How Transparent Accounting Leads to Smarter Decisions
Skip to content
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.”

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.


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.”


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.


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

Previously a Visiting Scholar at Kellogg

About the Writer
Drew Calvert is a freelance writer based in Iowa City, Iowa.
Most Popular This Week
  1. One Key to a Happy Marriage? A Joint Bank Account.
    Merging finances helps newlyweds align their financial goals and avoid scorekeeping.
    married couple standing at bank teller's window
  2. How to Manage a Disengaged Employee—and Get Them Excited about Work Again
    Don’t give up on checked-out team members. Try these strategies instead.
    CEO cheering on team with pom-poms
  3. How Are Black–White Biracial People Perceived in Terms of Race?
    Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
    How are biracial people perceived in terms of race
  4. Take 5: Yikes! When Unintended Consequences Strike
    Good intentions don’t always mean good results. Here’s why humility, and a lot of monitoring, are so important when making big changes.
    People pass an e-cigarette billboard
  5. Will AI Eventually Replace Doctors?
    Maybe not entirely. But the doctor–patient relationship is likely to change dramatically.
    doctors offices in small nodules
  6. Take 5: Research-Backed Tips for Scheduling Your Day
    Kellogg faculty offer ideas for working smarter and not harder.
    A to-do list with easy and hard tasks
  7. 2 Factors Will Determine How Much AI Transforms Our Economy
    They’ll also dictate how workers stand to fare.
    robot waiter serves couple in restaurant
  8. Entrepreneurship Through Acquisition Is Still Entrepreneurship
    ETA is one of the fastest-growing paths to entrepreneurship. Here's how to think about it.
    An entrepreneur strides toward a business for sale.
  9. Which Form of Government Is Best?
    Democracies may not outlast dictatorships, but they adapt better.
    Is democracy the best form of government?
  10. How the Wormhole Decade (2000–2010) Changed the World
    Five implications no one can afford to ignore.
    The rise of the internet resulted in a global culture shift that changed the world.
  11. When Do Open Borders Make Economic Sense?
    A new study provides a window into the logic behind various immigration policies.
    How immigration affects the economy depends on taxation and worker skills.
  12. What Went Wrong at AIG?
    Unpacking the insurance giant's collapse during the 2008 financial crisis.
    What went wrong during the AIG financial crisis?
  13. Why Do Some People Succeed after Failing, While Others Continue to Flounder?
    A new study dispels some of the mystery behind success after failure.
    Scientists build a staircase from paper
  14. The Appeal of Handmade in an Era of Automation
    This excerpt from the book “The Power of Human" explains why we continue to equate human effort with value.
    person, robot, and elephant make still life drawing.
  15. What Happens to Worker Productivity after a Minimum Wage Increase?
    A pay raise boosts productivity for some—but the impact on the bottom line is more complicated.
    employees unload pallets from a truck using hand carts
  16. 3 Traits of Successful Market-Creating Entrepreneurs
    Creating a market isn’t for the faint of heart. But a dose of humility can go a long way.
    man standing on hilltop overlooking city
  17. Take 5: How to Kickstart a Successful Career
    Young professionals, smart decisions now will open doors for you in the future.
    A woman maintains close connections and friendships throughout her career thus avoiding regret down the line.
  18. Immigrants to the U.S. Create More Jobs than They Take
    A new study finds that immigrants are far more likely to found companies—both large and small—than native-born Americans.
    Immigrant CEO welcomes new hires
  19. How Peer Pressure Can Lead Teens to Underachieve—Even in Schools Where It’s “Cool to Be Smart”
    New research offers lessons for administrators hoping to improve student performance.
    Eager student raises hand while other student hesitates.