The Spirit of Accounting: It's Time for Managers to Embrace the Capital Markets
For the first time, we are presenting in Accounting Today this edited excerpt from the prologue to Quality Financial Reporting, a book we published in 2002. Our goal is to stimulate new thinking about financial reporting issues and encourage far more productive attitudes and behaviors.
A BOARDROOM IN THE 1970S
The vice president of personnel of a major business is talking to the executive committee about a number of employee-related problems. The VP proposes implementing a "human resource management" or HRM system that will identify good candidates for employment, train them, provide them with attractive benefits, nurture them during their careers, and otherwise build a solid relationship with the workforce. The other executives, used to facing down unions and enduring frequent strikes, manage to stifle any incredulous comments, ask no questions, and turn to the next agenda item with no action taken.
SOMETIME IN THE 1980S
The vice president of marketing of an automaker has just presented a report to the executive committee that shows American drivers are dissatisfied with domestic cars' features, size, quality, gas consumption, and price. The report speculates that Japanese companies' giant strides in production efficiency and design will allow them to take over a large share of the U.S. market. The VP recommends that the whole company, from top to bottom, develop and apply an attitude of "customer orientation" to ensure that its products are attractive, priced right, and otherwise highly marketable. A key shift would be adopting a new philosophy called "Total Quality Management" that would streamline the entire production system while improving quality and cutting costs. The executives utter insincere words of thanks, roll their eyes, and turn to the next agenda item with no action taken.
SOMETIME IN THE 1990S
The vice president of production of a large manufacturing company is summarizing a consultant's report that recommends implementing a new inventory management system called "Just in Time" that will require building close relationships with suppliers to align their activities and quality standards with the company's needs. The executives, who know from experience that vendors must be kept off balance and in line by making them compete with each other, murmur politely while exchanging furtive looks, and turn to the next agenda item with no action taken.
The vice president of finance of a public company has just recommended to the executive committee that it create a new policy of reporting as much useful financial information as possible to the capital markets, including the public and the stockholders and creditors.
The VP urges going well beyond minimum standards created by the Financial Accounting Standards Board and the Securities and Exchange Commission by voluntarily providing market-value-based and other information that the markets will find useful for assessing the intrinsic values of the company's securities. This reporting practice, called "Quality Financial Reporting" or QFR, will significantly lower the company's cost of capital and stimulate demand for its securities by reducing the markets' efforts in generating and analyzing alternative information, by otherwise decreasing uncertainty, and by building a new trust-based relationship with the stockholders and creditors.
The executives have never understood very much about financial statements, but they know for certain that the markets automatically react to reported earnings per share, especially if they come out lower than expected. They sit quietly, hoping the VP won't propose an action item.
CONNECTING WITH MARKETS
These scenarios show that management must deal productively with transaction partners in four different markets for labor, outputs, inputs and capital. Although success in these markets involves understanding and managing both supply and demand, many managers traditionally tried to succeed by focusing only on their own side of the transactions, instead of both.
For example, many of them used to consider workers as hardly more than inanimate objects to be exploited. HRM dramatically changed their attitude by helping them see employees as partners who achieve the greatest productivity only when they are satisfied, nurtured, respected and fully informed.
In markets for products and services, managers used to focus on supplying what their firm could produce cheaply and then selling it for the highest possible price. This "supply-push" attitude caused them to shove out into the market whatever their companies could make. Customer orientation and TQM showed many of them the advantages of being in synch with their customers' needs and wants. This "demand-pull" thinking leads them to first determine what will satisfy customers and then provide it in a way that outdoes the competition. In other words, they create strong and mutually beneficial relationships with their clientele.
Many managers now understand that they have to work closely with their supply chain members, instead of bluntly demanding whatever inputs they need without considering the vendors' interests. Building mutually beneficial relationships with open and complete communications allows them to harvest the advantages of Just in Time because dependable quality and timely delivery are at least as important as low purchase costs.
DELL GETS IT, SORT OF
These thoughts of Michael Dell from a 1999 article in The Economist show he understands these revolutions: "A manufacturer will no longer be able to afford to treat a supplier like a vendor from whom every last ounce of cost-saving must be wrung. Nor can a customer be treated simply as a market for products and services at the best possible price. Instead, both suppliers and customers will come to be treated as information partners, jointly looking for ways to improve efficiency across the entire spectrum of the value chain, not just in their respective businesses."
However, we haven't found any evidence that Dell and other managers have made the same discoveries about the capital markets or have even considered bringing them into more productive relationships.
A NECESSARY EVIL?
We gained a special insight when a former student who is now a manager in a public company said that he considers the capital markets to be a "necessary evil." In contrast to this unfortunately common attitude, we assert that these markets are absolutely essential to any company for supplying it with capital at a reasonable price. They also provide stockholders with liquidity and valuation information, thus greatly increasing demand and market value for its shares. In addition, these markets are essential to the entire economy for raising and allocating capital among those who want and compete for it. As the world saw in 2008, economic activities grind to a halt when capital markets stop working.
Despite the capital markets' centrality for sustaining, growing and stabilizing firms and economies, we perceive that most managers still treat them like they used to treat the other three markets. That is, they approach them from a supply-push perspective by publishing financial information they prefer to publish, instead of responding to demands from market participants who say what they want or to what careful analysis reveals they need or would benefit from having. These behaviors are displayed even by managers who have adopted HRM, TQM and JIT. Unfortunately for them and others, their supply-centered attitudes toward capital markets persist as if investors' and creditors' demands for information simply don't matter.
Specifically, we see that virtually all managers provide no more than the least amount of required information. We also observe that they engage in such unproductive activities as creating off-balance-sheet financing, presenting complex and indecipherable cash flow statements, and composing obscure footnotes. What's especially puzzling is that they do these things despite pleas from sophisticated statement users for more useful information.
THE ORIGINS OF BAD ACCOUNTING
So, what created this seemingly universal disdain for the capital markets, and what sustains it today? We think one main reason is the poor training in financial reporting that managers typically receive. As a result, they behave naively as if the markets have only limited motives and abilities to interpret public information and supplement it with private information. It's clear to us that they think they can fool the markets merely by managing reported information, instead of grasping the obvious benefits of transparently revealing what is really happening. We understand their confusion; in fact, we admit we used to hold similar mistaken beliefs.
Another key factor is incentive compensation programs tied to financial statement numbers that lead many managers to manipulate their reported results, instead of managing their real results. Alas, this manipulation is often enabled by politically crafted reporting standards that are highly flexible and subject to interpretation.
QUALITY FINANCIAL REPORTING
With the same astonishment and enthusiasm that we experienced when we first stepped outside the old supplier-based paradigm, we now cast a vision for substantially different reporting practices that address statement users' demands.
Specifically, we believe the time has come for managers to join with the capital markets in collaborative beneficial relationships by applying what we call Quality Financial Reporting. The essence of QFR is that managers can reduce their capital costs, increase their securities' real values, and enjoy many other advantages by reaching out to the capital markets and making them essential partners, instead of treating them like slow-witted opponents.
Just as the other three management revolutions replaced aloofness and exploitation with partnership and cooperation in dealing with workers, customers and suppliers, we envision QFR as the revolution that replaces old attitudes toward investors and creditors with new relationships characterized by frequent, open, truthful, and otherwise trustworthy communication.
Despite the passage of a dozen years, we find these thoughts to be just as compelling and persuasive today as they were in 2002. Because we are yet to encounter any effective arguments against our points, we revive them in this column to stimulate new thinking and reporting practices that will lead to better relationships with the capital markets. It really is that simple.
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 or Accounting Today. Reach them at firstname.lastname@example.org.