Transparency in Accounting The Culprit or the Revealer


Transparency in accounting has been a controversial issue in recent years largely due to events such as the fall of Enron, the WorldCom scandal, and the latest financial crisis. Supporters of greater transparency used these opportunities to demonstrate that if companies had been more transparent in the beginning, investors would have been better informed of reality and the financial crisis would have been less severe. On the other hand, critics blame transparency and the accounting profession for the financial downturn by citing Statement No. 157 issued by the Financial Accounting Standards Board (FASB) which deals with mark-to-market accounting (Rose and Trussel 2009). "Depending on the audience, fair value accounting is either the most controversial aspect of modern accounting or the most highly desired result of FASB's current standards-setting project" (Schuetze 2006). The debate surrounding transparency raises the question of whether having transparency in accounting causes crises to occur or merely presents investors with an opportunity to "see" what is truly occurring within a company by reading the financial statements.

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What is transparency in accounting? Is valuing the employees and reporting that figure on the balance sheet an example of transparency? Without a consensus definition, pinpointing the true meaning of accounting transparency can be difficult. A simplistic defining of the phrase is when a company fully discloses its information to users. Adjectives used to further describe accounting transparency are relevant, reliable, understandable, and timely. Another method to explain transparency in accounting is to illustrate what transparency is not. Accounting transparency should be the opposite of its antonym, opaque, which is defined as "… hard to understand, obscure" (McAllister 2003). Regardless of the method used to define the phrase, businesses are realizing the need to be transparent. Financial markets and investors are not fond of negative surprises, which is why increased transparency builds confidence in the markets.

Greater transparency in accounting allows investors and other financial statement users to evaluate the full realm of risks involved in a particular company before making a financial decision. The more relevant and reliable information a business provides, the more investors will trust the company and its operations. This reason is often why the more transparent corporations outperform others over time. Transparency helps put investors' hesitations at ease and assures them that the company is not trying to hide a shady aspect of the business. Another reason for the need of increased transparency is to guard against companies attempting to manipulate earnings through impairment recognition. Businesses are more willing to report impairments in years of abnormally large profits because doing so allows companies to smooth earnings. This practice is the type of concern that accounting transparency seeks to eliminate. Businesses should be required to report an impairment in the year it occurs, regardless of the magnitude of profits for that year. Transparency should not be an option for companies to pick and choose when to abide but mandatory for them to follow at all times.

An additional reason for more transparency in accounting is the lack of such can lead to complex financial schemes by managers and executives, as was the case with the Enron debacle. Lack of transparency is an inviting environment for "gray-area" accounting, which may ultimately lead to fraud. In these conditions the opportunity component of the fraud triangle is highly present because investors are not fully informed about what is taking place within the company. However, like Enron, a business can be in compliance with General Accepted Accounting Principles (GAAP) and not have transparent reporting (McAllister 2003). Knowing this fact, companies must be held to higher standards than just following GAAP since GAAP compliance does not necessarily equal transparency. In some instances reporting outside the GAAP method, such as the use of pro-forma financial statements, may prove to be more transparent. Criticism is definitely warranted when businesses use pro-forma statements with the intent to mislead the users; however, the argument can be made that the use of pro-forma financial statements gives greater accounting transparency by increasing the comparability of the presented information. For example, a frequent adjustment when calculating profit in pro-forma reporting is the omission of goodwill amortization. Ironically, after studying this problem, FASB presently states goodwill should not even be amortized. As a result it is safe to say concerning this issue, "pro-forma reporting might have been more transparent than GAAP reporting" (McAllister 2003).

