We have a perennial puzzle we just can't explain to our satisfaction.Here it is: Why are managers so willing to go overboard in product development and promotion, yet so blissfully content in doing the least required when it comes to financial reporting?
We just don't understand why they're completely unwilling to discover what financial statement users would like to know and then go on to satisfy those demands better than their competitors. After all, there is a competitive market for information, just like for products and services. Prosperity will accrue to those who supply what is in demand in both markets.
THREE QUESTIONS
In effect, it appears managers have the attitude that they can "get by" if they just barely meet the minimum requirements under GAAP, instead of exerting maximum effort to produce truly useful financial reports. This thought raises three questions: Where does this attitude come from? What would happen if it went away? And what will it take to change things?
WHERE DOES IT COME FROM?
As near as we can tell, managers' dysfunctional attitude toward excellence in financial reporting can be traced to three misconceptions.
First, managers and accountants seem to think that GAAP (and IFRS) are some sort of infallible gold standard, such that compliance guarantees that users automatically believe and act on the resulting statements.
If this is what they think, then shame on them. It's clear that standard-setting is and always has been a political process, even highly so. Observers know that it involves intense pressure from people seeking spurious advantages.
What did managers think when accounting for options was being debated? Did they really believe analysts hadn't noticed that a key expense was not on income statements? Likewise, do they think users believe operating leases are just temporary rentals, instead of expensive off-balance-sheet schemes? And, heavens to Betsy, do they really think keeping changes in investment values under wraps will make users believe everything is cool?
They seem to think everybody is as gullible as Bernie Madoff's clients.
Second, we place a large part of the blame on lawyers who understand the capital markets even less than their clients do. The barristers are so worried about possible litigation from someone who might be misled by something management says that they overlook the fact that capital costs are much higher because of what management doesn't say.
We think lawyers are confused by their profession's norm that protects the sanctity of the courtroom. By that, we mean that much effort goes into determining what evidence can or cannot be used in reaching a verdict. Unlike a jury, the markets face no such restrictions on what they are allowed to see and hear. Analysts can use or ignore what's reported as they wish, and they're always on the lookout for other information wherever they can find it.
Third, most managers seem to have the bullheaded notion that capital markets are opponents, instead of partners. They see the economic process of allocating capital as a no-limit poker game in which only one winner takes all.
In fact, the markets are no such thing. They are (or could and ought to be) a paragon of cooperation, as managers reveal everything they can about their future cash flow prospects so they can get financing at the right price. Instead, what we get is very expensive bluffing, as if the markets can be fooled into paying too much. Oh, it's certainly true that bluffs sometimes pay off for a short run, but the magic can't last. While markets aren't 100 percent efficient all the time, they are certainly not 100 percent inefficient all the time.
We just don't see how managers continue to have the hubris to think they will be the one in a thousand who successfully tricks the markets into paying too much. Are they totally oblivious to the certainty that they'll do their own paying when the ruse is penetrated and the cost of capital soars because of the reduced demand for their stock?
We're sure that by now some readers think that we are completely wacky for even suggesting that managers should partner with the capital markets. After all, massive defensive ramparts on both sides have been built up over the years. However, we urge everyone to consider how supply chain innovations a decade or so ago caused companies to partner with suppliers who were formerly dealt with as enemy combatants. This cooperation has reshaped the production management landscape, and we think the prospects are just as great that it can do the same for financial reporting.
Surely there are additional reasons why so many managers are satisfied with minimal compliance with GAAP. If any of our readers have suggestions, we'd love to hear from you. Maybe we could put together another column based on your ideas.
WHAT IF IT WENT AWAY?
If managers were to comprehend that GAAP is composed of politicized minimum standards, we think much would change for the better. For one, the markets would be flooded with useful information every few days, instead of the convoluted and sketchy reports that begrudgingly appear once a quarter. It's ironic that most managers consider information about daily results for sales and other factors to be essential for getting their job done, but never consider how frustrated statement users get when they're kept in the dark for three months.
For another, frequent reporting of useful information would reduce the importance of analysts' earnings estimates. If a company's real results were to be reported more often, users wouldn't need to rely on guesses (often wild ones, at that) about what might have happened. Instead, they would already know.
The obvious consequence of abandoning this old do-as-little-as-possible attitude would be much less uncertainty and risk for investors. The reduced need for guessing and filling in the holes would enable analysts to actually analyze, instead of spending all their time hunting for the information they need. The end result will be lower capital costs and higher security prices. In the simplest terms, everyone will be better off.
WHAT WILL IT TAKE?
Maybe it's our own bias as educators, but we think that the solution is re-education to replace wrong-headed thinking with better ideas. However, something drastic has to happen to even raise the possibility.
Here are eight things on our checklist of what we think needs to fall into place.
1. A severe economic and/or market crisis that spurs reconsideration of the way things are. [Check!]
2. A new national administration committed to significant reform. [Check!]
3. A new Securities and Exchange Commission chair who understands the strengths and shortcomings of capital markets and is willing to institute reforms. [Check!]
4. A new SEC chief accountant who can articulate a new vision for what financial reporting should accomplish. [Not yet, but soon, we hope.]
5. U.S. and international standard-setting bodies composed of individuals who understand the flaws in the status quo and are inclined to create innovative standards that raise the required minimum level of information quality. [Check!]
6. An auditing profession that comprehends that its services would be more valuable if they verified economic truth, instead of minimum compliance with watered-down and otherwise useless GAAP. [Not yet, and we're not sure when.]
7. A management corps that experiences an epiphany that causes them to realize that capital markets thrive on information, including both quantity and quality. [Not yet, and we're not sure when, but perhaps the crisis will speed the day.]
8. A financial analysis profession that will stop taking abuse in the form of bad GAAP and even worse financial reporting. [Check!]
IN CONCLUSION
We see a lot of the right pieces falling into place, perhaps more than at any other time in history. Goodness knows, the economic need for useful information and the technology for processing and disseminating it are both in place like never before.
Will the audit and management groups see this opportunity? Or will it be the same old story of standard-setters and regulators chipping away at ignorance, slowly but surely raising minimum requirements?
We don't know about you, but we're ready for some significant action.
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.
