Tuesday, March 25, 2008

Put the Onus on the Company

I’ve recently been getting real cool and studying for the CFA (Chartered Financial Analyst) test. Going through the accounting sections can be mind numbing. But I have gotten a better idea of some hairy details of accounting for financial statements and reporting to the SEC. This by day and hearing about financial troubles by night has got me thinking about transparency and reporting. I’m going to provoke a bit of a thought experiment in financial reporting from a stance that no one else seems to be willing to take (especially at these times). However, I am at liberty to take such a stance mainly due to ignorance, inexperience, and maybe a hint of stupidity.

Ever since the SEC was formed, shortly after the crash of 1929, there has been push toward the mandating increasing transparency on public companies. Seems like a great idea. The more information people have the better investment decisions they should be able to make. I am going to hit the issue from another perspective, however, and argue it may not be such a good idea, especially as the economy becomes increasingly dynamic. The main thrust being; what if we put the onus on companies to supply us information and not on regulators? Instead of regulators trying to devise ways for every public company in every industry to conform to some universal standards what if companies decided to choose a way that fit their company and industry best? Well, I’ll admit, so far this sounds like idealistic horse-manure, but there are some hidden incentives here.

Investors will demand information of companies. If they don’t provide information, they will receive no capital. And in this way, this approach may unleash a competition for the most accurate and transparent disclosure. Companies may be more directly compensated for excellent standards than in today’s environment where essentially everyone is given either the stamp of approval or are under investigation. With the SEC model there are only two options, yes or no, good or bad. A company may have an incentive to cheat as much as possible while staying approved. Once approved all companies are basically on the same playing field. Information quality is viewed by most (but not the savvy) as uniform in quality. Do we really want uniformity in quality? What is the incentive for providing superior quality?

Cheating as much as one can while staying within the guidelines can be found in off-balance sheet accounting. It is perfectly legal, although it may be perfectly deceptive. There are loopholes to be exploited as there always will be. Especially as the nature of business changes more rapidly—the only thing we can be sure of in the future.

So let’s put the onus on the corporation. “No, I’m not going to give you rules. You give me the information. If I don’t like it I won’t invest. Furthermore, I’m going to see what your competitor does. If it does it better, well fat chance you’ll get anything.”

You may say this is too much of a burden for an ordinary investor. And it may well be. But there is already an industry for this, and this industry (one that I am quite fond of, to include my bias) is independent research. If there is no SEC, then independent research would become all the more important. This private industry is capable a moving at the speed of its focus industries. Specialization, superior flexibility (in comparison to a legislative timescale), new entrants, quick adoption of technology, etc. are all reasons why this industry could perform quite well. Will there be conflicts of interests? Sure, there always are (even at the SEC). But just as there is pressure to exploit conflicts of interest, there is always pressure to decouple conflicts of interest in order to enhance reputation.

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