Obstacles to Good Financial Reporting

Read these remarks from a former SEC Commissioner, which goes behind the scenes to discuss issues of reporting financial information for public companies. GAAP is integral in reporting transactions.

III. Obstacles to Good Financial Reporting

B. Company Reporting

After standards are adopted, companies must make decisions regarding how to apply them to report their financial condition and performance. Here, too, there are conflicts and counter-incentives that can infect the process. Ideally, we hope that managers will strive to convey in clear terms the true economic impact of their activities, and not simply choose the accounting treatment that has the most favorable impact on reported GAAP earnings. Beyond that is a more fundamental hope that managers will make business decisions based on the economics, not the accounting. The fact that a transaction increases GAAP earnings does not necessarily mean that it is in the best interests of shareholders. If a transaction provides a short-term GAAP booster shot at the expense of long-term value, it causes both a possibly misleading picture of the company's financial health and a misallocation of capital. 

In the reporting process, bad choices can take many forms. You can have the intentional, deceitful disclosure of misleading information - which, undoubtedly, is a very bad choice. But you can also have bad choices that do not rise to the level of fraud, but which nonetheless serve to mislead investors. Our recent enforcement action against 

Edison Schools illustrates that even choices that are technically permissible under GAAP can be misleading to investors.

Bad choices are possible, in part, because accounting standards sometimes make compliance with a preferable standard optional, and rely on the company to choose the better path. The use of non-GAAP information, while appropriate under certain circumstances, can also serve to confuse rather than clarify a company's performance. So the Commission recently clarified the conditions under which a company can report non-GAAP information. Companies also make a bad choice when they manage earnings by inappropriately manipulating subjective judgments to affect the timing of recognition or disclosure. 

Bad choices by reporting companies result in more opaque disclosure, thereby increasing the cost of capital. If the cost of capital increases as the quality of disclosure decreases, then why don't companies provide the most transparent financial reporting possible? More specifically, if there is a strong market incentive to publish quality financial data, then how could Enron - with its convoluted capital structure and impenetrable disclosures - become on of our nation's largest companies in terms of market capitalization? 

Unfortunately, counter-incentives can encourage companies to choose an accounting treatment that makes them look the best as opposed to the one that most accurately reflects their financial condition. One such pressure is the shift in focus by investors from long-term to short-term performance. In my view, the recent emphasis on quarterly earnings-per-share is a big mistake for investors, not only because it ignores the fundamentals that make for a good long-term investment. It also puts pressure on companies to engage in financial engineering to maximize short-term reported returns, even if it means sacrificing long-term value. As equity prices increase, so does the pressure to manage earnings to meet expectations. However, like any Ponzi scheme, it can't last forever. 

A similar counter-incentive can arise from within a company. If you were wondering whether I was going to work the topic of executive compensation into today's presentation, you can stop wondering now. One of the clear lessons coming out of this whole discussion about financial reporting - and the corporate frauds - is that if boards want to provide proper incentives for management, it is critical that they start by creating good criteria for performance-based compensation. The increased use of compensation that provides managers disproportionate wealth based on short-term results undoubtedly contributed to some bad choices. More reflection and creativity is needed to ensure that performance objectives encourage decisions that are economically in the long-term best interest of shareholders. Depending on the nature of the business, GAAP earnings-per-share is not necessarily the target you should be shooting for. 

Another counter-incentive is the potential for a race to the bottom in reporting as companies compete for capital. Once a single company has success attracting capital despite opaque disclosure or even deception, there is pressure on others to adopt similar practices or end up competing on a distorted playing field. If the initial actor is not called to task - by the market or the financial reporting gatekeepers - the pressure mounts on others to make similarly bad accounting and disclosure choices. That phenomenon does not excuse the companies that follow suit, but it may explain why practices like round-trip transactions were not isolated to a single company within an industry. 

While some auditors apparently facilitated improper corporate reporting, SarbanesOxley and the Commission's rules recognize that auditors and the audit committee have to play an important role in promoting good choices. That role is prominent in provisions creating the PCAOB, requiring heightened auditor independence, and making it illegal to lie to the auditors. Auditors should act as a check on management's lapses in judgment, and the audit committee should ensure the choices made in financial reporting are in the shareholders' best interests.