Truthfulness, Transparency and Incentives: Making Financial Reporting More Honest

Over the course of our semester, I’ve been drawn to the issue of how well accounting guidelines facilitate corporate transparency. Time and again, I’m surprised to learn how soft, voluntary or easy-to-manipulate many of these guidelines really are. Legislative efforts to increase the accountability of management and auditors often seem to work in a rather backwards way – they don’t punish the fraud, but rather, the act of obscuring that fraud. The Sarbanes-Oxley Act places an increased legal liability on their “signing off” on a company’s financial statements, and punishes transgressors more for their lack of candor than for the underlying crime. An analogous situation is when former-Olympic Sprinter was indicted for lying to Federal prosecutors in their investigation about her steroid use – though she served prison time, her official crime was not defrauding her competitors, fans and sponsors, but for lying the investigators.

My most important take-away from the Avery Case that my group presented this week was how easy it is for a company to fail in being either truthful or transparent while still seemingly being within the limits of accounting guidelines. While I can understand the impetus for a company’s management to massage their financial statements, it seems that so often, all they do is build a house of cards that tumbles within a few quarters or years. The Avery Case begged the question: how to best create an honest exchange between management and shareholders.

Business Ethics professors Joan Fontrodona and Antonio Vaccaro have a few ideas on the subject that they discuss in their September 7, 2010 article “The Myth of Corporate Transparency” in The Economist’s NewsBook blog. They focus on the difference between transparency and truthfulness, emphasizing the fact that the former doesn’t lead to the latter. Transparency, they claim, is the latest phenomenon in an effort towards truthfulness, but it is not synonymous, and comes with its own baggage. These days, transparency has a bad habit of settling for complete disclosure without making information more cogent. What’s the use of a 100 page financial statement when it takes the forensic accountants from CSI: Deloitte to decipher that, say . . . a company is treating their Capital lease an Operating lease, and that such a change would have a significant effect on its Debt/Equity ratio. While the Avery Corporation’s fictional CEO Arnold Tennenden certainly wasn’t being transparent, Fontrodona and Vaccaro’s article suggest the question, ‘how truthful would he have been even if he had been transparent.” Might they be any easier for the average stockholder (or confused rock musician who inherits shares) to understand?

In a choice between transparency and concealment, transparency is always preferable. That said, perhaps the road to Truthfulness lies in a different direction. That management is in charge of the production of financial statements but is also beholden to the success those statements present (the Agency Problem) is a fundamental challenge in the pursuit of Truthfulness. Human nature won’t change, but managers can be better incentivized to be honest. One suggestion is to change the timeline along which financial performance is measured. Every three months, there’s an excited scramble as financial analysts predict quarterly results and management massages their numbers to meet those predictions. Studies show that quarterly earnings meet (or exceed by a penny) the earnings-per-share predictions made by analysts far more than would be expected from a random statistical prediction. Harris Collingwood describes this phenomenon in his article, “The Earnings Game: Everyone Plays, Nobody Wins,” appearing in the June 2001 Harvard Business Review as “fetishistic attention to an almost meaningless indicator . . . [that] distorts corporate decision-making . . . reduces securities analysis and investing to a guessing contest . . . compromises the integrity of corporate audits [and] . . . undermines the capital markets.”

The take-away? Truthfulness reveals itself over the long-run. While transparency helps, perhaps the most effective way to encourage managerial honesty is to make their incentives based upon the long view as well.

Posted in The Accounting Standard Setting Process | 30 Comments

What are affecting earnings quality

Avery Corporation case have greatly focused on the earnings quality and interpretation of facts. Hence, I find the below article very relevant summarization of variables that influence directly or indirectly the quality of earnings. The author has evaluated below list of variables:

  1. Accounting standards: as discussed in previous blog entries on IFRS, the US GAAP leaves a lot of room for interpretation hence could affect the quality of earnings. It is suggested that strictness of the standards influences the quality of earnings.
  2. Firm characteristics: some research proves that there is strong correlation between earnings and shareholder composition as well as controlling shareholder.
  3. Board, auditing committee: number of board members and as well as the frequency of audit meetings and its participants may also affect the quality of earnings.
  4. Managerial characteristics: managers compensation plan as well as turnover the managerial positions could also affect the earnings.
  5. Auditing firms: loyalty to one auditing institution may also lead to more lenient interpretations hence misstated earnings.

