Academic journal article ABA Banking Journal

How Analysts Can Speed Market Reform: An Analyst Lifts the Veil of a Clannish Culture and Suggests Ways to Improve the Craft to the Betterment of All Parties. (Corporate Governance)

Academic journal article ABA Banking Journal

How Analysts Can Speed Market Reform: An Analyst Lifts the Veil of a Clannish Culture and Suggests Ways to Improve the Craft to the Betterment of All Parties. (Corporate Governance)

Article excerpt

As the flood tide of market hopes receded, corporate frauds, like beached whales, were revealed. These deceptions launched Congressional re-regulation of accounting, finance and governance. Yet this retributive spasm failed to mention larger causes of the wreckage. the April ABA Banking Journal, I urged two that need exploration and remedies. The first--blind spots and disinformation built into corporate financial reporting--was the subject of that article. The second cause--myopic research by otherwise blameless analysts--is discussed in this article.

Unlike accountants, the astute analyst seeks whatever data bears on the creation (or waste) of shareholder value. The wide span of this search implies that the scope of corporate reporting itself should be similarly enriched by information ignored in GAAP-based reports. Such reform, however, historically arises voluntarily, by managements willing to share with investors how, for example, their companies are actually managed. Since both sides stand to gain from better information, other companies will follow, one at a time. That's what happened in the two decades after World War II (especially at banks).

Conditions are ripe for a sequel, driven by real-world change. For example, about a decade ago, larger companies began collecting all kinds of data, in order to clarify goal-setting and performance appraisal at the segment level. Then in 1997, the Financial Accounting Standards Board (in SEAS 131) mandated coalescence of manager and investor perspectives as a key principle guiding line-of-business reporting. Finally, the recent eruption of big-company disclosure fraud, undetected pre-mortem, makes us ask whether these additional metrics might generate more predictive diagnostics through which to attract--or warn--future investors. What is the need? Are analysts paying attention? How might reform begin? And what benefits can it bring to bankers?

The need far reform

Baruch Lev, professor of accounting and finance at New York University, testifying before a House subcommittee in February 2002, told of the inability of current accounting--at its best--to describe "21st century financial events." The first of four frontiers, he said, is the "wide range of [networking] activities conducted through alliances, joint ventures, partnerships, and special purpose entities." To ignore this strategy-grounded networking misleads investors, lenders, economists and policymakers, while creating loopholes for fraud.

Second, Lev said that "transaction-based accounting... ignores most unexecuted obligations and contractual arrangements." These, of course, create major liabilities in the future. Enron's obligations to cover SPE losses, for example, were never reported to investors. Third, accountancy does not recognize as "knowledge assets" intangibles such as patents, trademarks, customer relationships and unique organizational designs, instead expensing them "as if...devoid of future benefits."

Finally, Lev argues that the fast growth of complex financial innovations in the last 20 years, such as derivatives, securitization and executive stock options, expose companies and their shareholders to considerable risks." True, the SEC now requires risk disclosure in financial reports, but "these are largely meaningless boilerplate [lacking] specific risk disclosures."

Another call to action came last October, at a conference called "Closing the Gap Between Financial Reporting and Reality," sponsored by the Association for Investment Management and Research (AIMR). Patricia McConnell, an accounting-oriented analyst at Bear Stearns, began her talk by saying, "The investment community's view of the importance of financial reporting has shifted 180 degrees." After Enron, she said, the community "realized that it is as much to blame for the excesses as are corporate managements, accountants and auditors. ... The financial community, to protect itself, must be the first line of defense. …

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