Every so often, we surprise ourselves when we read an old column and find it expresses some useful ideas that we put aside after we moved on to other urgent issues. Here's an example from January 2011, where we put our fingers on perhaps the most fundamental misjudgments displayed by a great many capital market participants.

Okay, we'll admit it up front: We're inveterate wordsmiths who love to work with language to make our points. We've even invented a few new words along the way to describe some financial reporting topics, such as "pfooling of interests," "volatilaphobia" and "duh-preciation."

We want to make a significant point in this column by focusing on two common words that everybody uses hundreds of times a day. Specifically, it matters whether someone thinks the capital markets exist for their benefit or to their benefit.

 

THE QUESTION

To start, we ask for whose benefit do capital markets exist? The answer is actually very simple: everyone's.

The capital markets' role in a free economy is to efficiently connect those who demand capital with those who supply it. If that efficiency exists, then capital is priced optimally, reflecting expected future returns and the associated risks.

Without efficiency, economic activity, growth and stability are all jeopardized. With it, though, a society's economic system more readily fulfills its functions of generating and distributing wealth.

One main factor that created and sustained the Great Depression was inefficient capital markets that had little or no liquidity, trust or useful information. Because people lacked confidence in the markets, those with capital were unwilling to supply it and those who needed it could not obtain it. We think those same kinds of friction exist in today's economy.

Our key point is that the role played by the capital markets is to help the economy contribute to society's overall wellbeing. To the extent that anything creates friction, the economy and society suffer.

 

TO THEIR BENEFIT?

Within that context, it takes an intricate interplay among four main participating groups to make the markets work for society's benefit. Because individual members of the groups gain from their distinct contributions, it's true the markets work to their benefit. In a sense, society rewards them for services rendered.

Consider managers who issue public securities: The system allows them access to fresh capital in primary markets, enabling their companies to come into existence or expand and then go on to provide goods and services, as the case may be. They use their shares as currency for buying assets and even other companies, and, of course, as their own compensation. The secondary markets create liquidity and establish the securities' value as well. Thus, markets benefit the economy, shareholders and managers.

The markets also sustain auditors by enabling them to have above-average income and social respectability in exchange for providing the valuable service to society of adding credibility to managers' self-generated representations in financial reports.

Third, financial statement users, including investors and financial analysts, can access many investment opportunities with an array of returns and risks. This diversity promotes wise investing and greater income for themselves and their clientele.

These users are the main mechanism for creating efficiency as they pore through reams of data to find the best investments for their goals. They help society by putting every security in play and enabling efficient equilibrium prices to be reached quickly. Their reward is the chance to accumulate substantial wealth.

Fourth, there are regulators, including accounting standard-setters. Like auditors, the markets provide them with respectable and satisfying livelihoods, primarily by creating and enforcing regulations that aim to reduce systemic risk by building confidence in the markets' fairness. In return, they are admired for their integrity and can take pride in contributing every day to society's prosperity. Former Securities and Exchange Commission Chief Accountant Walter Schuetze once explained that he felt it was his duty each day to carefully protect the capital markets by cradling them like a delicate crystal vase.

Of course, many others make the markets work, such as brokers, exchange managers, investment advisors, mutual fund managers and marketers, bankers, venture capitalists, and media pundits. We'll focus on the above four because of their direct involvement in financial reporting.

 

WITH BLINDERS ON

Unless they adopt a broad perspective, all these people see only their specific part of the system through the blinders of their self-interest and come to believe they're entitled to use their power, wealth and position to get what they "rightfully" deserve. Like self-focused adolescents, they may literally believe the markets exist for their benefit, instead of seeing they are only bit players in a bigger game in which they are allowed to participate to their benefit only because of their contributions to a greater good.

 

THEY'RE MISSING THE POINT

Alas, many, and probably most, participants seem to act as if the markets actually exist for their benefit, unfortunately to the detriment of everyone, even themselves.

