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?
Like fish in the aquarium, we will show our performance and our prestige through our transparency.
I would think the question of whether investors can afford the cost of these checks goes beyond analyzing whether such checks are feasible. It points us to a general malaise of dwindling integrity which is sadly becoming a part of our DNA and in some measure helps explain a growing need for having such stringent checks in place.
This brings us back to the fundamental question: Can systems survive without binding the people running them into a commitment of fair play? I believe no system of checks is capable of replacing inherent integrity. If we lack integrity, we may have as many checks as we like—the "system breakers" will always find a way to break the rules.
I don't know if the value of additional accounting and "transparency" will be worth its costs. But I do know we're headed down a path that misses the point. Corporate governance is a system that continues to fail us ... and joins the ranks of education, mutual funds, and healthcare as arenas beset by problems that no amount of money has "fixed" to date. Are ethics, integrity, and self-interest the common denominators to them all? Seems to me we're attacking the symptoms and not the disease.
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.
Investors are always free to vote on the adequacy of a company's financial transparency with their dollars. The problem with the events of 2001-2002 is that there were a concentrated number of frauds that, individually, would have only affected the company, but together created a loss of confidence in the markets so great that some have referred to it as the perfect storm.
The response of Congress might be too much and too expensive, but 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. It seems that Sarbanes-Oxley has provided a balm that has provided some confidence healing. Unfortunately, you cannot legislate morality, and I suspect that we will again see financial shenanigans in the future that will result in even more expensive legislation. (Note that I am not a disinterested party: I have authored a book called Manager's Guide to the Sarbanes-Oxley Act: Improving Internal Controls to Prevent Fraud, to be published in February by John Wiley & Sons.)
I think that in aggregate that Sarbanes-Oxley Act will increase costs to investors with few offsetting benefits. Most senior managements are honest (which does not require competence), and already have sufficient systems in place. Sarbanes-Oxley will only impose huge costs here. The only relevance is for companies where someone is attempting to steal. As far as I can tell, these situations were all well known before Sarbanes-Oxley, though perhaps only by the surprisingly few diligent analysts or reporters who had even a modicum of interest in questioning how 1 + 1 = 3. There are a few cases, such as Tyco, where theft was going on without public knowledge, but then the fox was guarding the henhouse, so to speak, and I doubt that Sarbanes-Oxley would have helped much.
In the meantime, many companies are forced to put in redundant systems, or at least controls that add only marginal value, while providing a feast for the accountants, lawyers, and consultants who were unwilling to speak up before, and who are still unlikely to bite the hands that feed them.
Do investors care about immaterial smoothing? I do not believe so. It is when management or earnings management leads an investor to misunderstand the health of the company that makes this wrong. There are always business judgments to be made. It is management that is responsible for judgments and the execution of an agreed-upon strategy. A lot of the new rules and regulations are simply geared to safeguard investors against management that may not have the shareholders' best interests at heart.
As in the past, one can audit and review business processes and transactions endlessly, with little to no business value creation. In the end, we must have confidence that management is of the highest integrity and can set the culture and tone of the organization accordingly.
The more transparency there is, the better. The purpose of accounting is to measure a firm's use of its resources, regardless of the volatility that results from that measurement. The catch is that greater transparency involves more accounting judgments. For instance, writing off assets requires accountants to first measure assets. Measuring assets by future cash flows or by other means can become very subjective. The U.S. needs to move towards a more principle-based accounting approach in order to achieve transparency while maximizing objectivity.
The core issue is that the legislative and regulatory response treats the symptoms (means) rather than the disease (motivation). Transparency is only as successful as the least creative obscurantist. While insiders are able to profit in markets where they can influence perceptions, there will be an inherent inequity in trading positions that the non-insider cannot hope to overcome. The implication is that any participation by insiders is detrimental to the confidence in the markets. This also leads to duplicity of corporate leadership by subverting the charter of those entrusted with stewardship of the stakeholders' investment.
If the objective is creating confidence in the equity markets as well as securing corporate integrity, then prohibit by regulation public equity trading by corporate insiders of the insider's equity; make insiders buy and sell equity directly to the corporation. The consequences of this course of action include reengineering compensation and the emergence of the board, representing stakeholders, as the seat of integrity for the corporation. The downside is that some really great talent, with questionable integrity, may no longer be attracted to corporate leadership. I think that is an acceptable trade-off in addition to being cheaper and easier to police.
Is the question whether investors can have too much transparency relevant in regards to the collapse of companies like Enron and WorldCom, considering the growing corruption worldwide on practically all levels? Definitely not, unless one believes that new laws alone can induce behavioral changes dramatically! It seems more probable that, due to over-commercialization, people are increasingly losing navigational control psychologically, becoming disoriented, and consequently susceptible to vice. Over-commercialization unfortunately demands exclusive navigational control of the ego, ignoring the inner voice and intuition, which leads to the alienation of man from himself and others--as the world situation clearly demonstrates.
While investors may always seek greater accounting transparency, this could be to no avail if management could still control how assets and liabilities are valued and/or if governments impose excessively expensive, ineffective, time-consuming, distracting, and misguided compliance rituals.
The Sarbanes-Oxley legislation is a case in point. It reflects the political imperative for the U.S. Congress to be seen as doing something about misleading corporate accounts. However, as your commentary suggests, these initiatives could be counterproductive.
One example is that Sarbanes-Oxley makes illegal the more effective and efficient investor protection that ironically exists in Russian companies traded on the New York Stock Exchange. Sarbanes-Oxley requires Audit Committee members to be made up of directors, but in Russia and some other countries, shareholders appoint people who are not directors to provide oversight of the audit function.
When a company has a separately elected watchdog board, audit firms in effect obtain two separate clients to separate out the inherent conflicts of interests from directors marking their own exam papers and reporting the results to shareholders. The watchdog governance board can also manage other conflicts like director nomination, remuneration and related party transactions.
However, to manage the conflicts of interest with related party transactions with a dominant shareholder, the watchdog board needs to be elected on the democratic basis of one vote per one investor, instead of the standard plutocratic basis of one vote per shareholder. Plutocratic voting permits oppression of minorities and can hollow out democracy in societies where corporations are politically influential.
The reliance of elected U.S. officials and influential educational institutions on funding from corporations might well mean that meaningful reform of corporate governance might develop outside the U.S. It would indeed be ironic if Russia led the world in strengthening capitalism!
What extra cost? Does the CEO know how the numbers are compiled? Aren't the financial systems will documented? Doesn't the company understand how it is performing?
You seem to be saying that a company that doesn't have good controls and doesn't know how it is doing in whole or in part is somehow a well-run business. And that putting in place the systems and controls to demonstrate how well it is run is somehow a burden to the true owners?
I would agree to a change in the law that allowed a company and CEO to sign a statement stating that under penalty of law he or she doesn't have any idea whether any statement filed with the SEC or reported to the stockholders is true. The only requirement that I would make is that the statement be at the head of every statement made by the company:
"I, as CEO (or member of the board) don't know if the following statements are true or false. If anyone can provide any evidence that I know the statements are either true or false, I am liable for civil penalties and monetary damages."
This give companies the flexibility to not have any business management at all.