Quoted from the opinion section of the April 26 NYTimes by Karthick Ramanna and Alan Dreschel
EVEN as the nation is gripped by the populist politics of the presidential primaries, special interests continue to shape the rules of the economy in the shadows. Last year, a market regulator called the Financial Accounting Standards Board released a proposal that could make it easier for corporations to withhold important financial information from shareholders. This could put the economy at greater risk of another huge accounting fraud, like Enron or Lehman Brothers. But the board’s proposal, which could become a final rule any day now, has gotten nowhere near the strong dose of sunlight it deserves.
Let’s back up. Current accounting standards require corporations to make financial disclosures of information that “could” influence investors. If this sounds wishy-washy, it is. The accounting board’s proposal would rewrite this already subjective standard to require corporate disclosure only when there is a “substantial likelihood” that information “would” significantly alter investor decisions.
The language change is troublesome because it lowers the bar for excluding important or “material” information. Even just changing “could” to “would” is a big deal. “Could” connotes possibility and invites broader disclosure; “would” connotes more certainty and can be used by firms to exclude disclosure.
Imagine a pharmaceutical company that discovers that a promising new drug in the pipeline is performing poorly in patient trials. Such information “could” sway investing decisions, and, under current rules, there’s a strong case for disclosure. But it’s much harder to establish that there is “substantial likelihood” that disclosing this information “would” significantly alter investor choices. If the new proposal is enacted, the drug company gets a free pass to avoid disclosure.
The accounting board justifies its proposal by arguing that investors and businesses alike are suffering from disclosure overload — a point echoed by several special interests pushing for the changes, including the United States Chamber of Commerce and several powerful Fortune 500 companies. There is some merit to this concern: Corporate financial disclosures are often foggy and impenetrable. But this calls for improved quality of disclosure — more plain English, less legalese — not weakening disclosure standards. This is particularly true with the advent of technology that enables rapid text searches.
Lehman Brothers reported a $3.9 billion quarterly loss in September 2008. Mario Tama/Getty Images
Given the technological advances, we support re-examining the current rules that govern “material” corporate disclosure. After all, these rules haven’t exactly served investors well. Consider the examples of Enron and Lehman Brothers.
When Enron collapsed at the turn of this century, the fallout was devastating: thousands of jobless and countless investors left with worthless shares. As the company unraveled, we learned that years of financial statements were little more than an illusion sustained by misleading and inadequate disclosures. Enron’s conduct was fraudulent, of course; but the deceit was partly enabled by rules allowing the company to overstate assets by over $1.5 billion because offsetting adjustments were “determined to be immaterial.” With a still-lower threshold for disclosure, as the accounting board is now proposing, Enron could have cooked the books even further, and the resulting devastation could have been greater.
Many remember Lehman as the firm whose crash ignited a global financial crisis; few recall how it exemplified the poor disclosure practices that were common in the years leading up to it. Not only did this fuzzy disclosure mislead markets on the health of the housing market, in Lehman’s case it helped mask the firm’s manipulation of financial statements. In one email from early 2008, Lehman’s president called its accounting gimmicks “another drug we r on.” Amazingly, in the aftermath of Lehman’s failure, the Securities and Exchange Commission concluded that the company’s non-disclosures did not violate current materiality standards.
There is reason to believe that such shoddy, deceptive practices remain common. A 2015 survey by researchers from Columbia, Duke, Emory and the National Bureau of Economic Research reveals that the nearly 400 financial executives surveyed believe 20 percent of firms intentionally distort their earnings figures by an average of 10 percent.
Disclosure is the cornerstone of fair and efficient markets. Investors can make educated decisions only if they have access to relevant information about public companies. Weakening disclosure standards imperils the integrity of markets.
In principle, the S.E.C. has final authority to set disclosure rules for public companies. But the S.E.C. decades ago turned over much of this work to the private-sector accounting standards board. This body draws its members largely from the accounting and finance professions, citing the need for expertise from industry. It’s this state of affairs that has partly gotten us to where we are today.
The board’s changes contradict the S.E.C.’s own strategic plan, which notes that “an educated and informed investor ultimately provides the best defense against fraud and costly mistakes.” The accounting board should abandon its efforts to undermine disclosure rules. Even better, the S.E.C. should use this opportunity to step in and strengthen them.