What Is The Purpose Of Financial Reporting?
Analysts who believe in the inherent reliability of GAAP numbers and the good faith of corporate managers misunderstand the essential nature of financial reporting. Their conceptual error connotes no lack of intelligence, however.
Rather, it mirrors the standard accounting textbook’s idealistic but irrelevant notion of the purpose of financial reporting. Even Howard Schilit, an acerbic critic of financial reporting as it is actually practiced, presents a high minded view of the matter:
The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company. Missing from this formulation is an indication of whose primary goal is accurate measurement.
Schilit’s words are music to the ears of the financial statements users listed in this chapter’s first paragraph, but they are not the ones doing the financial reporting. Rather, the issuers are for-profit companies, generally organized as corporations.
A corporation exists for the benefit of its shareholders. Its objective is not to educate the public about its financial condition, but to maximize its shareholders’ wealth. If it so happens that management can advance that objective through “dissemination of financial statements that accurately measure the profitability and financial condition of the company,” then in principle, management should do so.
At most, however, reporting financial results in a transparent and straightforward fashion is a means unto an end. Management may determine that a more direct method of maximizing shareholder wealth is to reduce the corporation’s cost of capital.
Simply stated, the lower the interest rate at which a corporation can borrow or the higher the price at which it can sell stock to new investors, the greater is the wealth of its shareholders. From this standpoint, the best kind of financial statement is not one that represents the corporation’s condition most fully and most fairly, but rather one that produces the highest possible credit rating (see Chapt and price-earnings multiple.
If the highest ratings and multiples result from statements that measure profitability and financial condition inaccurately, the logic of fiduciary duty to shareholders obliges management to publish that sort, rather than the type held up as a model in accounting textbooks.
The best possible outcome is a cost of capital lower than the corporation deserves on its merits. This admittedly perverse argument can be summarized in the following maxim, presented from the perspective of issuers of financial statements:
The purpose of financial reporting is to obtain cheap capital.
Attentive readers will raise two immediate objections. First, they will say, it is fraudulent to obtain capital at less than a fair rate by presenting an unrealistically bright financial picture. Second, some readers will argue that misleading the users of financial statements is not a sustainable strategy over the long run. Stock market investors who rely on overstated historical profits to project a corporation’s future earnings will find that results fail to meet their expectations.
Thereafter, they will adjust for the upward bias in the financial statements by projecting lower earnings than the historical results would otherwise justify. The outcome will be a stock valuation no higher than accurate reporting would have produced.
Recognizing that the practice would be self-defeating, corporations will logically refrain from overstating their financial performance. By this reasoning, the users of financial statements can take the numbers at face value, because corporations that act in their self-interest will report their results honestly.
The inconvenient fact that confounds these arguments is that financial statements do not invariably reflect their issuers’ performance faithfully. In lieu of easily understandable and accurate data, users of financial statements often find numbers that conform to GAAP yet convey a misleading impression of profits.
Worse yet, outright violations of the accounting rules come to light with distressing frequency. Not even the analyst’s second line of defense, an affirmation by independent auditors that the statements have been prepared in accordance with GAAP, assures that the numbers are reliable. A few examples from recent years indicate how severely an overly trusting user of financial statements can be misled.
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