How to Fix Financial Reporting

Improving transparency and accuracy of financial info could help rebuild shattered investor confidence, say financial experts. Here's what they think should be done

By David Bogoslaw

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.