It is important to quantify many different aspects while evaluating the quality of earning and would recommend below article for more insights.

Wu, D. (2009) What are affecting earnings quality: A summarization, Journal of Modern Accounting and Auditing, May 2009, Vol.5, No.5

Posted in The Accounting Standard Setting Process | 14 Comments

HK opens doors to Chinese Accounting Standards

I came across an article in the Financial Times on Dec 10th 2010, which talked about change in accounting standards.

‘Hong Kong Exchanges & Clearing announced on Friday that it would allow Chinese companies listed in the city to rely solely on mainland auditing companies and accounting standards to prepare their financial statements – a move corporate governance activists said would reduce local regulatory oversight.’

HKEx said the move “would increase market efficiency and reduce compliance costs of mainland incorporated companies listed in Hong Kong”. The exchange said that the majority of respondents to the public consultation that had taken place between August and October 2009 felt that mainland accounting standards had “substantially converged with Hong Kong accounting standards”.

HKEx said it believed “the co-operation agreements between Hong Kong and mainland regulators will enable effective monitoring and investigation of audit firms”, but did not outline what role the Hong Kong regulators would play.

Posted in The Accounting Standard Setting Process | 2 Comments

Mind the GAAP

Mr Turley, Chairman and CEO of Ernst and Young in his report in the Wall Street Journal, dated Nov 2007 has expressed his support for the SEC to set a certain date for the shift to IFRS.

Currently US companies follow the US GAAP as the financial accounting standards. The SEC has already allowed non-US companies to file US financial reports under the IFRS. They are wondering whether to allow the US companies to shed its former accounting standards (US GAAP) in lieu of the international IFRS.

A single set of high quality global standards have a number of benefits

(1) Greater Efficiency within companies

(2) Savings on legal and accounting experts

(3) Benefits for the investors: IFRS would prove to be a new level of reliable source for the investors.

(4) IFRS would provide a readily available foundation for capital markets, which could promote investments in emerging markets.

IFRS is becoming the dominant global language for the business. Many countries have already set dates for the change and according to the writer of this report, US too should set a date so that the companies can make necessary legal and regulatory changes for the shift.

Posted in The Accounting Standard Setting Process | 2 Comments

SOX Section 404 – is it really effective ?

The main objective of the Sarbanes–Oxley Act is to avoid frauds. Section 404 of the Act requires management of public companies and the external auditors to report on the company internal control over financial reporting.  In order to comply with this requirement, companies need to pay a lot of money. According to information I could find online, the accounting and auditing costs could increase by 30% to some companies, mainly the smaller ones.   

I believe that these extra costs are high enough to discourage companies from issuing in the US stock market, and I do have some doubts regarding the effectiveness of this section in the Act. When I read a little bit about this Act I could think of a person putting his hand on the bible to be sworn to tell the truth before testifying in court.  Indeed, this Act gives and explicit responsibility to mangers regarding financial reports of their companies. However, without being too familiar with the details of the Act, I believe that managers who are determined to commit a fraud will do it regardless of this Act, same as a person who testifies in court can avoid telling the truth even after swearing with a hand on a bible.  The act sounds more symbolic than effective to me. And even if this Act is effective, the question what is the trade off?  How many frauds would be avoided compare the money lost from companies that avoid issuing in the US?  We have to remember the opportunity cost. I believe, and again maybe I underestimate the effectiveness of this act, that at the end of the day, the American public loses more than it benefits from this Act. I think that the American public would better off had the legislators could think of severe punishments to managers who commit frauds.

Posted in The Accounting Standard Setting Process | 3 Comments

Are Foreign Issuers Shunning the U.S.?

