Accounting Today - January 2011

By Paul B. W. Miller and Paul r. Bahnson
‘For the benefit of’ or
‘to the benefit of:’
What’s the difference?

Okay, we’ll admit it up front: We are inveterate wordsmiths who love us- ing words to make our points. Over
the previous 15 years that we’ve produced
this column, we’ve even invented a few to de-
scribe some financial reporting issues, such
as “pfooling of interests,” “volatilaphobia”
and, more recently, “duh-preciation.”
In this column, we want to make a signifi-
cant point to those involved in financial re-
porting by focusing on two common words
that everybody uses hundreds of times a
day. Specifically, it matters whether some-
one thinks the capital markets exist for their
benefit or to their benefit.

To start, we ask for whose benefit do capital markets exist?

The answer is simple: everyone. Their role in a free market economy is to efficiently connect those who demand capital with those who supply it. If market efficiency exists, then capital is priced optimally, reflecting expected future returns and the associated risks. Without efficiency, economic activity, growth and stability are all jeopardized. With it, though, a society’s economic system more readily fulfills its functions of generating and distributing wealth.

One main factor that created and sustained the Great Depression was inefficient capital markets that had no liquidity, trust or useful information. Because people lacked confidence in the markets, those with capital were unwilling to supply it and those who needed it could not obtain it. We think the same sort of friction may very well exist in today’s economy.

In short, the purpose of the capital markets is to help the economy contribute to society’s overall well-being.

TO THEIR BENEFIT?

Within that context, it takes an intricate and

Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors’ views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

balanced interplay among four main participating groups to make the capital markets work for society’s benefit. Because the groups gain from their contributions, it’s true the markets work to their benefit. In a sense, society rewards them for services rendered.

Consider managers who issue public securities. The system allows them access to fresh capital in primary markets, enabling companies to come into existence or expand, as the case may be. They use their shares as currency for buying assets and even other companies, and, of course, as compensation. The secondary markets create liquidity and establish the securities’ value as well. Thus, markets benefit shareholders and help managers retain their jobs and prosper.

The markets also sustain auditors by providing them with a livelihood in exchange for contributing a valuable service to society. Specifically, completing their task of adding credibility to managers’ self-representations gives them above-average income and a great deal of respectability.

Third, financial statement users, including investors and financial analysts, can access many different investment opportunities with an endless array of returns and risks. This diversity promotes wise investing and greater income for themselves and their clientele. These people are, in effect, the main mechanism for creating efficiency as they pore through reams of data to find the best investments for their goals. They put every security in play and enable equilibrium prices to be reached quickly. Their obvious reward is a chance to accumulate substantial wealth.

Fourth, there are regulators, including standard-setters. Like auditors, the markets provide them with a respectable and satisfying livelihood, primarily by creating and enforcing regulations that aim to reduce risk by building confidence in the markets’ fairness. In return, they are admired for their integrity and can take pride in contributing every day to society’s prosperity. Former SEC Chief Accountant Walter Schuetze once explained that he felt it was his duty each day to cradle the capital markets like a delicate crystal vase that he was to carefully protect from harm.

There are, of course, many others who make the markets work, such as brokers, exchange managers, investment advisors, mutual fund managers and marketers, bankers, venture capitalists and media pundits. We’ll focus on only the above four because of their direct involvement in financial reporting.

WHAT IF?

Unless they adopt a broad perspective, all these people see only their little part of the system through the lens of their self-interest and come to believe they’re entitled to use their power, wealth and position to get what they “rightfully” deserve. Like spoiled adolescents, they may literally think the markets exist for their benefit, instead of grasping that they are only bit players in a bigger game in which they are allowed to participate to their own benefit only because of their unique contributions to the greater good.

Lamentably, the reality is that many, and probably even most, participants do indeed see the markets as existing for their benefit, unfortunately to the detriment of everyone, even themselves.

Because they can, managers wheel and deal with other people’s money like there’s no tomorrow. They think nothing of shading the truth to pull down insane compensation. At times, they’re so intent on feathering their nests that they forget everything else, including common decency and even the law.

We’re afraid auditors have also become sufficiently self-absorbed to the point that they tend to resist any change that would cause them to audit new information and expose them to what they see as unacceptable risks. What they miss over and over again is that their defense of the status quo prevents useful information from reaching the markets. By auditing only GAAP financial statements, their opinions are not particularly valuable because they merely affirm that the reports present mostly useless information. We think auditors also fail to see that being paid by clients diminishes the essential trust factor.

As for investors and analysts, many mis-
takenly think it’s perfectly fine to engage in
self-serving deals that weaken the markets’
contribution to society’s overall benefit. They
focus, for example, on forecasted and report-
ed GAAP earnings per share as if they mean
something, when all should know that they’re
basically worthless. The consequence is a lot
of market friction when “earnings season”
rolls around every quarter. Their shouting
about this meaningless statistic destroys mar-
ket efficiency, even if it makes some analysts
wealthy. Other misbehaviors are “pump and
dump” and short-selling while bad-mouth-
ing a stock.

THE NEED FOR AN EPIPHANY

What we see is a crying need for a massive epiphany. If markets really exist for society’s benefit and participants can earn great rewards with integrity by serving those broader societal interests, then they will be better off working toward that goal.

For managers, it would mean focusing on what they should do best, which is managing enterprises to generate wealth through innovation and serving demand for their goods and services. If they do a good job, it follows that they will be honestly (and handsomely) compensated without crossing a line. A key realization will reveal that the best way to increase their securities’ value is providing useful, complete and timely information. No obfuscation, no truth-bending, no withholding bad news, no propaganda, just the truth, the whole truth, and nothing but the truth, so that all can understand.