How Transparent Accounting Leads to Smarter Decisions
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Dec 2, 2016

How Trans­par­ent Account­ing Leads to Smarter Decisions

For com­pa­nies and gov­ern­ments alike, mas­sag­ing the num­bers is a los­ing long-term strategy.

Financial disclosure, not manipulating numbers, is the goal.

Planet Flem via iStock

Based on insights from

James Naughton

When you have good account­ing, you make good deci­sions,” says Jim Naughton.“This is true for any orga­ni­za­tion in any sector.”

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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.

When orga­ni­za­tions are rig­or­ous with their account­ing, they know bet­ter how to allo­cate resources and plan for the future.”

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.”

Featured Faculty

James Naughton

Assistant Professor of Accounting Information & Management

About the Writer

Drew Calvert is a freelance writer based in Iowa City, Iowa.

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