Quality Financial Reporting for Everyone

PART FIVE IN A SERIES

Over the last month, we have had the opportunity to describe in these pages the basics of Quality Financial Reporting. QFR is our proposed alternative to management's current dependence on compliance with generally accepted accounting principles to produce fully informed capital markets.

Whereas the status quo paradigm looks for ways to reduce information flows and provide comfort for managers and auditors, QFR turns the tables and spurs the search for new ways to bring comfort to financial statement users. By providing more complete information, managers reduce uncertainty, risk, and the demanded rate of return.

The ultimate results are lower capital costs and higher stock prices.

The Transition

Moving to QFR is much more than a tweak of the existing system. This fact makes it quite different from current clamors for reform in accounting standards and corporate governance. Further, QFR calls for voluntary change, not compulsive change. Willingly acknowledging your flaws is much more persuasive than a forced confession. If you can be counted on to tell the truth, you will be trusted.

In addition, moving to QFR is an individual decision. Much can be gained by being among the first to switch and much can be lost by holding back until everyone else has already made the move.

Reluctance to step forward and tell more of the truth, more clearly, and more often, certainly signals the capital markets that you are hiding something and you'll face higher capital costs and lower stock prices.

Seven Deadly Sins

The worst strategy is to wait for a regulator to tell you what to do. QFR calls for nimble and creative responses to demands for information, just as Total Quality Management calls for quickly meeting consumers' needs.

Why would anyone expect bureaucrats at FASB or the SEC to invent effective new ways to report what investors want to know?

In our view, QFR repudiates the following seven deadly sins of financial reporting. Which ones have you committed?

Underestimating The Capital Markets

By not respecting the markets' ability to quickly and appropriately process information from many sources and to disregard untrustworthy reports, managers have managed earnings and engaged in off-balance-sheet financing, vainly trying to prop up stock prices with smoke and mirrors instead of offering sound prospects for future cash flows.

Obfuscating

By not understanding the markets, managers have attempted to bluff them into paying too much for securities. Because of the markets' efficiency and the incentives for them to figure things out, policies that don't tell the truth clearly produce discounted stock prices.

Hyping and Spinning

Thinking that the markets can be duped, managers have also prepared pro forma descriptions of income that we call EBABS - "earnings before any bad stuff." People don't believe barkers at carnivals and the markets don't believe those numbers either. People don't invite barkers home for dinner and the markets don't pay very much for hyped stock.

Smoothing

It would be nice to play a round of golf with all pars and birdies, but few of us can do that. While we might pretend that we did by writing those scores on the card, the truth will be something quite different.

Much of what happens in GAAP is similar because it's designed to take out the peaks and valleys of real economic activity. Consider such things as depreciation, pension accounting, and income tax deferral. Massaging the numbers before reporting them only imposes costs on the users who want to know the truth. It also destroys trust.

Minimum Reporting

We've written a lot about this sin. Nowhere else would someone in an intense competition raise them arms in triumph and shout, "I did the least I had to do!" Yet, that is exactly what management proclaims when it publishes GAAP financial statements.

Minimum Auditing

In the same way, managers hurt themselves when they hire cheap and complacent auditors. It's a bigger mistake to use auditors who invent schemes to keep useful information out of the statements.

Before Andersen vanished in a puff of smoke, research showed that its clients' stocks were priced well below similar firms audited by others. Financial statement credibility is the point of an audit, not obtaining a generic stamp of approval of minimum compliance with GAAP.

Preparation Cost Myopia

We covered this problem in our column about CFOs. Managers tend to look at only the costs of keeping the books and printing the statements. Thus, they seek the cheapest accounting methods and audits without considering the cost of capital and the stock price.

On the other hand, if they think they can concoct a scheme that makes them look better, the sky's the limit. As one example, managers willingly paid premiums to structure transactions qualifying as poolings simply to look better by avoid recording goodwill. Did it ever occur to these managers that lower stock prices follow from pooling's inferior reporting?

Conclusion: The Seven Virtues of QFR

In contrast, adopting QFR brings adherence to these seven virtues:

Healthy respect for the capital markets;

Clarity;

Straightforward disclosure;

Telling it like it is;

Maximum reporting;

Maximum auditing; and

Putting preparation costs in perspective.

QFR is to the capital markets what Human Resource Management is to labor markets, what Total Quality Management is to product markets, and what Just-In-Time is to supply chains.

Specifically, it replaces adversarial and even abusive relationships with long-lasting mutually beneficial partnerships.

The most frequently heard criticism of QFR is that it isn't realistic.

We've thought about that one, and we just don't buy it. We really cannot see how the current minimum compliance system can stay intact when it is founded on the principle that it's not only possible but good to engage in practices that are designed to deceive and manipulate what people should know are very efficient capital markets.

That behavior is not just ill-conceived and doomed to fail, it is unethical.

We hope that our ideas have intrigued you sufficiently to get you to consider changing your paradigm. Let us know if we can help you.