Quality Financial Reporting for the Chief Financial Officer

PART TWO IN A SERIES

Last week, we began a series on the new mindset that we call "Quality Financial Reporting."

At the heart of QFR is the axiomatic proof that voluntarily reporting more complete and useful information will reduce uncertainty and risk for financial statement users, and lead to lower capital costs and higher stock prices. (See Part One for details).

It isn't enough to simply comply with GAAP because industry standards are ostensibly political compromises that do nothing more than establish rock-bottom minimum disclosure levels. Of course, managers must comply with GAAP because it is the law of the land. However, there is no economic justification for reporting only the minimum -- the result is greater investor uncertainty and lower security prices.

This insight did not come easily to us, and we don't expect it to come easily to others, especially our CFO colleagues who are responsible for actually producing financial statements.

A New Vantage Point

Perhaps more than anyone, CFOs understand the complexity of a company's economic reality. Unlike those who work at a division or subsidiary with only a piece of the company in view, CFOs must grasp the entire global entity, and then describe it to outsiders.

Given their vantage point, they should be among the first to accept the premise that mere compliance with GAAP and other regulations is woefully inadequate for fully informing statement users.

Accordingly, we admonish our CFO colleagues: you possess information that users want to have and you now understand that they face less risk if they know what you know, so why not just tell them?

We're convinced that open-handed reporting, with the cards face up, leads to long-lasting, mutually beneficial, productive relationships with capital markets. We even assert that reporting bad news will win higher stock prices, primarily because willingness to tell the whole truth boosts trustworthiness and reduces uncertainty. In addition, we think the markets are pretty efficient and that they will eventually discover the bad news if you don't tell them. If so, they'll smack you harder for not confessing early on. Delay adds insult to injury.

New Acronyms

Because the standard setting process is so compromised, we know that GAAP are nowhere good enough to guide CFOs into providing information that users need and want to have. In fact, we find three other acronyms that could substitute for "GAAP."

The first is PEAP, for Politically Expedient Accounting Principles. How else can you explain why huge pension liabilities and assets are off the balance sheet? Why are there three categories of marketable investments? Why is stock options expense reported in a footnote instead of the income statement? Why is the indirect cash flow presentation acceptable? Why did it take FASB five years and two tries to finish the income tax accounting standard?

If standards are compromised by pressures from preparers and auditors, who can believe that complying with them meets users' needs?

Another acronym is WYWAP, for Whatever You Want Accounting Principles. For example, you can choose between FIFO and LIFO as you wish. And, how about predicted lives for assets, as well as salvage values and depreciation methods?

The WYWAP list is a long one, but there are many other less obvious choices. For example, you can achieve off-balance-sheet financing by tweaking certain variables and transforming a capital lease into an operating lease. You can also take advantage of latitude in choosing discount rates for pensions and medical benefits.

Collectively, this discretion means that earnings are easily managed, and that rational comparisons between firms are impossible. It must be noted that auditors can give clean opinions on all these choices, too.

A third acronym is POOP, for Pitifully Old and Obsolete Principles. How would you react if your doctor prescribed sulfa drugs and a mustard plaster instead of antibiotics and a decongestant? You would be deeply concerned that this person hadn't kept up. So, what should users think when they receive financial statements based on old and obsolete standards?

For example, GAAP for inventories date back to 1947, depreciation and fixed assets to 1946, current/noncurrent classifications to 1947, stock splits to 1941, treasury stock to 1933, convertible debt to 1969, and the equity method to 1971.

We are stunned that the SEC rule mandating the frequency of interim reporting originated in 1934 when state of the art information technology included No. 2 pencils and columnar paper.

Altering CFO Evaluation Systems

When we bring these facts into focus, we find no rational reason to believe that minimum compliance with GAAP is enough to achieve fully informed capital markets and lower capital costs. Instead, there is huge room for improvement.

We point out again that QFR is whole new way of thinking. Unless people really step outside the GAAP-compliance box, they literally cannot see what's wrong.

Because of the large economic incentives for adopting QFR, it makes sense to raise the question of how to encourage change. We think one way is to alter the evaluation systems that motivate CFOs. We speculate that virtually all CFOs operate in systems that consider their shops to be "cost centers," such that they are rewarded if they cut their costs.

Thus, when choosing between a cheaper accounting method that produces inferior information and a more expensive one that reveals more truth, they are driven to choose the former despite the fact that doing so increases capital costs and reduces stock prices.

One solution would add capital costs into the CFO's evaluation equation, adjusted to remove the effects of overall market conditions. It wouldn't be perfect, but at least it would compel CFOs to quit pinching pennies and start thinking about information quality.

We discuss these ideas and many others in our book, Quality Financial Reporting, published last year by McGraw-Hill. Included in its pages are numerous specific suggestions for improving the quality of information flowing to financial statement users by making better choices within GAAP, such as direct method cash flows, recognizing stock option expense, and reporting more market values.

We also encourage CFOs to avoid all forms of off-balance sheet financing, or other things that hide or obscure information, such as indecipherable pension footnotes. In addition, we call for augmented reporting to provide much more information than required by GAAP. We think all CFOs will benefit from reading the book; for that matter, we think it provides useful insights to just about anyone in management.

Part Three describes how QFR can affect the activities and thought processes executed by a company's general counsel or other legal advisers. These professionals also need to shift their perspective and stop thinking that minimum compliance is sufficient.