As for arrogance - well, it has existed for millennia. It inevitably brings itself down, as reflected in the old proverb that "Pride goes before a fall." Proud managers (and their auditors, as well as others) are so enamored of their abilities that they fail to see the flaws in their thinking. You'd think jail terms and other negative consequences would sink in and change their behavior. Then again, maybe not.
We'll close by observing that roots of evil are also roots of opportunity for those who recognize ignorance and arrogance for what they are. There can be no doubt that future capital markets will be composed of participants on both sides who understand how they work and thus approach them humbly and with great respect. Instead of playing silly games of deception, they will lay their cards face up on the table and seek partners, not victims of transparent con games.
We ask readers what they're going to do with this analysis. Will they keep playing the same games, or will they be the first to embrace the future? We'd like to know.
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 email@example.com.
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