Because they can, many managers deal with other people's money like there's no tomorrow. They think nothing of shading the truth in their financial reports to pull down immense compensation. At times, it appears they're so intent on feathering their nests that they forget common decency and even the law.

We're afraid that auditors have also become self-absorbed to the point that they resist any change that would cause them to audit new information and expose them to what they see as unacceptable risks. What they don't see is that their defense of the status quo prevents useful information from reaching the markets. By attesting only to compliance with GAAP, their opinions are not particularly valuable because they merely affirm that the financial statements present mostly useless information. We think auditors also fail to comprehend that their being paid by clients diminishes the essential trust factor.

As for investors and analysts, many engage in self-serving deals that weaken the markets' contribution to society's overall benefit. In addition, they focus on forecasted and reported GAAP earnings per share as if they mean something, when all should know that they're so compromised that they're basically worthless. The consequence is a lot of market friction when "earnings season" rolls around every quarter.

Analysts' public proclamations about meaningless EPS amounts (and the media's mindless echoing of them) destroy market efficiency, even if some individual analysts are benefited. Other misbehaviors are "pump and dump" and short-selling while bad-mouthing a stock.

Regulators are not immune to turning inward. Sometimes, for example, it looks like they get so focused on finding politically acceptable and enforceable rules that they forget that their jobs exist to ensure that the markets are fairly informed and operated.

We think of pension accounting as an example because the bizarre compromises that were injected into GAAP 30 years ago remain largely unchanged primarily because regulators (including the Financial Accounting Standards Board) haven't wanted to go through a controversial due process to fix them.

In effect, all these parties operate at cross purposes, not only among themselves but contrary to society's interests in efficient capital markets.

 

AN EPIPHANY

What we see is a need for a massive epiphany that will reveal to the participants that they can earn greater rewards with integrity by helping the markets perform for society's benefit. Then, if society is benefited, they will be much better off themselves.

For managers, it would mean focusing on what they should do best, which is managing enterprises to generate wealth through innovation and meeting demand for their goods and services. If they do a good job, they will be honestly (and handsomely) compensated without crossing a line into unethical behavior.

A key would be their realization that the best way to increase their securities' value is by providing useful, complete and timely information. No obfuscation, no truth-bending, no withholding bad news, no propaganda, just the truth, the whole truth, and nothing but the truth, so that all can understand.

For auditors, this epiphany would lead them to see the benefit of verifying the actual truthfulness of managers' reports. They would add much more usefulness to financial reports by affirming their trustworthiness than by today's practice of merely confirming that they comply with arcane, compromised and outdated standards.

They would also recognize that their opinions are helpful only when they are acting with true independence from their clients.

For statement users, we hope these epiphanies would allow them to do what they do best - specifically, use truthful information to assess the amount, timing and uncertainty of future cash flows.

Their minds should not be wasted digging through deceptive GAAP reports that devious managers craft with their auditors' blessing. In addition, information risk created by untrustworthy financial reports would be dramatically reduced.

For accounting standard-setters, this epiphany would lead them to encourage all parties to replace their bad habits with positive innovations. Regulators can also help by calling on all parties to embrace change while consistently dropping heavy hammers on those who act like the markets are their personal sandboxes.

 

IS THIS POSSIBLE?

We know, we know. These ideas sound like they come from an ivory tower. In fact, they do because we're not caught up in the markets for ourselves. Our goal is to put a new intense spotlight on obstacles that keep them from reaching their full potential.

It's often said humans use less than 10 percent of their brain power. We think the same is true for markets, except that the percentage may be even lower.

For sure, no one has yet seen what can be accomplished when great minds from all four market sectors come together to seek their mutual interests in the context of serving society.

However, until this epiphany occurs, inefficiency will reign and the markets won't come close to creating value up to their potential, because the participants don't seem to understand the markets operate to their benefit, not for it.

Paul B. W. Miller is a professor emeritus 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 pauland-paul@qfr.biz.