We’re bringing back a column from 2007 that attacks the essentially unanimous mistake of focusing on the costs of providing information without giving sufficient attention to the benefits gained by incurring some costs and the benefits lost by cutting others. The encore is inspired by the Financial Accounting Standards Board’s “Simplification Initiative” that the board hopes will “improve or maintain the usefulness of the information reported to investors while reducing cost and complexity in financial reporting.”

Everyone likes better results for less money, but we’re certain that simplification is not the best path toward the fundamental financial reporting reforms that are so obviously needed. Our premise asserts that people are strongly inclined to manage what gets measured, and to ignore what doesn’t get measured.

We also assume that CFOs are evaluated using the costs of preparing their financial statements, not the benefits generated from producing more informative reports. Thus, they’re incentivized to economize on their preparation efforts without concern for any other consequences. Our key recommendation is that the cost of capital should be included in CFOs’ evaluation criteria. Read on … . .

Ask ten accountants on the street what they think about Sarbanes-Oxley, and ten will say, “It costs way too much!”

Next, ask ten accountants why their company or their clients don’t report operating cash flow using the recommended direct method (instead of the indirect method), and ten will say, “It costs way too much!”

Then ask ten accountants what they think about quarterly reporting, and all of them will say, “It costs way too much!” These assessments have been repeated so many times that no one seems to doubt them, except us.

 

ALL COSTS AND NO BENEFITS

FASB’s original Conceptual Framework asserted the simplistic “pervasive constraint” that the benefits from useful financial information should exceed the costs. Of course they should, but there’s more to say.

Managers always cite this constraint when they confront the board about proposed standards. They smugly believe that all reporting costs are borne by them while all benefits flow to financial statement users. From their perspective, providing information to the capital markets is all pain and no gain.

Their mistake is that they look only at the easy-to-measure costs of operating their GAAP reporting systems. Naturally, new standards tend to increase those costs. What they consistently overlook is what happens after they publish statements based on the new standards. Actually, if users receive greater quantities of more useful information then managers’ capital costs will decline, bringing potentially huge benefits to everybody.

 

IRRESPONSIBILITY ACCOUNTING?

We suggest that this shortsightedness about the benefits of reporting is nurtured by the responsibility accounting systems imposed on CFOs and controllers.

Because financial reporting doesn’t generate obvious revenues, their shops are surely evaluated as cost centers, not profit centers. Thus, they’re motivated to resist any changes that increase their costs. Further, they’re inclined to reduce those costs, perhaps by using the indirect method for operating cash flows, for example. It’s also no surprise that they wish they could report every six months, instead of each quarter.

However, they’re missing a really big point.

Cost centers are widely used despite their all-too-common pitfall of creating perverse incentives that distract managers from serving their real customers’ needs. For example, we’re reminded of a decision on one of our campuses to stop preparing employee reimbursement checks for amounts under $50 because it “cost way too much” for the treasurer’s clerks to process them. For the sake of cutting these costs, everybody else had to waste their valuable time trudging across campus and standing in line to get paid.

Obviously, this arrangement did not reduce costs at all. Rather, it merely shifted the burden of some costs from the treasurer’s office to the people it is supposed to serve.

That true story carries a moral for financial reporting. In particular, when CFOs compromise reporting quality, they’re not really saving money. Sure, they’re reducing their own out-of-pocket costs, but they’re imposing on others much larger costs that are huge multiples of their spurious savings.

They’re being penny-wise but pound-foolish, all because their evaluations are based on cutting their costs without regard to what happens elsewhere.

 

USERS’ COSTS

We’ve observed that many accountants and managers harbor the false idea that financial accounting is an end in itself, not the means to an end. Because it must be accomplished by law or by contract, and because it must be done according to GAAP, the process focuses on compiling the reports as cheaply as possible while neglecting the needs and interests of those who use the information, or who would use it if it were useful.

