Does Transparency Work?

IMGCAP(1)]Opaque financial instruments that banks and insurance companies have created and misrepresented, and that were blamed for the current recession, seem to call for greater transparency. But what exactly is transparency? How is it done? Does it work?

Disclosures in financial reports of assets, liabilities, owners’ equity, revenues, and expenses are reputed to be successful examples of transparency, despite their significant measurement limitations and misrepresentations.

It is well-known that the Financial Accounting Standards Board tries to improve financial reports through its due process. Not so well known is that FASB’s conceptual framework is a specially developed basis to advance transparency. Critics claim, however, that the current conceptual framework does not guide standard-setters to accurately measure perennially troublesome transactions like the opaque financial instruments.

FASB agreed and, in recognition of the significant growth in international business, joined with the International Accounting Standards Board to reconcile and improve their current conceptual frameworks. Nevertheless, FASB’s current conceptual framework provides consistent, principles-based guidance and could, if rigorously applied, advance transparent financial reporting.

A quick example applied to a basic form of financial instruments, marketable securities, makes the point. Marketable securities are debt or equities readily bought and sold on an exchange, are purchased on a specific date, and have undergone price changes. Alternative accounting representations are historical cost (past market prices) and mark-to-market (market prices on the reporting date).

The conceptual framework proposes that if representation of a transaction or event satisfies the conditions of definition, reliability, measurability and relevance, then it should be recognized in the financial statements. If the representation does not satisfy one or more of the conditions, then it is not to be reported in the financial statements. The conceptual framework guidance for marketable securities affirms definition, reliability and measurability for both historical cost and mark-to-market representations.

However, mark-to-market prices provide updates and feedback on the date of the financial reports. Mark-to-market prices are, therefore, timely and relevant.

Not so for historical cost. Past market prices are obviously not as timely as mark-to-market prices. The securities are not, therefore, to be represented by historical cost. The conclusion is intuitively correct: Consider buying ownership shares in a company that itself owns stocks and bonds in other companies. Do you want to know the old values of its marketable securities or the most current prices as of the financial reporting date?

Although the conceptual framework was available to FASB when it promulgated an accounting standard for marketable securities, its guidance was for the most part disregarded. Three categories were created for marketable securities: “trading,” “available-for-sale” and “hold-to-maturity.” A consequence was to obscure a transparent event. The “trading” category represents the securities at mark-to-market, but the “available-for-sale” and “hold-to-maturity” categories represent the securities at historical cost. News stories at the time reported that “available for sale” and “hold-to-maturity” categories were created to accommodate influential business interests.

Furthermore, “management intent” determines the category to be used, i.e., how the securities are reported, not mark-to-market measurement. In other words, “management intent” determines whether to recognize gains or losses, not the relevant and reliable measurement of the securities.

So, after a full round of due process and the availability of conceptual framework guidance, FASB’s reporting decision with regard to the simplest type of financial instruments, marketable securities, is subject to management manipulation and is not the least bit transparent or understandable to users. Furthermore, “management intent” can conceal poor decisions with regard to actual declines in market values of securities.

Another “improved” conceptual framework will not convince influential businesses and their political allies to go along with principles-based guidance when it works against their interests, regardless of the call for transparency or however dire the economic conditions.

For example, even now, FDIC Chairperson Sheila Bair praises “hold-to-maturity” as a way that banks can avoid volatility in their financial reports. In other words, “You can’t handle the truth.” Be that as it may, any conceptual framework would inevitably work against management interests. Assume that an “improved” conceptual framework is written to support historical cost instead of mark-to-market. Given such a conceptual framework, expect businesses to insist on an accounting standard with the flexibility to report mark-to-market prices during a booming economy.

In other words, management would avoid recognizing losses on some securities while reporting gains on others. That sleight of hand would be implemented via esoteric accounting categories like “trading,” “available-for-sale,” and “hold-to-maturity.” And when compensation is tied to performance, executives “earn” bonuses on phantom earnings regardless of whether the business or economy is booming or in a recession.

The call for transparency in financial reports has significant limits. FASB and the IASB might consider an additional route to transparency. They, with the help of accounting academics — who, by the way, are often criticized for doing irrelevant research — might consider developing and implementing an education framework. They might advance transparency from the users’ perspective of financial reports. It would be fundamentally different from FASB’s and the IASB’s consideration of users’ input in their due processes.

The primary goal would be the development and delivery of methods to inform users how to read and interpret financial reports without a PhD or financial advisor — very useful in the age of individual retirement accounts. Apropos the accounting standard for elementary marketable securities, they might clearly explain “available for sale” and “hold-to-maturity” esoterica.

Chauncey M. DePree, Jr., is a professor at the University of Southern Mississippi’s School of Accountancy and Information Systems in Hattiesburg.