The 2006 article in Financial Executive by Jeffrey Marshall discusses the cost-benefit analysis of Sarbanes-Oxley Section 404 for non-U.S. issuers. The article lists the benefits of being listed in U.S. exchanges for international companies, the costs of SOX regulations for these companies, and the reasons why companies choose not to go public in U.S.

After witnessing the huge scandals regarding internal control and corporate governance issues and the enormous impacts of these scandals, I believe SOX is a very important protective measure that should not be negotiated about. These protective measures are important not only for internal control, but also for other processes such as risk management.

During the 2001 economic crisis in Turkey, approximately 1 in every 4 banks went bankrupt. This massive fall was based on various reasons. The most important reasons were the lack of effective company management, the lack of the reserved capitals of the banks, and the lack of effective internal controls. After the crisis, the government put several regulations in action and made the banks’ lives miserable during the transition process. Although each player in the market was complaining about the burden and negative aspects of the new regulations, during the 2008 global recession Turkey was one of the few countries where the banking system was not affected terribly.

The takeaway of this recent example is the importance of strengthening the control and risk management processes. Both U.S. companies and non-U.S. companies should perceive the SOX measures as a seatbelt and/or an airbag for a possible accident coming up.

The article mentions two large Chinese companies that chose to be listed in the Hong Kong exchange as a cheaper and less burdensome way (compared to be listed in U.S.). I hope that these companies do not learn to comply with the strict rules of SOX through a much harder and costly way.

Posted in Sarbanes Oxley, The Accounting Standard Setting Process | 1 Comment

Sarbanes-Oxley: A price worth paying?

The subject matter of the Economist article “Sarbanes-Oxley: A price worth paying?” is a fantastic Rorschach test for the business community.  That is to say, the Sarbanes-Oxley bill is such a complicated piece of legislation that any attempt to analyze it results in the author communicating more about herself than the law.  For example, early in the article the author of this piece mentions Alan Greenspan’s praise of the law, but immediately qualifies it as “faint praise” since quickly passed laws that address complex subjects “can normally be expected to fail abjectly.”  The author does not explain why this is the case though.  Have there been objective historical studies on the efficacy of laws based on the time it took to pass them and the complexity of their subject matter?  Or is this, as I suspect,  just a free-market believer’s skepticism of government coming out?

On a larger level the Rorschach effect of Sarbanes-Oxley can be perceived in an individual’s cost-benefit evaluation of the bill.  On the benefits side, the law created an accounting oversight board; banned auditors from providing non-audit work to clients they audit, thus removing an obvious conflict of interest; required companies to establish independent audit committees; forbade company loans to company executives; forced top executives to certify company accounts, thus creating more accountability; and extended protection for whistleblowers.  All of these rules should provide significant comfort for shareholders who have no choice but to rely on the validity of company financial reports when making investing decisions.

On the cost side, implementing the changes required by the law has been financially expensive for corporations.

It seems to me that it is impossible to quantify the value of the benefits, therefore rendering it equally impossible to ever come up with an objective cost-benefit analysis.  Instead, we must acknowledge that a person’s position on the value of the law will be predominantly based on their previously established beliefs regarding regulation, corporate integrity, and the relative need for corporate oversight.    The author correctly states that people will be debating the value of Sarbanes-Oxley for many years; as long as people have clashing views on regulation, corporate integrity, and corporate oversight, this debate will not end.

Posted in Sarbanes Oxley | Leave a comment

Sarbanes-Oxley: A Price Worth Paying? – Sumesh

After the fall out of companies like Enron and WorldCom, US government came out with laws that would restore confidence in accounting principles and public companies.  In 2002 Sarbanes- Oxley act (SOX) was passed. SOX’s initial direction to SEC was to boost up public company oversight board (PCAOB) by Jan 2003. As an independent, non-government board PCAOB’s function is to protect the interest of the investors and install public confidence in independent audit reports.  SOX have a huge impact on companies and people involved in capital formation process.  This includes, and is not limited to personals in the roles of company management, audit committee, external auditors, attorneys, security analyst and regulators. The law highlights the importance of corporate responsibility, financial disclosures, auditor’s independence and analyst’s conflict of interest.

