Although most everyone involved in financial reporting studied economics, we’re certain they didn’t learn enough, or have forgotten too much, about opportunities that exist whenever demand for something is not served by those who could supply it.
Ironically, these opportunities are often found where longstanding monopolies have operated without competition. Historically, most monopolists try to violate the law of supply and demand by setting prices higher than delivered value and/or not updating their products and services. To their shock, disregarding their captive customers’ needs makes them vulnerable to innovative competitors who find new ways to supply what’s demanded. Formerly stable markets for retailing, telephone service, recorded music, taxis and television have all been recently disrupted by such innovators.
This column targets the monopoly-enabled stagnation in financial reporting that has for too long seen those who ought to supply useful information utterly neglect the needs of those who demand it. Because these suppliers are complacently self-satisfied with their seemingly safe situation, users are stuck with suboptimal public information for supporting their decisions.
We’re writing to encourage at least some managers and accountants to start actually supplying what users demand.
HENRY FORD AND GAAP
We assert that huge opportunities await whoever abandons the existing supply-side perspective on financial reporting and begins to adopt a new demand-side outlook.
Henry Ford unforgettably displayed supply-side thinking when he quipped, “Any customer can have a car painted any color he wants so long as it is black.” Likewise, today’s managers, auditors and regulators have declared that, “Users can have any financial information they want so long as it complies with GAAP.”
Unlike Ford, who quickly offered more colors as soon as he could, financial reporting practitioners keep doing things the way they’ve always been done.
Supply-side managers pursue two unwise goals while relying on three false premises.
The first premise assumes that accounting standards define the most that managers must report, not the least. The second asserts that they bear all reporting costs while users reap all the benefits. (In fact, both incur costs and enjoy benefits.) The third premise says that they have no reason to compete in the capital markets by presenting more useful financial statements.
These managers’ first goal is trying to boost their stock’s market price by creating fanciful financial images that don’t reveal useful truth. Their second goal is minimizing compliance costs without any concern for the additional costs that they impose on users. Ironically, they often go astray and waste money pursuing obvious ruses like off-balance-sheet financing.
In contrast, demand-side managers pursue two wise goals based on three solid premises.
Their first premise acknowledges that standards are mandatory minimums produced through a compromised political process that has not kept up with technology and changes in users’ needs. To them, fully informing the capital markets offers a great opportunity.
The second holds that both preparers and users not only incur costs but also reap benefits from satisfying the markets’ information needs. As a result, these managers consider far more than just their own costs of compiling their reports. Specifically, they’re sensitive to the users’ costs of obtaining and analyzing information, as well as their own cost of capital.
The third premise recognizes that they face stiff competition in capital markets for investors’ money. Countless research studies show that companies that provide better information do better (in terms of lower capital costs) than other companies that are presumably run by managers who don’t understand the situation.
Demand-oriented managers first aim to cultivate mutually beneficial partnerships with markets through trustworthy and transparent reporting that exceeds minimum requirements. In short, they aim to tell the truth, the whole truth, and nothing but.
These managers’ second goal is wisely managing all their reporting-related costs, not just minimizing their compliance costs. Because they know they can make money by spending money, they’re willing to incur the costs of innovating because they expect to more than recover them through lower capital costs and higher market values for their shares.
WHAT’S THE DIFFERENCE?
To help explain this difference, we suggest that the information technology industry is demand-driven while the U.S. Postal Service is supply-driven. The former is constantly innovating, building and destroying technologies (and companies) at a breakneck pace while delivering outcomes their markets demand. The latter, on the other hand, is still basically going about its business just as it always has, and keeps losing market share to its competitors.
We’ll let you decide which of those two the financial reporting profession more closely resembles.
We observe that supply-thinkers treat capital markets as a “necessary evil” that they begrudgingly report to simply because they must. In their view, reporting standards exist primarily to produce rigid uniformity. They shape their accounting policy decisions to achieve compliance and implement them with spurious precision, all without assessing whether their reports are actually helpful. It’s no surprise that they never consider adopting any new practices unless they can enhance their contrived images or are forced to change.
