How Transparent Accounting Leads to Smarter Decisions

Many Fortune 500 companies have learned the importance of transparency in financial disclosures—some of them the hard way. But the recent string of municipal bankruptcies, including Detroit, suggest that plenty of governments are still not convinced. And what they don’t believe can hurt them.

“Rigorous accounting is the key to ensuring that capital is allocated in the right way,” says Naughton, an assistant professor of accounting information and management at the Kellogg School. “This is well-established when it comes to private enterprise, but it’s true for governments as well. There is plenty of evidence that strict reporting regulation improves public welfare.”

So what should companies—and especially governments—be doing to increase transparency, boost investor confidence, and ultimately make better decisions? Naughton offers these tips.

PUT YOURSELF IN THE SHOES OF THE INVESTOR

Financial disclosure regulations exist for a good reason: they are essential for a successful stock market. After the stock market crash of 1929, a series of regulations were introduced to protect investors, and new rules were added over time to enhance transparency. “It’s like the market for lemons,” Naughton says. “Without reliable, transparent and accurate disclosure, the market breaks down.”

But transparency benefits companies as well as investors. A number of studies have shown that investors are more willing to buy stock in a company when they have a clear understanding of the company’s finances. So while it may be tempting for business leaders to manage for the short term by massaging their numbers before the disclosure deadline, ultimately that can be a losing strategy.

“It’s like managing a persona or the perfect Facebook profile,” Naughton says. “It’s unsustainable. It’s better for business leaders to accept that investors are sophisticated and to think from their perspective. If you put yourself in the shoes of an investor and ask, ‘What would I want to know about this company?’ rather than sticking to what’s required under regulation, I think that would improve your firm’s position in the market.”

Plus, transparent accounting has the added benefit of helping organizations develop more effective long-term strategies. “When organizations are rigorous with their accounting,” Naughton says, “they know better how to allocate resources and plan for the future.”

The same principle holds for government accounting. When accounting information is inaccurate or incomplete, states and cities will make bad financial decisions. In one study, for instance, Naughton and his colleagues found that understating the cost of employee pensions not only leaves state pensions underfunded—it also leads states to overestimate how many workers they can afford going forward, thereby exacerbating fiscal problems.

“It’s similar to a CEO who believes his own inflated numbers,” Naughton says. “It compounds any financial problems.”

GET RID OF HARMFUL INCENTIVES

One way organizations can ensure accurate and transparent accounting is to remove the incentives leaders have to manage for the short term. This means avoiding a system that rewards biased disclosures.

“If you are the CEO of a company,” Naughton says, “the incentives you have for your executives should never be only tied to short-term financial results that are reported externally, such as earnings reports. They should be based on internal metrics, especially those that can be tied to long-term value creation.”

“Businesses can always say, ‘the success of our company is tied to activity x,’ and they can create incentives to promote that activity,” Naughton says.

Focusing on the short term is an even bigger problem when it comes to government accounting, since politicians often have greater incentives to cut corners, overpromise, and scrub losses from the books.

There also seem to be fewer consequences for public sector distortions. Most serious accounting scandals, from Enron and Worldcom in the early 2000s to more recent cases such as Autonomy and Toshiba, involved the use of accounting gimmicks to boost profits. In each case, executives faced substantial fines and even jail time. In contrast, when states use accounting gimmicks, politicians are rarely held accountable. For example, when a recent accounting gimmick employed by Illinois reduced its pension obligation by $6–$8 billion, no public official faced any adverse consequences.

“Individual politicians face such limited consequences that there’s almost a reward for accounting gimmicks,” Naughton says.

For Naughton, who is also a Harvard-trained lawyer, this is why states and municipalities should begin to adopt private sector accounting norms for budgeting purposes—specifically, “accrual accounting,” which more accurately reflects the long-term situation of a government or business than cash flows. A government’s source of revenue may be different from that of a business, but both share the same financial objectives. And a well-run government can decrease taxes, which is the equivalent of a dividend payout.

SET UP INDEPENDENT ENTITIES

The best financial decisions are made when those who crunch the numbers are distinct from those who set an organization’s strategy. So independence between accounting and decision-making is key.

“Financial reporting should be about the state of the firm or the government, not the CEO’s or the governor’s narrative of the firm or the government,” Naughton says.

In the for-profit sector, “a lot of financial reporting regulations are designed to minimize the discretion in what companies report,” Naughton says. “Companies not only get audited, but there is also the Public Company Accounting Oversight Board (PCAOB) that verifies that audits meet certain standards.”

For states and municipalities, the picture looks quite different. Elected officials often work on a budget without independent oversight. One solution could be to have an independent agency responsible for communicating to politicians what their proposed plans would cost—something similar to the service that Congressional Budget Office provides at the federal level. Currently, each state manages its budget in its own way, which can lead to extreme variation in accounting practices, and occasionally some very fuzzy math.

Naughton acknowledges that businesses and governments operate under different constraints and toward different purposes. But the upshot, he says, is that transparency is critical to any organization that wants to spend money wisely.

“Accounting helps you know what’s working,” he says, “and what you need to improve. Whether you want to increase your market share or improve public welfare, transparency can help.”