Eight years after SOX came into existence; it’s still debatable if the law had done enough to contain corporate scandals or if the law itself is a cause for scandals as corporations try to adjust to the new environment created by the law.  A point of view can be raised if the law had bridged the gap too much between management disclosures and auditors insight. If that is the case the question arises how much information is shared and how much of it can risk companies exposure to competitive threat or to something like insider trading.  I believe the SOX law is over leveraged and it provides external entities too much legal support to probe into a corporation. An example is section 302 which says “all deficiency and material weakness in internal control have to be disclosed to audit committee and auditors”. A corporation is an entity by itself in a free market and should decide for itself what practice it should follow in light of its market position and market place preferably based on guidance’s and not by law.

The comment above doesn’t undermine the role of government in preserving a non-monopolistic even marketplace or the government’s reach to interfere in a companies practice for good reasons. However the vintage point of establishing a corporate culture or corporate responsibility from an outsider perspective many not fit the frame of any company.  A corporate culture is something that evolves over time and the guidelines for corporate responsibility should be driven from within the company rather than as a mandate of law. An example for such a mandate with no reward to a company is section 301, in which a company is required to have an audit committee with members of certain expertise. This does not provide any incentive but pushes an extra cost and regulatory compliance burden on the company. Finally, couple of company’s failures and wrong practices is no reason to punish the rest of the 99% companies that are well run.

Posted in The Accounting Standard Setting Process | 10 Comments

The Sarbanes-Oxley Act-Is it Worth Paying the Price?

The Sarbanes-Oxley Act of 2002 was created to protect of the investing public, shareholders of public corporations, and employees of these public organizations.  Looking back, do you think that former employees of Enron would have appreciated an act like Sarbanes-Oxley aimed at maximizing oversight of accounting procedures?  Many high level executives have expressed such displeasure with the cost, time and confusion the act has caused, that many CFO’s around corporate America have considered resigning their positions.  Sure, there may be some major or minor adjustments that need to be made to the Act as the wrinkles are worked out, but that’s part of the process.  The premise of protecting the innocent investing public and shareholders from fraudulent activity is sound, and will have long-term benefits for the general public.

Corporate executives are clearly wary of the newfound accountability the law requires of them with regard to their company’s financial reporting.  Fearing that they could be held liable for something they were not aware of is uncomforting.  Then again, they are compensated highly for this responsibility, and simply need deal with it.  Corporate executives need to ensure, now more than ever, that proper compliance control measures are in place, to mitigate the possibility of fraudulent activity within the organization.

Ultimately, there needs to be an efficient balance in place within organizations that allows the Sarbanes-Oxley Act to have it’s intended impact, while allowing organizations to still operate profitably and efficiently.  This will not happen overnight, however, both sides, the government and organizations need to work together to achieve this balance.  Those that are angry with law need to be patient.  Some say that Wall Street works best when fear and greed are in balance.  I couldn’t agree more.

Posted in The Accounting Standard Setting Process | 14 Comments

“Are Foreign Issuers Shunning the U.S.?” Sarbox Debate

Jeffrey Marshall discusses Sarbanes-Oxley Act’s Section 404 in his article titled “Are Foreign Issuers Shunning the U.S.?”.  This section states: “Issuers are required to publish information in their annual reports concerning the scope and adequacy of the internal control structure and procedures for financial reporting.”

Mr. Marshall discusses the theory that foreign issuers are running from U.S. exchanges partly because of the costs associated with complying with this section of Sarbox.  However, there are other reasons that foreign issuers may list outside of the U.S.  For example, many exchanges outside of the U.S. are becoming very liquid and it may be more convenient to just list in the country where the company is located.  Globally, exchanges have grown even as some are increasing regulation (i.e. Japan). 

I think that accounting regulation, while costly, is necessary in providing comfort to investors (psychologically) regarding the financials being disclosed by public companies.  The problem is – how do you quantify comfort?  Is this benefit > cost of compliance? 

Section 404 may also add one more layer of complexity that makes it difficult for management to get involved in accounting scandals.

Posted in The Accounting Standard Setting Process | Leave a comment