(Archived Content)
FROM THE OFFICE OF PUBLIC AFFAIRS
JS-693
To improve corporate behavior and to reward corporate performance we need to improve the quality and utility of the information that all corporations disclose to investors. Our existing disclosure framework is not adequate.
Peter Wallison and AEI are to be congratulated for bringing together once again so much talent on such an important topic. I certainly hope that non-financial indicators of business performance can succeed in providing investors the information they need and deserve, where GAAP has failed. But I also hope that we can improve the state of financial disclosure and, by doing so, provide stronger incentives for companies to disclose business performance measures.
To succeed, I believe that we must acknowledge the insufficiency of the accountants mindset, which animates our existing disclosure framework, and focuses on identifying facts (about the past) that are precisely comparable between firms. Investors have a different mindset and focus on comprehending the probabilities of likely and unlikely future deviations from particular desired or expected outcomes. We need to remedy this mismatch between what investors are looking for and what our disclosure regime provides.
There has always been an asymmetry between the information available to corporate insiders and to outside investors. A principle purpose of any regime of minimum disclosure standards is to redress this imbalance. The computing, communications and data management revolution of the last two decades has significantly increased the information advantage of insiders, giving them access to timely and detailed data about near-term company prospects in customer order flow, cost management, revenues and other indicators of performance.
This information needs to be organized and presented to investors on a systematic basis. Some companies are doing this. More need to do this. To provide stronger incentives for companies to make these business value disclosures we need to improve the clarity of financial disclosures.
To do this we need to move beyond the false dichotomy between on- and off-balance sheet. Shareholders and creditors need to know the real economic leverage being employed, whether through on- or off-balance devices. We need a measure of all the contractually obligated liabilities both on and off-balance sheet and a parallel measure of all of the firms contractually obligated revenues. Tying these together will give us the firms contractually-obligated net-present value, a true indictor of the firms leverage.
Clearly disclosing this number which will not include hoped-for or anticipated revenues, but only those for which there is a customer contract would create a strong incentive for companies to disclose more clearly how they plan to generate the cash flow to close the gap between expenses and revenues and to disclose the measures of business performance that will indicate the extent of their plans success.
To move in this direction, there are two challenges that I think deserve our attention. The non-linear nature of contingent claims, particularly reflected in options, poses a significant but manageable technical problem for financial disclosures. A more general challenge, affecting both financial and non-financial disclosures, is to squarely confront the subjective nature of risk.
To measure accurately the present value of the future contractually obligated cash flows we need to deal with the contingent nature of various assets and liabilities, particularly options exposures. Simply put, investors need different facts about an option at different stages in an options life cycle. This does not come naturally to the accountants mindset of looking for discrete facts directly comparable between firms but properly understood it need not be at odds with it either. However, this information is vital for investors.
Imagine a short list of attributes needed to describe a caterpillar: length, width, color and number of legs. Perfectly adequate to the task of portraying caterpillars, these four attributes will not portray very well the features of butterflies. Precise comparisons of caterpillars and butterflies using just these few attributes may well mislead and confuse. To describe the non-linear process of metamorphosis we need something more than a precise comparison of key facts about caterpillars or even key facts about butter flies.
We are not, however, just interested in observing facts. To carry the analogy to investors forward, we are interested in whether these particular caterpillars are likely to turn into butterflies or whether they are likely to become moths. We are not principally interested in comparing caterpillars to caterpillars. We are interested in those attributes of caterpillars which help us comprehend the probability of the hoped for transformation into butterflies.
To deal with contingent values, financial disclosures useful to investors need to include those features that best foreshadow the probabilities of different outcomes and those that summarize the course of the transformation.
The broader challenge for our disclosure regime is the subjective nature of risk.
Risk is deviation from a particular goal or objective. You cannot understand risk without first articulating an objective. The intended, the desiredor the expectedpath must be identified before you can think clearly about likely and unlikely deviations.
In the world of derivative accounting and disclosure, this issue is frequently boiled down to the question: Is it the asset or is it the hedge? Without a clear statement of objective it is difficult to answer that question. But if you have a clear understanding of the objective (or, at least, of the expected outcome) then you can articulate the risks being managed and, therefore, identify which is the asset and which is the hedge. For our disclosure regime premised on the accountants mindset this is a challenge because it suggests that there is no single correct way to disclose a particular set of contingent cash flows.
Applied to non-financial measures the subjective nature of risk is not complicated but it may be awkward.
While investors are interested in some absolute financial comparisons between firms (such as earnings per share), they are keenly interested in the performance of the particular business that is, of the relative success of one company at managing deviation from their stated objective compared with the success of other companies at managing deviation from their stated objectives. The objectives may be quite different but we ought to be able to compare their ability to manage relative to their own objectives.
It should be self-evident that investors need information about whether a company is growing its business as planned or whether it is failing to do so. Accurate disclosure of useful financial and non-financial indicators will require companies to be more transparent about their objectives and about their deviations from objectives that is, to be transparent about their failures or their un-successes.
As awkward as this may be for individual companies, for the health of our economy it is vital that we do an even better job of rewarding good corporate performance. In our system of investor-based capitalism this must involve improving the quality and utility of the information provided to investors.