How to Fix Financial Reporting
On Nov. 15, finance ministers from the 20 wealthiest countries are scheduled to convene in Washington, D.C., to discuss what could amount to a comprehensive overhaul of the global financial system. The alarming speed with which the credit crisis has spread from toxic mortgage-backed assets in the U.S. to banks as far afield as Iceland, Russia, and Korea certainly calls for a radical rethinking of how these markets are set up and regulated.
How far-reaching such a structural makeover turns out to be is anyone's guess, but one issue that demands attention sooner rather than later: strengthening the rules that govern how publicly traded companies report financial information. Strictly speaking, the financial crisis erupted from risky investments that have tainted the balance sheets mainly of banks and other financial institutions. But the crisis of confidence, some believe, is pervasive and extends to confusing accounting practices applied by a much broader universe of companies. Investor confidence in the markets hangs in the balance until financial transparency and disclosure are significantly improved.
The core of the problem is the failure of many companies to provide a complete and accurate depiction of their financial standing, which is reflected in deficient disclosures of asset values, liabilities, and overall risk on corporate balance sheets. Even as financial analysts and regulators have called for increased transparency, the banks at the center of the credit crisis have stepped up requests that fair-value accounting for impaired assets be suspended to allow the credit markets to loosen up (BusinessWeek.com, 10/15/08).
Short Shrift to Capital Markets
Some people, including William Isaac, a former chairman of the Federal Deposit Insurance Corp. (FDIC) during the mid-1980s, have even blamed the credit crisis on the Financial Accounting Standards Board's 15-year-old rule requiring that assets be valued according to their current market value, even if the market for them has temporarily vanished. They claim that the rule forced companies to write down asset values, destroying equity and impeding banks' lending ability. Resisting pressure from the financial-services industry to suspend fair-value accounting, the U.S. Securities & Exchange Commission and the Financial Accounting Standards Board on Sept. 30 issued a ruling that allows executives to value assets using their own financial models and judgment when no market exists or when assets are being sold at fire-sale prices.
The way Paul Miller, an accounting professor at the University of Colorado, sees it, a major paradigm shift is required in how companies think about the capital markets. Over the past 30 years, companies have awakened to the importance of working more cooperatively with three of the four constituencies they depend on for their success: their customers, their employees, and their supply chains.
Companies have learned they can build loyalty and market share by being more attentive to customers, can get more from their workforce by taking better care of employees' needs, and can pull off just-in-time supply chain management and boost profitability by giving suppliers access to their internal electronic supply systems, says Miller.
"We've learned to work with three out of four markets, but with capital markets we continue to think of it as one we can continue to abuse and keep in the dark and they'll continue to throw money at us. But that's not the way they work," he says.
Management has a responsibility to shareholders to keep capital markets well-informed about their firms' prospective cash flows and intended uses of any capital they raise. "If you make up your mind to go to the capital markets reporting as little as possible, or information that's deliberately biased, the capital market knows it" because asset managers have experience and also have plenty of other choices about where they can invest, he says.
What heads of corporations fail to realize is that the capital markets don't reward them for making information more difficult to find and trust, says Miller. Producing positive earnings that are illusory only hurts management's reputation and leads to discounted stock prices.
More Transparent Derivatives?
For investors to develop more trust in the market, two key financial reporting practices need to be reformed, in Miller's view: the treatment under U.S. Generally Accepted Accounting Principles (GAAP) of off-balance-sheet financing, and pension-fund accounting. Under the current rules, companies are required to disclose only net liabilities and assets. The way they do so, for operating leases, for example, tends to distort their balance sheet and confuse investors, says Miller. The FASB has been working in conjunction with the International Accounting Standards Board in London on a project that would require all leases to be capitalized on companies' balance sheets.
A second joint project between the two standard-setting bodies has already produced accounting standard FAS 158 in the U.S., which took the reporting of pension-fund assets and liabilities out of the footnotes and put it on the balance sheet as a net amount, says Miller. Phase two of the pension accounting project is still under way and is focused on reporting the impact on earnings of offering pensions.