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In an effort to increase financial reporting transparency, companies are implementing a new technology called eXtensible Business Reporting Language (XBRL). This new way of financial reporting provides tags to individual items of data on financial reports. Computer software has the capability to read the tags and provide an array of information on that particular item for the users. XBRL data can be used in different formats, as well as through the internet. XBRL improves accessibility and the analysis process which allows better comparison of information throughout the financial world. Because users prefer comprehendible financial reports, XBRL's use of "standardized financial reporting elements improves the clarity and therefore the understandability of financial information presented to the public" (Saeed 2009). Increased comparability and understandability created by the emerging XBRL method will play a significant role in the movement for greater transparency in accounting.

One area of transparency concern is accounting for certain financial instruments. To address this matter, mark-to-market accounting, also known as fair value accounting, was introduced. Mark-to-market is another form of valuing certain assets in addition to existing methods such as lower-of-cost-or-market, which is often used to value inventories. The mark-to-market accounting technique requires the valuation of assets and liabilities at current market price or fair value instead of historical cost. Critics have opposed the transparency of this valuation method and have attempted to blame mark-to-market for causing troubles in the markets. For example, as the financial crisis has worsened, many people in the financial world have called for the suspension of the mark-to-market method. However, many supporters have come to the defense of the accounting method stating that mark-to-market did not cause the financial crisis; it created a more transparent view of businesses' operations by producing relevant financial data.

To clear up confusion on the relevance and determination of the fair value method, FASB released Statement of Financial Accounting Standards (SFAS) No. 157. With the 2006 issuance of SFAS 157, FASB began requiring companies to use mark-to-market to account for particular financial instruments (Rose and Trussel 2009). By implementing this method, businesses are perceived to be portraying a more accurate picture of their current financial situation. For example, tradable securities that have declined in value during the year would now be reduced to their current market price. Not allowing companies to continue carrying these investments at cost presents a more transparent view of the present financial position. Harvey Goldschmid, a former commissioner of the United States Securities & Exchange Commission, declared, "Easing or even eliminating that rule, as some industry groups and politicians have proposed, could remove transparency for investors" (Bernard 2009).

Another accounting area where transparency is a concern is pensions and other postemployment benefit plans. Businesses underfunding their employees' postemployment plans and gaps in the accounting standards created a transparency concern for the methods companies were using to present the information. To address this problem, FASB released SFAS 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, in September of 2006. By issuing this standard, FASB sought to improve the transparency and representational faithfulness of postretirement benefit accounting by requiring the movement of the funding status of plans to the balance sheet. This information was previously reported as a footnote disclosure. With such adjustments users of the financial reports hopefully can easily locate and more effectively analyze the data, which will improve the usefulness and transparency of financial reporting (Espahbodi and Soroosh 2007). A recent example of a corporation striving to be more transparent with its pension accounting occurred with an announcement by Honeywell. Before the modification Honeywell utilized a shorter amortization schedule for pension expenses, which created more volatile earnings compared to the rest of the industry. To fix this dilemma, the Fortune 100 company decided to implement a mark-to-market approach by recognizing in the present year adjustments that surpassed a set amount. "We applaud management's decision to adjust the pension philosophy and move toward matching asset risk with liability risk" (Holland 2010).

As was the case with pensions and other postemployment benefit plans, off-balance sheet numbers like leases and derivatives create major transparency problems. Companies prefer to keep the maximum amount of debt off the balance sheet for various reasons such as improving financial ratios or managing earnings. Moving debt from the balance sheet to the footnotes allows businesses to mask risky undertakings such as derivatives, credit default swaps, and subprime loans. The concealment of these transactions creates a complicated environment for users trying to evaluate risk and can even lead to the balance sheet becoming practically useless (Auger and Lander 2007). To restore accounting transparency, FASB issued Financial Interpretation (FIN) No. 46, Consolidation of Variable Interest Entities. FIN No. 46 addressed the issue of when to categorize a special purpose entity as a variable interest entity, thus requiring a consolidated financial statement of all controlling interests. Instead of manipulating transactions to improve the financial statements, businesses should report the economic reality, which will give investors what they truly want - transparency (Auger and Lander 2007).

