FOOL ON THE HILL
The Best Disclosure Makes Money

The current financial reporting system encourages minimal obfuscatory disclosure. It costs companies money in the form of a higher cost of capital, and investors must take on more risk. Companies should realize that there is a financial, not merely ethical, benefit to better reporting.

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By Tom Jacobs (TMF Tom9)
November 21, 2002

Sometimes you read something so simple, clear, and convincing that you wonder why you never saw it before. It happened to me in Chapter 1 of Paul B.W. Miller & Paul R. Bahsnon's compelling book Quality Financial Reporting, which argues for just that.

Many of us have been focused on the massive corporate misdeeds of the last years and on ways to prevent them. We also advocate this or that fix -- from the expensing of stock options to putting the right people in the SEC -- to help reduce abuse of the financial reporting system that while technically legal acknowledges the letter but not the spirit of the requirements.

Yet according to Professors Miller and Bahnson, our attention is wrongly diverted from the forest to the trees, to activities that are rearranging the deck chairs on the Titanic. From seeing what's really going on. The forest and the Titanic are our system of GAAP -- generally accepted accounting principles -- which creates an incentive environment for all companies to report the minimum. Would most of our companies' execs appear in public wearing signs emblazoned "Acme Products: Our Financial Reporting Is Barely Good Enough to Get By"? Of course not. Yet this is exactly what they do.

The authors assert that many U.S. corporate managers look at the following choices and pick "B":

"A. Provide financial statements that are so completely timely, trustworthy, and thoroughly informative that they reduce the uncertainty faced by investors and creditors and get them to give you their money while fully understanding the operating and financial risks that they face by dealing with you."

"B. Try to use GAAP and financial reporting policy choices to present financial statements that make your company look more attractive than it really is so that you can tease, cajole, entice, and otherwise trick investors and creditors into giving you their money on an impulse, hoping for the best."

The race to the bottom
You hear choice B when a questioner on an earnings conference call asks for a break out of numbers by division, and after a pregnant pause an exec says, unapologetically and even aggressively, "We don't break out those numbers." It's choice B when someone asks whether the company will consider expensing stock options, and the response is that they will comply with all regulatory requirements. It was choice B when Enron didn't even disclose a balance sheet in its quarterly press release and Jeffrey Skilling swore at the analyst who asked him why not.

Make no mistake. Choice B means "It's not in our interest to disclose our performance in ways that would help you monitor our business performance more easily and accurately. We're not going to do anything we're not required to do." This is shortsighted and raises the company's cost of capital.  

Quality financial reporting costs money
GAAP accounting imposes a huge cost on everyone by making it tougher for money to flow to its highest valued uses. It requires boatloads of people on one side whose job it is to obfuscate the truth and on the other to decipher the truth. Why? Miller and Bahnson present four axioms:

  • Incomplete information creates uncertainty.
  • Uncertainty creates risk for investors and creditors.
  • Risk makes investors and creditors demand a higher rate of return.
  • A higher rate of return for investors and creditors is a higher cost of capital for the firm and produces lower stock prices.

Or, if you are a positive thinker, the authors restate them:

  • More complete information reduces uncertainty.
  • Less uncertainty reduces risk for investors and creditors.
  • Reduced risk makes investors and creditors satisfied with a lower rate of return.
  • A lower rate of return for investors and creditors is a lower cost of capital for the firm and produces higher stock prices.

Self evident, right? Yet I think most people would get the next question wrong: Who do you think has a lower cost of capital, Bristol-Myers Squibb (NYSE: BMY), an established pharmaceutical company in an industry known for fat margins, or Berkshire Hathaway (BRK.A), a collection of recently poor-performing insurance companies and paint, jewelry, furniture, carpet, and underwear retailers?

In fact, it's the latter. Bristol is in the middle of sorting out several years of messes during which it pushed product through to wholesalers (channel stuffing) to bulk up sales numbers, among other things, and won't file its Q3 Form 10-Q until February 2003 -- three months late. While Warren Buffett and Charles Munger and the managers that run the Berkshire Hathaway businesses have consistently, resoundingly, and unfailing made choice A above to tell you the whole truth -- beautiful or ugly.

But you don't have to be in the Bristol doldrums to incur a higher cost of capital. You could be any one of the 9,000+ companies that does not sport a Standard & Poor Triple A corporate debt rating. The nine that do -- and earn the lowest cost of capital, just above Treasury rates -- are Berkshire Hathaway, American International Group (NYSE: AIG), Automatic Data Processing (NYSE: ADP), ExxonMobil (NYSE: XOM), General Electric (NYSE: GE), Johnson & Johnson (NYSE: JNJ), Merck (NYSE: MRK), Pfizer (NYSE: PFE), and UPS (NYSE: UPS) (as of July 25, 2002). These companies are not 100% without issues -- see Bill Mann's latest on General Electric -- and creditworthiness depends on many factors, but a company that chooses B over A even in part isn't going to come anywhere near this list. As a shareholder, you are taking on this greater cost of capital and more risk. Why should you? Why should anyone? And why do only nine companies have a Triple A rating?

Of course choice A -- quality financial reporting -- would be scary. It would mean, to use the language of economists, that capital would, like any other resource, flow more easily to its more highly valued use. Lots of the labor force would be, uh, moved around. This would have consequences, but the short-term pain would be worth the long-term gain. 

"But Johnny does it!"
Can it happen? I think the professors are too polite and that 99% of U.S. companies -- not just "many" -- choose B. Execs may think they have no alternatives, that they must meet the competition, but they're like your child after that first peer group prank or cigarette/drink/I'll stop there at the party, "But Mom, everyone was doing it!" If pressed, they plead that "the system" (how sixties) gives them no other choice but to bury all simple but unfriendly truths in footnotes to financial statements exactly the same way that politicians insert special favors into bills at the last minute in the dead of night so that responsible representatives, let alone their constituents, can't perform their jobs.

To turn the tide, we can -- and must -- vigorously insist that financial reporting requirements give investors the tools they need to make the best investing decisions. This will lower companies' costs of capital and increase investors' risk-adjusted returns. But we probably can never legislate or regulate a system in which company managers decide to be the best in clear, complete, and candid disclosure. They must see the rationality and convince their colleagues and boards that it will bring financial rewards. When the good companies -- the ones who can survive the transparency -- do this, it will put the pressure on and encourage flight from the bad companies that stick with choice B.  

Investors have a job too (as former SEC Chairman Arthur Levitt reminded us in our recent interview). We must keep up that pressure on management at companies that appear to be better businesses by writing, calling, and asking difficult questions on calls and at annual shareholder meetings. Insist that they choose A. If there is no change, we must take our money to better places.     

Tom Jacobs (TMF Tom9) is a senior analyst who writes for The Motley Fool Select. Enjoy your 30-day free trial today! To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.