Quality Financial Reporting

This short fable illustrates the futility of operating a business based only on supply without regard for demand. That way of doing business is rooted in the attitude: “If we build it they will buy it.” In today’s economy that sort of arrogance will get a company nowhere, even if it has a monopoly on a product or service. Once it’s clear a company doesn’t care about its customers, other innovators will come and take them away.

This type of situation caused the AICPA special committee on financial reporting (the Jenkins committee) to issue its report, Improving Business Reporting—A Customer Focus, in 1994. It urged the accounting profession to adopt a customer focus when providing information to the public. Nevertheless, it appears some accountants are like the car dealer above because we have not made any significant reforms in how we deal with capital markets. Instead, the entire accounting profession seems to have fallen victim to an overwhelming inertia that is blocking any significant changes. To remain relevant everyone—practitioners, academics and regulators—needs to tap into the same economic forces that have caused demand-driven enterprises to succeed while supply-based businesses have withered on the vine.

My proposal is that the change to being demand driven can be accomplished through what I call quality financial reporting (QFR). This concept offers a new paradigm that shows the tremendous rewards that await managers who change the way they report financial information to stockholders and to the public.

QFR SUMMARIZED

QFR is an attitude, not a set of specific practices. It involves companies getting in touch first with capital market participants to better understand their needs and serve them more quickly, thoroughly and conveniently than their competitors. To be this nimble and creative, accountants cannot consider minimum compliance with politically compromised GAAP to be sufficient, any more than car designers can consider minimum government safety and pollution standards sufficient when creating marketable vehicles. Instead, QFR calls for voluntarily expanding the scope and quality of reported information to ensure market participants are more fully informed.

What kinds of concerns might give companies the incentive to adopt this new attitude? These four axioms show what happens when financial reporting does not tell the whole story:

Incomplete information fosters uncertainty.

Uncertainty creates risk.

Risk motivates investors to demand a higher rate of return.

That demand results in a higher cost of capital and lower security prices.

Companies have somehow overlooked the axioms even though the key to customer focus lies in understanding that uncertainty increases capital costs and puts managers, employees, customers, creditors and stockholders at a disadvantage. More important, higher capital costs harm society by reducing the economy’s efficiency. Despite its simplicity, this logic can transform financial reporting.

To exceed the requirements of GAAP, managers, practitioners, auditors, regulators and educators must change the paradigm. In particular, managers should respond to the powerful drive for greater wealth by making changes in the content, format and frequency of reports.

To accept QFR, we must understand that regulation has not been and never will be able to bring about optimum reporting practices. However, competitive forces combined with regulations will get us closer to where we should be.

First steps. A risk-free route to applying QFR lies in making better choices when preparing GAAP financial statements. For example, FASB has issued three standards that recommend certain reporting practices while permitting companies to use other practices that are less informative: Statement no. 89, Financial Reporting and Changing Prices, Statement no. 95, Statement of Cash Flows and Statement no. 123, Accounting for Stock-Based Compensation. Despite FASB’s extensive research and input from statement users, managers have overwhelmingly chosen the less preferred alternatives. Specifically, they have rejected FASB’s recommendations for reporting supplemental market value information, for using the direct method of accounting for operating cash flows and for putting option expense on the income statement. By so doing, companies have increased uncertainty, risk and capital costs. QFR makes it clear that using the preferred methods produces the opposite results.

THE JENKINS COMMITTEE AND QFR

In its report, the Jenkins committee used these words to justify dependence on FASB but mistakenly framed the issue as a choice between a standards-based system and no standards at all:

Some constituents . . . ask: Why not let the marketplace for capital determine the nature and quality of business reporting? The marketplace, they argue, already offers powerful incentives for high-quality reporting. It rewards higher quality reporting and punishes lower quality reporting by easing or restricting access to capital or [by] raising or lowering the cost of capital. Additional reporting standards, they argue, would only distort a market mechanism that already works well and would add costs to reporting, with no benefit.

Unregulated reporting is unrealistic, if only because standards are so thoroughly imbedded in the reporting system they cannot be eliminated.