Consider again the direct method of reporting cash flow. In response to managers’ objections, FASB succumbed to the myth that statement users can easily convert an indirect tabulation to a direct one. Specifically, SFAS 95 (ASU 230) allows managers to present only the indirect, a choice that the managers of 99+ percent of public companies have made to reduce their preparation costs.

However, these purported cost savings are illusory. We tested this popular myth in the 1990s and published our results showing that it simply isn’t true. After analyzing 10,000 annual reports, we found that implementing the indirect method is more costly than conventional wisdom suggests. Our key evidence was the almost universal significant disparities between working capital account changes on cash flow statements and those indicated on balance sheets. These differences arise because the effects of non-operating transactions are hidden away among their current asset and liability transactions and have to be painstakingly tweezed out before applying the indirect method. In short, this non-articulation between cash flow statements and balance sheets means users cannot readily produce their preferred direct method presentation.

Therefore, the relevant trade-off is between the company’s cost of preparing a direct method presentation once (with full access to all relevant records) in comparison to huge redundant costs incurred by a host of statement users who must each guess at the truth because they can’t tell precisely what happened. We’d venture to say that the preparers’ savings are a pittance when compared to the combined increase in all users’ costs.

Our point is that reducing preparation efforts doesn’t reduce total costs. Instead, the CFO only shifts them over to financial statement users while making them much larger.

 

THE REBOUND EFFECTS

As if that isn’t bad enough on its own, two other rebound effects occur when CFOs slash their costs. First, the users don’t incur their additional costs without extracting some compensation, namely a higher rate of return. Second, their residual uncertainty from relying on their own rough estimates means that they face more risk. In turn, they’re compelled to demand an even higher return.

The consequence is also twofold. The users’ higher return rate translates into a higher cost of capital that can cause the reporting company to burn through a lot of money in a year. In addition, the markets’ demand for a higher return depresses the value of the company’s stock.

The double-whammy means that a CFO’s seemingly prudent decision to cut preparation costs by, say, $100,000 a year, could be taking literally millions out of shareholders’ pockets through higher capital costs and depressed stock prices. That’s a terrible outcome. The solution is fairly simple, but we know managers will resist because, “It will cost way too much.”

 

HOW TO FIX IT

Our simple solution is to make CFOs accountable for their companies’ cost of capital in order to encourage them to make more careful decisions about cost/benefit trade-offs.

Suppose that a CFO is considering an innovation that would increase reporting quality by exceeding GAAP’s requirements, such as using the direct cash flow method or providing understandable pension footnotes, supplemental information about market values, and monthly reports of key statistics. Since the CFO’s compensation would be tied to the cost of capital, which is known to be strongly linked to reporting quality, then these improvements will first reduce investors’ risk and their analysis costs and go on to promote a higher value for the company’s stock.

The end result? More compensation to the CFO and happier shareholders. It’s win-win.

We especially note that the motivating force for more quality won’t be coercion from FASB or the Securities and Exchange Commission, but Adam Smith’s invisible hand, pushing management to personally gain by serving the capital markets’ needs.

From this base, the next step would have managers realize that they would gain by providing better information than their competitors in the capital market. After all, doing well in that market is just as important to the shareholders as capturing market share for the company’s products.

We confess that we’re astonished when managers boast about how well they serve their customers’ demands while they simply turn their backs to the obvious needs of their capital market partners.

We’re sure that paradox wouldn’t happen if they started to actively manage their capital costs by providing significantly more useful financial reports.

 

WILL IT BE DONE?

We used to think that reform in accounting would be easy — just show managers and accountants a better way and they’ll go for it.

Well, it isn’t so. Shortsightedness and inertia abound in the management corps, as well as in the corporate and public accounting professions.

Will they jump at this suggestion? Don’t count on it. They should, but, after all, they are accustomed to pinching pennies for themselves while losing megabucks for their shareholders. AT

Paul B. W. Miller is an emeritus 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 or Accounting Today. Reach them at paulandpaul@qfr.biz.

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