We’re convinced these attitudes have promoted an innovation-stifling malaise among managers, accountants, auditors, standard-setters, regulators, and, yes, academic accountants and textbook writers.
We’ve also concluded that the lingering drumbeat for international standards is a thinly disguised self-serving effort to keep practice from evolving. The misguided advocates are pursuing this hoped-for but nonexistent advantage from global uniformity, all while couching their support in vacuous terms with spurious references to meeting users’ needs.
On the other hand, managers who aim to serve users’ demands have completely different attitudes that push them toward providing truly useful information.
To them, capital markets are not adversaries but essential associates who need to be fully informed. They know that high-quality reports nurture productive relationships with multiple benefits for everyone. They want their policies to provide the most truthful and useful information, not simply replicate what everyone else does or merely comply with politically compromised standards.
Because demand-thinkers know that innovation can enhance reports’ information value, they try to discover and provide what users need. They also understand that precision never overpowers usefulness, as reflected in the adage that, “It’s better to be approximately right than precisely wrong.”
We lament that virtually all of today’s financial reporting practitioners are so blinkered by traditional education and experience that they cannot yet see the world from this angle.
We know the supply-driven perspective dominates because so many preparers act as if there are no advantages to having fully informed capital markets. In particular, they’re content to publish GAAP financial statements that deliver very little that is actually useful. Sure, they report many facts, such as assets’ original costs, but most aren’t relevant for users’ decisions.
Even worse, financial reports are filled with other items that are neither relevant nor factual, specifically results of depreciation and other systematic allocations based on assumptions and predictions instead of observations. The result is an earnings-per-share number that is so contaminated by compromise, omissions and shortcuts that it cannot be rationally applied to any decisions. We shudder to think about how much confidence is placed in it.
In addition, supply-thinking’s dominance means the two of us haven’t personally witnessed any truly fundamental positive reforms in GAAP during our accounting lifetimes (going back 50 and 35 years). If data- processing technology had progressed at financial reporting’s rate, accountants would still be using No. 2 pencils and multi-columned paper spreadsheets.
Sure, standard-setters claim they’ve produced reform, but they’ve kept what we call a “pivot foot” anchored firmly in the status quo. For example, the Financial Accounting Standards Board eliminated pooling and brought current values for the acquired entity’s assets and liabilities onto the new entity’s balance sheet. That’s good, but why didn’t they require the same measures for the acquirer’s assets and liabilities?
The real proof that supply-siders aren’t meeting statement users’ demands is the latter’s dependence on analysts’ projected earnings and various self-generated non-GAAP measures when they try to estimate a stock’s intrinsic value.
We project a bleak future unless an epiphany enables monopolistic information providers to escape their oblivious supply-dominated paradigm. Absolutely none of them can evade the economic forces that crush suppliers who disregard demand.
HOW TO CHANGE?
The world will be better off when these seeds of reform take root:
- Managers grasp that they need capital markets more than the markets need them.
- Managers understand how the cost of capital affects their companies and how reporting useful information can reduce it.
- Everyone comprehends that managers and users alike incur the costs and enjoy the benefits of useful financial reports.
- Managers perform research to identify what users really need to make their decisions and stop waiting on political bureaucracies to create innovative new practices.
It isn’t enough for us to tell supply-side managers to “think outside the box” because most don’t realize they’re in one. In fact, the only way they can lose their unproductive mindset is by embracing the completely different demand-side paradigm that has helped so many others achieve prosperity.
Then, and only then, will they quit acting like monopolists and start producing genuinely useful reports.
WHO WILL LEAD, AND WHEN?
Alas, our call to move to the demand side will appeal to only a few (as of now) who are willing to see that it’s unproductive to treat capital markets as an annoyance and financial reporting as a burdensome compliance activity.
We’re explicitly recruiting adventuresome managers and accountants who would have no problem disrupting the moribund financial reporting world.
As for when to start, that’s easy: Now!
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 firstname.lastname@example.org.
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