Our previous two columns addressed the Securities and Exchange Commission's recently appointed Committee on Improvements to Financial Reporting, which has been charged with suggesting things that can be done to strengthen the system.Specifically, we have looked at some of the premises and other points in a discussion paper produced by the chair, Robert Pozen (available online at www.sec.gov), finding a few flaws here and there.
In this column, we follow up by looking at five more points in the discussion paper that deserve broader exposure and that will demand additional attention from the committee beyond what's in the paper.
A DIFFERENT KIND OF IMPASSE
Pozen makes the following point in describing conflicts between different constituencies: "For example, preparers often want less volatility in earnings, implying less fair-value measures, while users generally prefer that more assets and liability [sic] reflect their current values. This places tension on the desire to have financial reports that reflect the economic substance of the entity."
One gold star to Pozen for identifying a controversy that has stymied accounting standard-setters for more than half a century. However, he just drops this observation without considering its implications. Perhaps he thinks it is like a conflict between Republicans and Democrats, where the resolution is a matter of finding the right compromise to allow both to say they won something.
Well, it just isn't.
Poised on one side of the issue are those who provide information in order to support the value of their securities in the capital markets. Their problem is that choosing to not meet the consumers' needs leads to all sorts of penalties, especially a low demand for their securities and low values. This economic street is totally one-way, unlike political issues. If users don't get what they want, it's preparers who pay the price.
In other words, this isn't like Republicans versus Democrats, it's like General Motors versus car buyers. If GM doesn't give the buyers what they want, the carmaker doesn't sell many cars at good prices.
Accounting standard-setters can do absolutely nothing to change these fundamental market forces. Even if preparers get their way at the Financial Accounting Standards Board, users always have the last word. Nobody can make them believe bad financial statement numbers. They can either make their own revisions based on other information, or they can simply walk away altogether. The consequence is depressed stock prices, because they're poorly informed and well conscious of it. Hopefully, some committee members understand this point.
ANTICOMPETITIVE? SHOW US!
Later, Pozen again mischaracterizes the impasse under a section headed "Preparers vs. Users." He makes this trite point: "Most companies are reluctant to have more reporting segments because this may involve the disclosure of competitively sensitive information." We have three comments.
First, we have seen or heard this generality more times than we can count. We are still waiting for someone to offer any proof that segment information provides any competitor with intelligence that they haven't already gained through other means. It is said, we think, merely to rationalize not revealing more, in the hope that the capital market won't worry about what it doesn't know. A vain hope indeed.
Second, Pozen assumes that no managers will reveal useful information unless they are forced to and everyone else is also forced to. If information about segments is useful for setting stock prices, then smart managers should want to provide it. Further, they should want to compete for lower capital costs by providing more useful information than their competitors provide, instead of settling for the lowest common denominator.
Third, managers need to realize that they're competing in two markets: one for their products and one for their securities. They can't ignore the second and hope to succeed. Consider that advertising is done to attract customers by revealing what your product will do for them. Would you keep that information under your hat just to prevent your competitors from learning about your product? We don't think so, and we don't think wise managers will be bound by compromised minimum standards once they figure out how truly useful segment information will help the market reach a fair stock price.
CONSISTENCY ISN'T COMPARABILITY
In discussing the existence of alternative accounting procedures, Pozen seemingly takes a stance in favor of users when he says: "Providing companies with [accounting] options may be a useful compromise when there are acceptable alternatives, but it makes it more difficult for users to compare companies." Paul Miller actually addressed this fallacy in his first major journal publication nearly 30 years ago!
Specifically, consistency across firms is necessary but not sufficient for comparability. It does no good to have everyone use the same procedure if it doesn't put useful information in the statements. For example, if all companies report their marketable investments at cost, there will be consistency but absolutely no comparability, because like holdings will be reported at unlike amounts. In the same way, expensing all research and development costs certainly does not produce comparable information, because different companies have different degrees of success with their efforts.
Our point for Pozen and other members of CIFiR is that the best way to produce comparability is to get truly useful accounting practices written into standards. Once that is done, the problem goes away. But if bad practices are created, there's nothing anyone can do to produce comparability.
ALL THE COSTS, ALL THE BENEFITS
Pozen tips his hat to a perennial issue when he observes: "Determining the costs and benefits of a new accounting standard or rule involves difficult predictions. Often, the true costs and benefits may not be able to be fully known or understood until after the new standard or rule is fully implemented." Of course, they're not known even then.
Our advice to the committee is to be certain that you grasp the full panoply of costs and benefits for all parties. Don't fall for the old song and dance that only managers incur costs and only users reap benefits.
Nothing could be further from the truth.
In particular, user's processing and capital costs need to be considered along with preparation costs. If preparers reduce their out-of-pocket preparation costs, they unavoidably increase users' processing costs by a large multiple, because all users have to make their own estimates or adjustments to make up for the shortfall. In addition, their information lacks reliability, with the consequence that capital costs will go up. Further, it is true that users bear the preparation costs, since it is shareholders who pay for them.
Of course, management benefits from better information, too, if only in terms of being led to make better decisions about how to operate the company. And if they're also shareholders or option holders, they gain from higher-quality and more-costly information because it will encourage higher stock prices.
In short, a simple cost/benefit analysis is a pipe dream. A more complete analysis will almost always lead to a conclusion that more benefits will follow from additional but wisely incurred reporting costs.
To put a scale on things, suppose a company has a market cap of $5 billion and a cap rate of 12 percent. If better information causes the cap rate to drop by 50 basis points, the market cap could rise to $5.2 billion, while a decline of 100 basis points could raise it to $5.5 billion. That kind of bump is worth spending quite a few million dollars to publish more useful statements.
YOU'RE KIDDING, RIGHT?
We choked a bit when we read Pozen's gratuitous description of the standard-setting process: "FASB develops major standards based on a conceptual framework." He is either smoking something (unlikely) or believing press releases coming out of the board. FASB uses the framework, for sure, but standards are always inconsistent with it because of compromises.
A couple of sentences later, he says: "The conceptual framework, however, is not complete and is not consistent with all of existing U.S. GAAP." Of course not, and it never will be. The framework is a vision for what financial reporting can accomplish and how to get there. It was never conceived to be a description of practice. In fact, practice is such a mélange of compromises that no framework can ever describe it.
Our concern is that the CIFiR chair doesn't understand either the framework or how FASB works. He needs to listen to others, because it would appear that his compass and map aren't working.
GRAND SUMMARY
We have said a lot in this and the two previous columns. CIFiR is potentially a helpful committee. It represents a rare opportunity that comes along maybe once a decade. Alas, we've seen a lot of these efforts over the years, and virtually nothing of value has come from them except a few quotable comments. We've yet to see accounting standards take on a different form because of them.
But don't let our jaded pessimism rob you of your hopeful optimism. On the other hand, be sure that your optimism is tempered by the dozen or more points that we've made about the shortcomings in Pozen's vision for CIFiR. We simply don't have confidence that this effort will differ from those that have gone before.
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@qfr.biz.
