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.