The Spirit of Accounting: A tale of two theories of evidence
For decades, we’ve tried to understand why so many managers make questionable decisions when selecting and implementing their financial reporting policies. As if they’re oblivious to the adverse consequences, virtually all of them choose to report obscurely instead of clearly.
We have three familiar hypotheses that help explain this unproductive behavior. And a fourth that’s radically different.
The first explanation suggests that managers’ ethics unwisely embrace bending, twisting and otherwise distorting the truth. Some, even many, seem willing to deliberately report half-truths and even untruths as long as doing so serves what they misguidedly consider to be their best interests.
Second, we think many, perhaps most, managers are indifferent to what market efficiency implies for financial reporting. In particular, they fruitlessly manage their financial statements because they attribute way too much power to them. For example, we think they wrongly believe that stock prices are driven solely by reported earnings, that market participants cannot see through the earnings games the managers play, and that quarterly reporting is sufficient because markets assess risks and returns only infrequently.
Third, we believe they’ve embraced a “herd mentality” that drives them to never stray from the norm. Paradoxically, the idea of being the first to go above and beyond minimum GAAP requirements strikes fear in the hearts of managers, even those who are otherwise genuinely visionary and innovative, even disruptive, in every other aspect of their business.
We turn now to a fourth hypothesis that sees managers as not-quite-so-innocent victims.
Specifically, we find that attorneys’ advice stifles any potential management efforts to improve their financial reporting policies because they mistakenly impose their legal theory of evidence on managers with absolutely no consideration for the capital markets’ needs for useful information.
As background, practicing law is fundamentally an adversarial conflict-resolving process in which attorneys are either advancing or defending their client’s interests versus another party’s interests. This foundation causes lawyers to advise a client to release information under only two circumstances:
- Its message advances the client’s interests in the dispute.
- A court order or other legal mandate requires the client to disclose it.
Even in the second situation, attorneys instruct their clients to reveal nothing more than the least they must.
This legal theory is applied during the discovery phase of litigation when each party goes to court to force their opponent to release relevant information while resisting the opponent’s efforts to force them to do the same. It’s also at work when attorneys tell their clients to answer questions under oath with a simple “Yes” or “No” without offering up more than the other side asked for.
THE WRONG IDEA
We’re convinced that lawyers create huge problems when they misapply this conflict-driven theory of evidence in the financial reporting arena.
Specifically, their invalid assumption that capital markets are their clients’ adversaries compels them to advise them to reveal only information that may make them look good, while withholding anything that might do the opposite. In dealing with mandatory disclosures, they direct them to reveal nothing more than the required minimum and, if possible, spin it to present an enhanced image.
Ironically, this completely acceptable courtroom behavior is irrational for financial reporting because it restricts the nature and quantity of information that attorneys’ clients present to the markets.
Contrary to the lawyers’ premise, the fact is that the interests of managers (and their shareholders) are much better served by treating the markets as partners, not adversaries. Rather than using carefully crafted messages in pointless attempts to shape decisions, managers can, and should, stimulate demand for their companies’ securities by voluntarily providing large quantities of timely, comprehensible and otherwise useful information.
Think about it: If one of two companies with equivalent future cash flow prospects provides financial messages that are more clear and complete, the markets will ascribe less risk to its securities and bid their prices higher than the other’s.
VERDICTS VS. MARKETS
In their world, lawyers deal with judges and juries who must reach only one of two verdicts, most notably “guilty” or “not guilty.” Further, the rules of evidence demand that the verdict be based strictly on information that’s properly presented during the trial.
Thus, contrary to common sense, a judge must instruct a jury to ignore a spontaneous outburst from a witness or audience member. The same rules apply to information obtained through an improper search: Even though it reveals relevant truth, its inadmissibility prevents the judge or jury from relying on it. However, and it’s a really big however, capital markets face no such constraints.
