Financial reporting would not be needed if all stakeholders in the firm shared the same information about how the firm has performed in the past and had similar expectations as to how it will perform in the future. Furthermore this shared information should be correct and well representative of the actual business conditions of the firm. In reality, those within the firm are inevitably in a better position to know its state than those stakeholders outside of it. Moreover, the former are not just informationally advantaged, but as managers they can actually shape the firm’s future performance. This is the fundamental informational asymmetry that bedevils financial reporting, a reflection of the conflict of interest between shareholders who only care about the financial performance of the firm as reflected in its market price, and managers who can directly benefit from exploiting the firm’s assets. [m1]
These informational asymmetry and moral hazard issues add the possibility of deliberately distorted reporting to the already formidable problem of measuring firm performance even in a non-strategic setting. Moreover, measuring past firm performance is largely a means towards the end of forecasting future performance for it is only the future and not the past that affects firm valuation. [m2] Clearly managers can affect the degree to which past performance predicts future performance, thus affecting the value of financial reporting.
Adding to these measurement problems are changes in the way in which firms transform capital into returns. Once the main function of the firm was to apply unskilled labor to physical assets, so that the reporting which concentrated on the disposition of those physical assets adequately captured firm performance. Xxxx Indeed, even accuracy in measuring assets could be sacrificed for other goals such as verifiability through the doctrine of conservatism without greatly reducing the usefulness of the reports. But today firms create value by the use of such intangible assets as knowledge and the skills of its workers with the result that the relationship between its physical assets and its performance is greatly diminished. This creates two problems: a pure measurement issue of how to account for the presence and role of intangibles and a strategic measurement problem in that this broken relationship opens up a wider scope for managers to manipulate earnings.
An example of these problems comes from a sizable accounting transaction[m3] : the decision by Cisco Systems, in May 2001, to write-down its inventory by $2.25 billion, an amount larger than the inventory value in its books.xxx[m4] One explanation is that the write-down related to the value of inventories that could be not sold by its suppliers in the value chain where Cisco had a contractual or moral obligation. In particular, during the e-commerce boom Cisco had offered vendor financing to many dot com firms in exchange for sales contracts, while signing contracts itself with downstream suppliers in anticipation of tight demand. These obligations were not reflected anywhere in the financial reports. Of course, even granting these problems, there was also the suspicion that the sheer magnitude of the write-off resulted from the use of the well known tactic of the “big bath”, in which all the bad news are anticipated in advance, all at once, thereby creating reserves to boost income in the future. [m5] [m6]
This example and the difficulty in disentangling its purpose are indicative of the difficulty that users face today with financial reports. In fact, the underlying accounting fails to account for the way in which the modern firm operates and for the intangible factors which underlie value creation or destruction. Moreover, managers are able to take advantage of the resulting ambiguity to act in their own best interest and not necessarily that of the firm or other stakeholders. Most importantly, this is not an example of outright fraud or audit failure, but rather an example of what is arguably a far more compelling problem: the systematic inability of the current financial reporting system to meet the needs of users, to understand the ways in which complex organizations perform and to hold managers accountable.
This example also undermines one of the arguments in support of the current financial reporting system and against changes to that system: the need to maintain comparability and consistency across firms in the ways in which they account. But even strict rules, such as those that apply to inventory valuation or special purpose entities, is no guarantee that firms will apply those rules in the same way given the underlying ambiguity about what is being measured. This is really an argument for more information disclosure to enable stakeholders to better discern the purpose and meaning of specific business activities.
Other examples of the difficulties posed by the existing financial reporting system are reflected in many of the recent scandals, as the prosecution of the perpetrators did not deal directly with the core malfeasance issues but attacked more peripheral facts. Thus,
* Arthur Andersen was not convicted for performing bad audits but of destroying evidence.
* Martha Stewart was not convicted for trading on insider information, but for lying to federal investigators.
* Dennis Kozlowski of Tyco will likely be convicted for not paying sales taxes in the state of New York not for plundering the treasury of his company in lavish self-given benefits that were “approved” by a deceased director.
The press attributes these aberrations to the hesitation in the part of prosecutors to discuss a set of “arcane accounting laws” in a court of law where jurors, lawyers and judges will have great difficulty comprehending the issues presented by armies of highly paid attorneys who, in collaborations with expert witnesses, point out the ambiguities of the law and explore the “beyond reasonable doubt” concept.
It is also striking that the parties that have been involved in many of these cases are stalwart institutions which help define the nation’s economic environment. [m7] Take for example the case of Enron, which had over 600 CPAs on its payroll and hired McKinsey for strategic advice, Arthur Andersen for audit and consulting services, and worked with Citibank, Merrill Lynch, and JP Morgan for structuring and supporting its financial operations. These firms, the best and the brightest in the business, helped Enron stretch the boundaries of accounting in order to manage its earnings. These financial institutions had entire groups devoted to “structured [m8] transactions”[1] whose main purpose was to disguise the nature of the financial transactions of Enron within the “arcane set of rules” of accounting that they expected never to be revealed to the world, and in case of litigation expected the prosecutors to avoid.
Enron also had an intricate web of additional financial relationships with its directors who advised it on many issues while handsomely profiting from their relationship. These directors were also stalwarts of society and most likely were aware of the aggressive nature of Enron’s accounting even if there were not cognizant of the criminal profiteering of some of its top managers. Ex-regulators, leading academics and well known international figures were compensated by being on Enron’s board as well as by providing other services as external consultants. The fundamental problem is that the highly complex nature of Enron’s transactions would have been very difficult to detect by even the most committed and best trained external director.
The need for drastic change in financial reporting has been recognized by many. Arthur Levitt[2], the former chair, commenting on Senator Carl Levin makes a very damning statement:
… well before the Enron disaster, he saw the fiction that corporate financial statements had become: companies technically were in compliance with accounting rules, yet their financial statements were hiding huge debts and other liabilities. (p 243, emphasis added)
What is needed to update the financial reporting system to deal with this kind of complexity? The rest of this paper discusses the options in detail. Here we present the main issues and principles of a new financial reporting process.