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Troubled debt restructuring is an additional accounting area where the level of transparency is questioned. In October of 2010, FASB issued an exposure draft aimed at increasing transparency and consistency in the reporting of troubled debt restructurings. Because of varying opinions surrounding this topic, the draft was intended to spell out what types of loan modifications constituted troubled debt restructuring (FASB 2010). Along with troubled debt restructuring, executive compensation needs improvement in regards to transparency. Companies need to be more upfront and honest about their executives' compensation because investors deserve to know what executives do to deserve such enormous pay. In particular, more transparency is needed where incentive packages are tempting executives to take on higher risk projects. Without this information users of the financial statements do not know the true value of the business being evaluated.

Even though transparency in accounting is beneficial and needed in many areas, side effects still occur. One consequence of being transparent presents itself when accounting for contingencies under SFAS No. 5. Examples of uncertain liabilities a business may incur include pending results of a lawsuit or warranty payments (Auger and Lander 2007). Although companies must follow guidelines for reporting contingency information, releasing too much valuable information can damage a company's competitive advantage. Another effect of increasing transparency in accounting occurs with the implementation of the fair value method for financial instruments. During positive economic times, mark-to-market would benefit businesses tremendously, but when a market downturn occurs, companies could be in for a long, bumpy ride. Opposition to this method proclaims companies will be forced to write-down assets to ridiculously low levels for the present time, although they believe these assets will soon recover their full values. A further problem is the difficulty in determining current market prices for financial instruments that do not have a regularly traded market. A third negative repercussion from the use of the mark-to-market technique is the volatility of the results between reporting periods (Needleman 2008).

Furthermore, opponents of transparency in accounting argue that too much is bad. While investors are making a push for total accounting transparency, managers prefer otherwise. Critics dispute the validity of the statement that the more transparent companies perform better by posing the question: Do more transparent businesses actually perform better or are better performing companies more transparent? Another argument against full transparency is to preserve financial steadiness in the market. Businesses should only release the most important information because full disclosure would confuse the average investor, creating panic in the market. A way to accomplish this philosophy is to misrepresent a company's financial situation when necessary to prevent disturbing the markets, since the average investor may not fully comprehend the true condition of a completely transparent business. "We need to find the right balance between faithful representation of a company's financial situation and wider financial stability" (Fidler 2010).

Two recent studies have concluded that increasing transparency can create other problems. The first case addresses the asset substitution problem of debt. Increased transparency reduces asymmetric information between the markets and a business, which lowers the cost of capital and increases liquidity. Investors can then execute a riskier investment strategy because the liquid assets are more easily substituted. These actions ultimately cause the company's investment value to decline (Burkhardt and Strausz 2009). The second study encompasses the idea of expected stock mispricing because of transparency in accounting. The research demonstrates how the combination of investor base and greater accounting transparency causes financial analysts to expect greater mispricing in stock prices (Elliott 2010).

A human instinct during a crisis is to start "pointing fingers" and blaming someone else, as was the case with the recent financial crisis. The accounting profession and transparency seemed like easy targets to shoulder the blame; however, despite the side effects associated with accounting transparency, businesses should continue striving to achieve the maximum amount of transparency possible. Regardless of which occurs first, over time a correlation appears to develop between more transparent companies and better performing ones. This relationship points to the fact that businesses seem to be rewarded for being transparent because investors trust these firms more than the ones operating opaquely.

With mixed views surrounding the validity of transparency in accounting, the question remains: Is transparency really the culprit during crises or just the revealer of a company's true financial situation? Considering the diverse beliefs, this debate continues among the financial experts and the accounting profession. Regardless of the level of transparency, investors must remember risk is involved with any investment. To offset this risk, investors must do their best to stay informed. They should pay close attention to detail by reading the footnotes of financial statement to gain a greater understanding of how companies are operating. The topic of transparency will evolve as businesses and standard-setters work together to ensure financial statement users are receiving reliable, relevant, and understandable information.