A realistic alternative is a quality-driven financial reporting system that relies on standards to establish minimums while freeing financial managers to compete by providing information that goes beyond minimum requirements. Under this view, businesses need standards to promote progress, facilitate understanding and take action against those who try to mislead. But standards alone can’t create quality.

INCOMPLETE INFORMATION

Suppose a company owns a block in downtown Dallas that it purchased in 1952 for $5 million. Under GAAP, management is not required to report that its value is now closer to $200 million. How will the market react to this incomplete information?

One remote possibility is that the market will accept the smaller figure and grossly undervalue the company’s securities, increasing its cost of capital. Another possibility is the market will throw up its hands and walk away because management hasn’t provided useful information. In 1994, Warren Buffett told a student audience, “If I pick up an annual report and I can’t understand a footnote, I probably won’t—no, I won’t —invest in that company because I know that they don’t want me to understand it.” The point here is that bowing to the temptation to manage a company’s financial image through accounting policy choices won’t work. Doing so destroys trust and shrinks demand for the company’s securities, driving value down, not up.

While investors might be attracted to the company despite the limited public information, the situation will force investors to discount the price of the company’s securities to protect themselves. Some will gather their own private information, which means

They will incur processing costs that they must recover.

The data will be incomplete, unaudited and unreliable.

The few who have the information can earn abnormally high returns.

QFR addresses these problems by attacking their root: uncertainty. Ironically, the problems are easy to avoid because financial managers already know most of the information investors will find useful. If they don’t, they should; further, they are in a better position than financial statement users to produce it reliably.

ARGUMENTS AGAINST QFR

Practitioners invoke two arguments against QFR: New information is costly, and it reveals a company’s plans to its competitors. While both arguments are reasonable, a closer look indicates the obstacles they present are surmountable. Some financial managers think they are helping stockholders by limiting the cost of producing, auditing and publishing information. However, they miss the point that stockholders face lower security prices when useful information is not reported. More informative reports make stockholders and everyone else better off. Although information overload is possible, the “Q” in QFR stands for quality, not quantity. The market needs better information, not more.

Those who think additional information would help a company’s competitors should consider two points:

Management is locked in a capital market contest that is just as important as the competition for its products or services; it’s shortsighted to neglect one while pursuing the other.

Because QFR is voluntary, it does not force anyone to exceed minimums. Managers decide what they will reveal. If they don’t want to report something, they don’t have to. The decision is in their hands, not in those of standard setters.

While there are additional responses to these objections, this forum doesn’t provide enough space to discuss them all. I believe these and other obstacles cannot defeat the unarguable truth that more complete reporting can produce large economic rewards. It’s up to practitioners to decide whether they will claim those rewards directly or try to get them through incomplete or even deceptive reporting. QFR shows that the latter options will fail.

MARKET-VALUE-BASED INFORMATION

Much has been written about the role of market value information in financial reporting. The arguments were sometimes strongly worded because the issue was defined as whether the financial statements should use values or costs. QFR helps break this impasse by framing the issue in terms of whether voluntary supplemental reporting of market value information will, in FASB’s words, help investors and creditors “assess the amounts, timing and uncertainty of prospective net cash inflows.” As long as GAAP remains focused on costs, companies must report these numbers. However, QFR should encourage everyone to consider whether supplemental reporting would be helpful.

While many remain skeptical about its relevance, market value usefully describes assets and liabilities because it continuously reflects their ability to affect cash flows. Assets that might bring larger future cash flows have a greater value than those assets with lower expectations. Assets that might bring in cash sooner have a greater value than those that might bring it in later do. Assets that are more likely to produce cash have a greater market value than those that are less so. Although accountants might find comfort in reporting historical cost, book value and the present value of predicted cash flows, they should realize that market values are more effective for describing an asset’s current ability to affect future cash flows.

It doesn’t matter whether market values’ usefulness can be proven; it is enough for financial managers to realize they offer great potential for improving reporting. Managers who report only historical numbers are like carmakers that design vehicles without stereos or comfortable seats. They might claim a small capital market share, but most investors will look elsewhere.

