• 03 Nov 2003
  • What Do You Think?

Can Investors Have Too Much Accounting Transparency?

The earnings of all publicly owned organizations may soon take a hit as the organizations comply with various provisions of the Sarbanes-Oxley Act and new FASB rules. Are these and perhaps other "cures" to the corporate scandals really worth the cost to investors?
by James Heskett

Summing Up

Basic conclusions that can be drawn from responses to this month's column are that it may or may not be useful to try to legislate accounting transparency. But such efforts address symptoms, not causes, of behaviors leading to purposely misleading financial reporting. As Scott Green puts it, "We cannot look at investor losses as the only benchmark to evaluate the costs of Sarbanes-Oxley. One must also consider the cost of capital if confidence in the markets does not return…Unfortunately, you cannot legislate morality..." This theme was picked up by Richard Eckel, who wrote, "... legislative and regulatory response treats the symptoms (means) rather than the disease (motivation). Transparency is only as successful as the least creative obscurantist." He recommends, among other things, prohibiting "by regulation public equity trading by corporate insiders of the insider's equity..."

Several respondents suggested the need for a careful approach to the issue of greater transparency. E. Smith asked, "Do investors care about immaterial smoothing [of earnings]? I do not believe so. It is when ... earnings management leads an investor to misunderstand the health of the company that makes this wrong." Ruth Sager suggests that the current reactions to misleading financial reporting could potentially go too far. As she says, "Fashion in any field is like that. It goes to a ridiculous extreme before becoming more practical. Legislation is therefore a problematic way to achieve the golden mean in normative behavior."

Edward Hare agrees, pointing out that "Corporate governance is a system that continues to fail us ... and joins the ranks of education, mutual funds, and healthcare ... Are ethics, integrity, and self-interest the common denominators to them all?"

Echoing his point of view, does our current approach to greater accounting transparency through legislation and regulation attack the symptoms and not the disease? If so, is this a reflection of the worth of attacking even symptoms in order to restore credibility to financial markets? And if not through legislation and regulation, how then do we address the disease rather than the symptoms? What do you think?

Original Article

The collapse of companies like Enron and WorldCom cost investors tens of billions of dollars. But that amount may be dwarfed by the cost of conforming to new laws driven by those corporate scandals--laws that are intended to protect investors. It prompts a question: Is the cost of accounting transparency worth it to investors?

At issue are various provisions of the Sarbanes-Oxley Act of 2002, including its Section 404, which will become common knowledge from Wall Street to Main Street, as well as rules promulgated by the Financial Accounting Standards Board (FASB) in recent years. This is not an issue of interest only to those of us in the U.S., as suggested by a number of investigations and recommended guidelines being put forth in several member countries of the E.U. in response to accounting improprieties at Ahold and other European companies.

Among other things, Sarbanes-Oxley seeks more independent directors on boards and in key board committee positions. It discourages companies from buying auditing and particularly large amounts of consulting services from the same supplier. And now, by means of Section 404, it will: (1 require senior executives to certify that their companies have financial controls that work, and (2 give external auditors the added task of evaluating and reporting on not only a company's numbers but also the systems that produce the numbers. Finally, public accountants will have to evaluate the work of the boards' audit committees that hired them. The bill for the additional external auditors and significant investment in hardware and software for new control systems is estimated to double. If not offset by improved productivity and lower costs, it will result in a hit to the earnings of all publicly owned organizations.

Investors will face challenges as a result of guidelines recently issued by the FASB, as well. Foremost among these are efforts to encourage more aggressive write-offs of so-called non-performing assets, such as retail stores still in operation but performing below a certain level, as well as the creation of reserves against earnings that are much more accurate and timely than in the past. As a result of these guidelines, write-offs are more frequent, at times becoming a quarterly feature of a company's earnings. Reserves are created closer to an adverse event at a time when the cost of the event may be better known. One result has been greater volatility in earnings. In short, gone are the days when various accounting practices led to earnings "management" or "smoothing," whether or not such practices resulted in more stable stock prices.

Responses such as these to recent corporate scandals prompt several questions: Are these and perhaps other "cures" worth the cost to investors? Is it possible to have too much accounting transparency? What do you think?