With an estimated $1 trillion or more worth of assets languishing in pools of securitized loans on the balance sheets of financial firms, the need for more thorough disclosure of these distressed assets is even more urgent.
Some market strategists are convinced banks will have to revert to plain-vanilla investment products over the next few years until investors regain their appetite for more sophisticated vehicles. But Kenneth Scott, senior research fellow at the Hoover Institution and a professor at Stanford University's law school, thinks the mistrust for securitized assets like collateralized mortgage obligations (CMOs) could be alleviated by improving the transparency around these assets. The problem with these assets stemmed from the repackaging of less marketable CMOs together with other pools of low-quality mortgage and auto loans into collateralized debt obligations (CDOs), and then even-further-removed instruments called "CDO squared"—a kind of derivative of a derivative.
One reason the credit markets froze up was because the market questioned the value of these assorted securities once defaults and losses began to mount, and asset managers realized how impossible it was to calculate the impact of losses in the first pools of collateralized assets on tranches of lower-quality loans further down the securitization chain. The structure of securitized assets could be made more transparent if there was a data bank that combined information from all the asset pools that were being shuffled around, according to Scott, although he concedes that creating such a database would be very difficult to achieve.
A Call for Electronic Financial Reporting
An alternative solution, at least in theory, he says, would be to assemble all the reports on these myriad pools that hedge funds and other asset managers issued to investors and then to figure out who is bearing how much loss and to what extent risk is rising in supposedly triple-A securities. "If you could start to create this data base that's comprehensive enough by bringing together all of the pool reports and putting them into some computer model, you might be able to reduce this paralyzing uncertainty," he says. Ironically, the ratings agencies, which have come under fire for improperly identifying the level of risk in securitized assets, may be in the best position to do this, since they already have collected much of the data and a lot of the models, he adds.
Enforcing stricter capital requirements for companies and insisting that assets be more liquid than in the past could also help bolster investor confidence, says Walter Pagano, who heads the Litigation Consulting & Forensic Accounting Services Group at Eisner LLP in New York. The Treasury Dept. is already mulling whether greater emphasis should be put on the kind of liquidity companies have within their current debt-to-capital ratios, he adds. There's also likely to be a call for enhanced corporate governance of assorted issues around companies' balance sheets, he predicts.
Financial reporting also needs to move away from big documents to electronic database formats that relieve analysts of the need to reenter all the numbers in their own spreadsheets, and would free up analysts and regulators to actually analyze the data, says Philip Moyer, chief executive of EDGAR Online (EDGR), a Web site that publishes corporate filings to the SEC.
"This needs to happen in the asset-backed securities marketplace so you know the actual impact on an investor's portfolio," he says.
EDGAR Online is spearheading an effort to implement an interactive data protocol called XBRL in the U.S. that would do just that. XBRL, which is already being used in China, Japan, and Korea, creates a common set of labels for line items on companies' financial statements that allows analysts to more easily compare items between companies. Currently, companies are permitted to label items however they want, says Moyer.
Aiding Investor Insight
Regardless of which technology is adopted, investors need access to tools that will enable them to burrow deeper down into financial statements to see the level of detail they require to assess a company, however and whenever they want to, says Cindy Fornelli, executive director of the Washington-based Center for Audit Quality, which focuses on public company audits.
The CAQ recently completed an 18-month public dialogue tour that brought together investors, high-level company officials, a state Attorney General, and a former chairman of the SEC, among others, to discuss ways to modernize financial reporting and make it more relevant to investors. The organization plans to release its findings by the end of this year.
One suggestion that came out of the panels was that companies start to list key performance indicators for their specific industry in their financial reports, which would allow investors to compare information between competing companies. Fornelli says she would prefer that companies do this voluntarily across an industry, since they know best which indicators are most important, rather than have the SEC create a rule.
Christine DiFabio, vice-president for technical activities at Financial Executives International (FEI), an industry association whose members come from 8,000 public and privately held companies, believes restoring investor confidence requires looking at a broader set of issues. "We can't just fix this crisis by looking at accounting and reporting," she says. "We have to look at broad-based practices across the business environment, including companies' ability to get cash and access to capital."