The Spirit of Accounting: Why are we still so critical of the financial accounting status quo?
Hoping to jar managers and accountants out of their comfortable but complacent mindset, our October column kicked off a series criticizing the way things are.
Here’s our premise: The status quo’s flaws go unacknowledged and unrepaired because those two groups’ financial accounting paradigm keeps them from seeing that GAAP financial statements are not useful, even though they are used.
Our goal is to bring about a shift to the preferable financial reporting paradigm. We’d favor a rapid adoption like what we’ve all experienced firsthand with smartphones, in contrast to the 1,800-year slog it took for most to accept the idea that the earth orbits the sun.
Last month, we described the snare of being satisfied with accounting processes without regard to their results’ usefulness. In contrast, the financial reporting paradigm compels accountants to reject any process that fails to produce useful outcomes. For example, we regret the Financial Accounting Standards Board’s decision in September to drop pension accounting from its agenda. We think its members dealt irresponsibly with the obvious truth that the GAAP process for computing annual pension cost cannot possibly support rational decisions.
We also explained that everyone tenaciously clutches onto the status quo while ignoring its high costs. Specifically, uncertainty created by incomplete information increases risk for investors that leads to higher capital costs and discounted stock prices, thus degrading the efficiency of capital markets and the overall economy.
This month, we briefly discuss reporting responsibilities and then describe how the two paradigms differ in their orientation, standard-setting priorities and attitudes toward standards.
In primary capital markets, companies sell and investors buy rights to participate in the former’s future cash flows. In secondary markets, investors subsequently trade between themselves without involving the company. We’re focusing on the latter because they have far greater economic impact.
We begin with an insight that many will find to be astonishing: Managers’ reporting responsibilities ought to include protecting the interests of others in addition to their existing shareholders. This assertion contradicts the traditional doctrine that managers’ stewardship reporting duty applies only to current owners, thus allowing them to disregard potential buyers of their companies’ shares.
Two reasons prove that this conventional view is too simplistic.
First, rational analyses by both existing and potential investors involve comparing the market value of the target company’s shares with their estimated intrinsic value. These users’ dependence on management for information renders them highly vulnerable because they’re exposed to the risk that reports may be biased in a way that helps current shareholders get a better price when they sell.
This bias is problematic because of the transmutation that occurs when shares change hands. Specifically, stock trades instantly transform sellers into non-owners and buyers into shareholders. Perversely, any successful attempts to use accounting to advance existing shareholders’ interests end up producing losses for the buyers that equal the gains for the sellers. Ironically, management’s chicanery actually helps those who are no longer owners and hurts the new owners!
Contrary to traditional thinking, we conclude that management has a weighty fiduciary duty to inform all who may trade in its shares, including both current shareholders and the capital markets as a whole.
Second, the fundamental rationale for regulating capital markets is the macroeconomic policy goal of promoting market efficiency and stability. Those outcomes are most likely when securities’ intrinsic and market values converge.
In turn, that result can happen only when all potential buyers and sellers are well-informed. It follows that society’s welfare can be promoted by mandating that public companies provide full and fair disclosures to all market participants, not just their existing owners.
Therefore, we’re persuaded that managers have crucial fiduciary and legal obligations to publish complete and fully neutral financial reports that facilitate secondary market transactions involving their securities.
Bottom line, the specific market for an individual company’s shares is more risky and inefficient when its reports aren’t fully informative, trustworthy and timely. More significantly, the fact that today’s GAAP financial reports collectively lack those three qualities means the broader capital markets are also more risky and inefficient.
Because capital markets need lots of information, they’re hampered when managers fruitlessly paint pretty pictures in their financial reports that few believe and that no one should.
We’re convinced this disconnect has persisted for so long because the orientation of the status quo paradigm elevates information suppliers’ interests above the interests of information consumers.
Basically, managers can offer only two things that capital markets demand:
- Future cash flows to their owners; and,
- Useful information about those cash flows.
When they fail to meet either or both of those demands, they inflict negative consequences on themselves, their stockholders, the markets and the economy.
