I THINK the topic — how companies can improve their disclosures to investors — is an important one.
As an economist, I generally see things from a different perspective than lawyers.
When economists confront an issue, they think, "What reward can we give people to do the right thing?"
This is like your mother saying, "If you finish your homework before dinner, you can have ice-cream for dessert."
I'm here today to offer a different and, I think, better way of approaching corporate disclosures — the economist's view. I want you to think about all the good things that can result for the company, its managers and its shareholders if the corporation makes more full and fair corporate disclosures. It's like everyone getting ice-cream for dessert.
In general, management should think more about the market, and less about hypothetical lawsuits. The focus should be on disclosing information to the market that management thinks is important for shareholders or potential shareholders to know. And that information should be an honest assessment of the direction and risks that companies face.
Simply put, management needs to tell a story. Of course, management should be careful to make its story strictly non-fiction! And the goal should not be to put investors to sleep, but rather to make the information it is conveying to investors compelling and understandable.
Management can most effectively tell its story through the Management Discussion and Analysis, the MD&A. Management can also tell its story by using clear financial statements and analyses. Financials will be more understandable and compelling if they focus on accounting for the substance of transactions. Let me turn first to the matter of improving financial disclosures.
As you may know, the Sarbanes-Oxley Act passed last summer required the Commission to conduct a study, by July of this year, on the adoption by the US financial reporting system of a principles-based accounting system.
Although the exact meaning of the term "principles-based accounting" is not clear, it is generally agreed that such accounting requires a company and its auditors to consider whether its accounting is in accord with the principles governing a particular transaction, not merely whether or not it fits within a specific rule.
In other words, auditors must account for the substance of a transaction, rather than its form. First and foremost, principles-based accounting would emphasise the spirit of the accounting standards, not just their letter. In addition, principles would apply more broadly, thereby allowing fewer exceptions.
There would be less confusion arising from the numerous exceptions that exist under generally accepted accounting principles (GAAP). Principles-based accounting emphasises the professional judgment of managers and the company's auditors, rather than the need for interpretative guidance.
So, again, there would be less confusion stemming from an array of interpretive comments. Of course, management and auditors would need to be aware of their central role in a principles-based regime, and act with the utmost care and integrity.
Such a system would provide overriding principles that incorporate specific guidelines as examples to give the system more context and more teeth. For now, we still have to work with GAAP. Personally, I do not think either strictly principles- based or strictly rules- based accounting is feasible. Ultimately, we should have a hybrid of rules and principles.
In assessing the value of GAAP, it is important to remember that it does have its good points! GAAP provides basic uniform accounting standards, as well as consistency of accounting standards across all companies. And, although the detailed exceptions and rules sometimes hide them, GAAP itself is indeed based upon certain fundamental principles of accounting.
Unfortunately, GAAP as applied in the US has gone beyond those principles to the point that it has, at times, obscured them completely, creating a morass of exceptions and bright lines. GAAP's complex of rules creates situations where lawyers and accountants may play games with the rules, rather than focussing on the principles underlying them.
The more specific the rules, the easier companies may find it to structure transactions specifically to circumvent them. This, of course, is the problem with "bright line" rules: the impulse is to make sure the line isn't crossed instead of making sure the books reflect the true economic condition of the company. The substance of a transaction should dictate the accounting, not vice-versa.
It is also important to remember that simply complying with GAAP may leave gaps in disclosure and give investors an incomplete — or even misleading — picture of a company's operations.
Similarly, just as compliance with GAAP without more information is not a remedy for all of a company's ills, using pro formas is not necessarily a deadly disease. As long as pro formas are not used in a misleading way, they can be an excellent tool to give investors more information about a company.
Another lesson learned is that clear disclosure in footnotes or the MD&A is required to bridge the gaps between what GAAP allows and the economic reality of the company's operations.
As counsellors, you should remind your clients to look to the principles underlying GAAP so that companies report accurately their business operations — not to strive to take advantage of the technicalities in GAAP to distort the bottom line.
Managers should also correct some of the imperfections in GAAP by better disclosure outside the GAAP framework — by describing their actions more fully in the company's MD&A.