AUDITS AND INDEPENDENCE

QFR offers guidance for all areas of financial reporting, not just the contents of reports. For example, it sheds new light on the importance of auditor independence. Specifically, audits add credibility to management’s reports and reduce uncertainty, risk and the cost of capital. It follows that management can help stockholders by engaging unquestionably independent auditors. If new standards increase independence, stock prices will rise. However, there is little wisdom in waiting for regulators to act because QFR shows managers they can create value by voluntarily increasing auditor independence. Financial managers are better off engaging the toughest auditors they can find so they can advertise their reports as having survived their scrutiny.

From the accounting profession’s side, savvy auditors will attract QFR clients by protecting and promoting their independence. These auditors will understand that client service means doing good for the client, not just making the client look good. Of course, managers and auditors should not wait for tougher independence rules. Rather, they should figure out on their own how to differentiate their statements and services from those of their competitors.

QFR reveals that traditional audits have lost value because minimum compliance with GAAP produces low-quality information. If financial statements lack relevance, increasing their reliability with an audit does not make them more useful. Thus, CPAs who seek markets for new assurance services should not overlook the potential for auditing the relevant information managers would produce under QFR.

QFR AND PUBLIC POLICY

Financial reporting affects the public interest in numerous ways. For example, an efficient economy generates and distributes wealth. In turn, a well-run capital market is key to an efficient economy and useful information is essential to that market. Until now, securities regulation and litigation have been the only policy tools applied to promote useful information. The public encourages managers to report primarily by threats of recrimination for failing to comply with standards. This “stick” approach has been reasonably successful, especially in the United States. In contrast, the QFR paradigm offers a “carrot” that rewards managers for producing quality information by reducing capital costs and increasing security prices. Ultimately, widespread adoption of QFR will produce a more efficient capital market, a more productive economy and a more prosperous society.

How can policy makers encourage managers to use QFR? I have five recommendations:

Federal regulators must not flinch when prosecuting financial managers and others who try to mislead investors by reporting false and incomplete information.

Managers who try to provide useful information should have a safe harbor against sanctions for their legitimate efforts to improve reporting quality beyond GAAP.

FASB, the SEC and the AICPA should help auditors and managers see QFR’s advantages.

FASB should continue to issue standards that identify best practices and weaker alternatives; further, they should require managers who don’t adopt the best practices to explain why.

CPAs should lead Congress and others to understand that choking off useful information creates inefficiency and higher capital costs. Limited reporting simply forces the market to seek other, less credible, less complete and more expensive information. Congress must understand that laws can never force the market to act on information that is not useful or ever keep it from getting useful data from other sources.

MOVING AHEAD

Everyone will gain from QFR, except a very small group who may have successfully misled the market. It’s better to ignore these few and encourage others to reduce uncertainty by flooding the market with useful information. Some market participants will resist QFR, just as they were slow to embrace other business revolutions. For example, some still reject total quality management, human resources management and just-in-time inventory management. Like QFR, these innovations show that it is better to build open relationships with markets. Thus, TQM mandates continuously addressing customers’ needs, HRM encourages team building and JIT requires managers to work closely with suppliers. Similarly, QFR would cause managers to create positive capital market relationships.

Moving ahead with QFR offers little downside risk and the potential for substantial benefits. The result could be a fable with a quite different ending:

A customer walks hopefully into a car dealership. When the salesperson asks what she is looking for, the customer says she is tired of the standard model and wants a car with a CD player, leather seats, cruise control and a bright color. The salesperson breaks into a big smile and says, “You’ve come to the right place. Sit down and we’ll find out what we can build to meet your needs. We’ll offer you a competitive price and deliver the car in a week—less if our network has one that matches your specifications.” The customer can hardly believe her ears and walks quickly toward the salesperson’s office.

PAUL B.W. MILLER, CPA, PhD, is professor of accounting at the University of Colorado at Colorado Springs. He previously served on the staffs of FASB and the SEC chief accountant.