For one, their participants have a wide range of possible “verdicts” beyond deciding simply whether to invest or not. For example, they also decide how much they will invest and for what duration. In addition, they can choose between taking long or short positions. Of course, they can invest their money elsewhere for any reason, including dissatisfaction with a company’s reporting practices.
Another significant difference is investors’ freedom to use or ignore whatever evidence they come across. For one thing, this flexibility means they’re not forced to rely on GAAP financial reports. For another, they can (and do) go to great lengths to gather information that supplements or modifies formal reports.
TWO HELPFUL IMAGES
We propose two images that should help managers understand why they’re unwise to rely exclusively on their attorneys for advice on financial reporting.
According to the lawyers’ paradigm, decisions are reached in a room that is windowless and bare by design. Although it has a door, a burly guard prevents jurors from leaving while keeping out any information that wasn’t properly presented in the courtroom.
Inside this isolated space, jurors cannot obtain, much less review, evidence that wasn’t admitted in court. Thus, they cannot contact friends for advice or leave the room to conduct their own investigation.
They certainly can’t say, “We don’t understand this case so let’s look at another one.” Instead, they must strive to agree unanimously on a yea or nay verdict. If they can’t, the resulting mistrial forces the judge to convene a new trial or dismiss the case.
Perhaps to attorneys’ bewilderment, capital market participants enjoy an entirely different situation.
AN INFORMATION MALL
In contrast to the isolated jury room, we envision the markets as an essentially infinite shopping mall in which many vendors aggressively compete for investors’ dollars. If investors aren’t attracted to a specific opportunity, they can simply move on to consider any of literally thousands, nay, tens or even hundreds of thousands, of other possibilities to find what suits them. Of course, they’re also allowed to engage experts for help with their shopping.
In addition, they’re not compelled to agree with anyone, and certainly not everyone, on which opportunities to buy, hold, sell or let pass. Literally, it’s each to their own.
Further, this mall not only allows but incentivizes investors to gather and process all kinds of evidence from a virtually limitless supply with differing degrees of credibility and utility. Finally, only they decide what information they will use or disregard.
It’s especially significant that they’re not forced to act only on what appears in published statements; indeed, they can disregard those reports completely or rebuild and interpret them as they see fit.
Because it’s true that investors have all that leeway to apply or reject information, it’s bizarre that managers and their attorneys fret so much about conjuring positive financial images through manipulated GAAP statements and reports.
Their efforts to paint pretty pictures not only fail to boost demand for the company’s securities but also work to their disadvantage. Simply put, it does no good to look good if you aren’t good.
Likewise, could it be that the Financial Accounting Standards Board and its predecessors have misapplied their efforts for decades by trying to find the one best way to describe specific situations or events? Wouldn’t it be more productive to let managers choose among several options while requiring them to fully explain why their methods are superior for revealing the truth?
For that matter, why not allow companies to satisfy the needs of different investors by reporting more than one way? Imagine, for example, providing users with side-by-side statements and schedules that do and don’t defer income taxes, offset pension fund assets against pension liabilities, or use off-balance-sheet financing.
Above all, it’s well past time for everyone (managers, attorneys and standard-setters) to embrace the notion that capital markets can never have too much information.
A BIG FAT NOTHING
We believe viewing the markets as an information mall reveals that all the lawyers’ quibbling and scheming adds up to a big fat nothing.
The same can be said for all the managers’ clever but futile schemes to boost their reported earnings per share, for example.
Instead, a decision by management to strive to publish truly useful financial reports would help ensure that users have genuinely good reasons to rely on their companies’ financial statements. If they can trust those statements, they’re less motivated to look elsewhere.
Bottom line, everyone needs to get a grip on reality and abandon the false hope that manipulating today’s limited financial reports can promote higher security prices. In fact, the best evidence shows they don’t even come close to being as effective as managers and their lawyers believe.
As witnesses must do in court, it’s time for every manager to tell the truth, the whole truth, and nothing but the truth, by going beyond GAAP and disregarding their attorneys’ misbegotten advice.