The futility of managers’ and auditors’ deficient presentations is further revealed by the fact that market participants (in the aggregate) are not hoodwinked by incomplete and otherwise misleading GAAP reports. Therefore, no one benefits when information suppliers fail to provide what the markets demand, except for miscreant managers who rig their compensation schemes, and no one should want to protect them.
To be clear, we observe that today’s GAAP financial statements are in such sad shape because managers and auditors have historically dominated and set priorities for the standard-setting process. However, if standard-setters can shift their paradigm, they’ll change the relative importance they’ve assigned to the affected parties’ interests.
Because of politics, FASB and its predecessors have always put the highest priority on these three issues:
- How strongly will preparers object to a proposed standard?
- How much will it cost management to implement that standard?
- Will the standard increase auditors’ litigation risk?
Of course, these questions are relevant, but GAAP statements lack essentially any usefulness because standard-setters have always made them too important.
Instead, FASB would produce much better standards if it assigned its highest priority to these issues:
- What information will help investors assess future cash flows?
- How much will it cost users if that information is not reported and how much will preparers gain if it is reported?
- How much more value can auditors add to financial reports by verifying the reliability of truly useful information?
Resolving those issues with priority for the interests of information consumers will lead to these results:
- Standards will fill financial statements with useful information.
- Cost-benefit assessments will consider not only preparation costs but also users’ costs for data acquisition and analysis plus preparers’ benefits from lower capital costs and higher share values.
- Auditors will reap rewards from providing services that actually make their clients’ reports useful.
Eventually, managers will realize they can reap substantial benefits by meeting capital market demands for information more effectively than their competitors. We suggest that none of them should need a lightning bolt epiphany because they’ve already learned that it’s advantageous to serve their customers’ demands before their own.
Everything will be different when this paradigm shift occurs!
Attitudes toward standards
We’ve also observed that managers treat reporting standards like a limbo stick that’s lowered as competitors sneak under it instead of a high-jump bar that’s raised as the event advances. Consider these examples (among many more):
- Off-balance sheet financing;
- Obscuring facts about their compensation;
- Using the indirect method to report operating cash flows; and,
- Reporting only once every three months.
We offer two observations about managers. First, these dysfunctional practices show they’re ignorant of the fact that markets discount stock prices when useful information isn’t readily available. Second, they believe standards define the most they must do, instead of the least.
We find it helpful to contrast accounting standards with building codes that set minimum requirements for new structures.
For example, drains must be vented and electrical outlets must safely deliver power. Codes are obviously necessary but no architects ever stop when they’ve complied with them. Rather, they go way beyond their requirements to meet homebuyers’ demands for, say, attractive kitchens with spacious pantries, granite countertops and state-of-the-art appliances.
Similarly, carmakers exceed minimum safety and other regulations in their quest to satisfy customers’ demands for entertainment systems, air-conditioning, comfortable seating and blind-spot warning devices. They simply wouldn’t sell many cars if they just met the minimum requirements.
Why, then, do the very same managers who strive to meet their customers’ demands always feel they’ve done enough when their financial statements merely comply with GAAP without fully meeting the capital markets’ demands?
To return to those examples:
- Why haven’t managers comprehended that off-balance-sheet financing is a pointless ruse?
- Why do they hide their compensation costs when doing so increases the markets’ wariness and reduces their stock values?
- Why don’t they report operating cash flows directly as inflows minus outflows? After all, the obsolete but almost universal indirect method was concocted decades ago by ingenious users as an expedient work-around to overcome the lack of published cash flow statements.
- Why do they report quarterly in compliance with a standard set in the 1930s? Their own experience should make it clear that leaving users uninformed makes them both frustrated and ultra-cautious.
These and many other reporting foibles prove that managers are foolhardy for doing nothing more than the least required by standards.
There you have it
We’ve explained the negative consequences that managers and accountants create by clinging stubbornly to their deeply flawed paradigm. Further, we’ve suggested that thinking differently will allow them to harvest many benefits.
That message isn’t new because we’ve been sending it for a couple of decades to shake everyone into full awareness that a far better worldview is out there.
More is coming ... .