The Perfect As The Enemy Of The Good

Haresh Sapra is a professor of Accounting at the University of Chicago Booth School of Business.  He has written an column for Bloomberg, in which he argues that more transparent financial statements would lead to adverse market effects.  He points to two "insights" that he suggests support his thesis: 1) removing one imperfection from a financial system may make the system worse, and 2) company managers are influenced by the information that is disseminated as a result of the more transparent statements.

The argument that fixing only one flaw in the reporting system would harm the system is intellectually lazy at best, a red herring at worst.  What impact fair value accounting had in 2008 - 2009 is irrelevant.  To claim that fixing a flaw should not be undertaken because other flaws remain is ludicrous.  All market participants should be pushing for all weaknesses to be repaired in the most timely fashion.  That all of the issues can not be resolved at once is no excuse to allow others to continue to linger.

Professor Sapra states that "Companies aren’t passive technologies, but are managed by insiders who respond to changes in the disclosure environment."  Well of course, and we would not be concerned about accounting standards if management is not influenced by the standards.  In fact, the standard setters are counting the reactions of management in response to any new standards.  What can not know for sure is the precise nature of these reactions, or the reactions of any specific market participants.

What both of these "insights" fail to acknowledge is that the purpose of financial statements is not to produce any particular characteristics in the securities markets, not is to influence the behavior of management.  Financial statement are intended to reflect the economic reality of the entity issuing them, the activities and position as of specific dates.  Markets will set prices to discount expected cash flows, and market participants will estimate the cash flows and set discounts rates based partly, and only partly, based on the statements.  More transparent financial statements will engender confidence on the part of the participants, more participants entering the market, and a likely decline in the cost of capital.  And if that is not a perfect outcome, it is certainly a good one worth pursuing.