Quality Financial Reporting - What Is It?

Over the last six years or so, starting long before the current search for accounting reform, the two of us have gone through the process of changing the way we look at public financial reporting.

Mind you, we didn't just tweak our perspective but completely changed our views on the objectives and methods of financial reporting.

It wasn't easy - between us, we have more than fifty years of experience in teaching accounting and still more of practicing. We are both former members of the staff at the Financial Accounting Standards Board, and Paul Miller worked for the Chief Accountant of the Securities & Exchange Commission. We also wrote a book about the Financial Accounting Standards Board called The FASB - the People, the Process, and the Politics that, over four editions since 1986, has been widely cited as the authoritative commentary on financial reporting regulation.

However, it reflects our old thought pattern that the road to more useful financial statements always runs through FASB.

The Source

Much to our surprise, we stumbled across an idea in 1996 that suggested that perhaps we and all other accountants had been looking at things totally wrong.

Specifically, we read a passage from Financial Reporting in the 1990s and Beyond, published in 1993 by the Association for Investment Management and Research. It pled with managers to provide direct method cash flow statements as FASB preferred instead of the indirect method that the board was pressured to tolerate despite its inadequacy.

A thought exploded in our heads: "what if financial statements were designed to meet users' demands instead of the needs of managers and auditors?" In effect, we wondered how to apply Total Quality Management thinking to financial reporting. What if managers were to treat shareholders and creditors as customers and financial statements as products and then start fashioning the latter to meet the former's needs?

Four Axioms

Along the way, we formulated these four axioms of Quality Financial Reporting:

Incomplete information creates uncertainty;

Uncertainty creates risk for investors and creditors;

Risk makes investors and creditors demand a higher rate of return, and

A higher rate of return for investors and creditors means a higher cost of capital for the firm and lower security prices.

The axioms are significant because they describe economic incentives that can lead managers and auditors to serve users' information demands without coercion through regulation. What an earthshaking idea!

Beyond the GAAP

Some might ask: "If managers comply with generally accepted accounting principles (GAAP), aren't they meeting users' needs? Doesn't the standard setting process guide managers to produce information for that purpose?"

Frankly, no, it doesn't.

From our inside perspective, we find that public justifications for the standard setting system are more rhetorical than factual.

The proof is found in the history of FASB decisions where a predictable pattern occurs. The board starts with a user-friendly proposal to create real reform but corporate executives (CEOs and CFOs) and auditing firms strongly resist its efforts. Eventually, the proposal is compromised in response to these pressures.

Over the last ten years, additional pressure comes from members of Congress, obviously in response to, shall we say, financial incentives provided by FASB's opposition. As examples, we point to standards for pensions, investments, business combinations, medical benefits, cash flow statements, income taxes, financial instruments, foreign currency translation, and, the pièce de résistance, stock options.

Old School

So, here's the scene: old school thinking asserts that capital markets reward management for providing GAAP-compliant reports once every three months. However, GAAP are so compromised and incomplete that they don't get the job done.

Besides, the quarterly frequency was established in 1934 and certainly leaves markets wondering what is happening between reporting dates. How can anyone believe this system effectively reduces uncertainty and produces higher stock prices?

Further, we realized that it would be nearly impossible to politically reform the system.

On the other hand, what can prevent managers from pursuing the benefits (lower capital costs and higher stock prices) on their own? After all, GAAP do not forbid reporting more information than is required.

We have become convinced that the incentives inherent in the axioms will ultimately lead to widespread use of QFR through an economic natural selection process that will change behavior much more effectively than regulatory reform.

The automobile business provides an analogy: what if cars were produced to merely comply with minimum government standards? Even Detroit has caught onto the idea that you can win more business by serving customers' needs beyond minimum regulatory requirements.

We're convinced the same principle applies to financial reporting: the markets will pay more for your stock if you satisfy more users' information needs and prove your trustworthiness. It's as simple as that, at least in concept.

Voluntary Disclosures

As examples of where the QFR strategy could take managers, GAAP already include three standards that tolerate less informative practices while recommending other preferable methods that FASB believed would better serve the markets' needs. These standards concern cash flows, market values, and options.

Although FASB prefers the direct method of reporting cash flow, less than one percent of public corporations apply it. FASB also recommends that managers disclose market value information about tangible assets and alternative measures of income, but no one does. And, until recently, only Boeing and Winn-Dixie complied with FASB's suggestion that options expense be included in reported earnings.

These voluntary disclosures actually comply with GAAP. But, as we envision QFR, managers will go well beyond GAAP and SEC regulations to produce reports that are actually useful. They will obviously need trustworthy auditors, too, if anyone is to believe those reports. Remember, we're talking about a new mindset, not a mere tweaking.

In the following weeks, we will explain more about QFR by describing its implications for CFOs, for legal advisers, and investor relations officers. If you want to dig further, consider investing in our book called, naturally enough, Quality Financial Reporting, published last year by McGraw-Hill. Although that's a plug, our real interest is getting you to make the same shift in thinking that we went through. The view is stunning from over here. Come check it out.