Discussion of Ronen
Stuart Turley ([email protected]) is Professor of Accounting in the Manchester Business School at the University of Manchester.
As the development of international standards for financial reporting has advanced over the last decade, it has been accompanied by increasing commitment to the use of fair values as the basis for measurement of assets and liabilities. Of course, this remains a controversial issue.1 Debate has concerned not only the basic choice to rely on a fair value framework and the practicalities of deriving fair value measurements but equally, or even more, fundamentally the overall impact on the financial reporting system and the interpretation and use of accounting numbers. Some preparers and users feel that, while the logic for individual standards and treatments may seem clear, the aggregate impact on the reporting statements is a loss of usefulness and that the broad perspective that financial statements should provide on the economics of the business of the reporting entity is being lost.
Against this background, many of the issues raised from the ‘broader perspective’ in Ronen (2008) are particularly timely, not least because they focus attention away from the specifics of fair value measurement to wider points about the context in which those measures are reported. Joshua Ronen's approach in his Abacus Forum paper is essentially not to debate the technical correctness of fair values or other measurement bases but to ask questions about how such a system of measurement can be made to work in an overall reporting framework. Specifically, there are two underlying points of principle which influence the development of the arguments in the paper. The first concerns the need for any measurement system to be evaluated against the objectives of the intended reports. These objectives are stated in familiar terms as informativeness for the suppliers of capital and stewardship. The second point of principle in approach, although perhaps less explicitly acknowledged in the paper, is that a system of reporting cannot be considered separately from the related regime of governance in which it is located. That is, if the technical components of the accounting system are to serve their objectives, we need additional related mechanisms and incentive (or disincentive) structures to bring that about. This point recognizes the social and human dimensions of accounting rather than simply its technical measurement attributes.
These two lines of approach are reflected in two sets of discussions in the paper. The first part of the paper develops ideas regarding the content of what can be reported in order to make financial statements informative, while the remainder concentrates on proposals concerning the broader governance context of auditing and management remuneration which affects the likelihood that reporting will be reliable. The comments below are similarly grouped around these twin themes. At the outset I would want to emphasize that both principles—the first that any measurement system has no absolute and universal validity and must be evaluated against what it is trying to achieve and the second that any system must be considered in relation to the governance context within which it is located—are points that I would strongly endorse. My observations arise in relation to the way in which these principles are followed through in the analysis and the extent to which the proposals ultimately are consistent with those points.
MAKING A FAIR VALUE MEASUREMENT SYSTEM INFORMATIVE
One of the paper's contributions is the way in which it brings together a comprehensive set of ideas about reporting. Ronen thus draws on a considerable bank of ideas that he has developed and published over many years. The fundamental elements of what is discussed concerning the content of accounting reports are derived from Ronen and Sorter (1972).
Some of the discussion rehearses the well-established arguments and problems concerning measurement in financial reporting along with reference to what have been important topics in the recent past, the choice between an assets/liabilities and a revenue/expenses approach to reporting and the debate between principles- and rules-based strategies in standard setting. The approach of the FASB in FAS 157 is discussed and used to bring out important points about the reliability of fair value measures and the role of estimates and about distortions in financial reporting.
A major implication of the discussion of fair values and exit values is that it leads to the argument that, in order to offer really informative reports, further additional disclosures are necessary. Specifically, the paper advocates how disclosure of management forecasts of expected cash flows can be used to arrive at a ‘market-risk-determined value of the firm’. Through comparison of this figure with the exit values of net assets and the market value of equity capital, two additional variables designated as ‘specific advantage’ and ‘specific residual’ can be identified. An additional aspect of the paper is the set of proposals that accounting reports should comprise a costs and benefits statement, an income statement (based on changes in the market risk determined value) and a statement of changes in asset and liabilities composition.
A critical general point arising from the analysis is that, in attempting to provide a framework within which fair values based on exit values can work, Ronen advances the case for additional disclosure and in doing so returns to the essential idea that the best way to provide information on future cash flows is through management's forecast estimates of those cash flows directly. This naturally leads to the arguments about why this kind of information is not already a mandated disclosure, concerning the approach of managements in making such estimates, their willingness to release forecast information, competitive sensitivity, etc.2 In practical terms there are also questions of whether the system passes what might be a ‘complexity test’. The information in the variety of different reports advocated and the concepts, and even the terminology, associated with the ideas of specific advantage and specific residual are not entirely straightforward. It can of course be argued that complexity is simply a function of the multi-faceted nature of the economics of business and that simplicity without informativeness is unhelpful, but, given the difficulties some users have experienced in coming to terms with fair value reporting, it is relevant to question how the new information set would be used.
Overall, two general observations can be made in evaluating the proposals for the content of reporting advanced in the framework in the paper. First, what is really proposed is a system of fair values plus other new information. It may indeed be the case that additional factors need to be taken into account in evaluating the economics of a business, but there is a fundamental issue about whether it is the responsibility of the legally mandated financial reporting system to provide that additional information and what factors and considerations lie outside the boundary of accounting. Conventionally, mandated disclosures have not incorporated forecasts and the case for, and value of, disclosure of such information could be made in connection with systems of reporting other than the current promotion of fair values.
Second, an important foundation argument used in the paper when discussing the validity of the fair value approach now reflected in accounting standards concerns the problem of the reliability of the information given the potential for subjective estimates to be used. Clearly the reporting of forecasts runs into equal or greater problems concerning the subjectivity and reliability of the estimates. That is, the reporting of the information alone does not address a major problem to which it is seeking to respond.3 It is for this reason that the crucial proposals for making the reporting system effective actually lie in the area of creating a set of incentive structures that encourage more truthful reporting and it is these proposals that are discussed in the next section.
MAKING A FAIR VALUE REPORTING SYSTEM RELIABLE
Turning to the suite of proposals concerning broader aspects of the governance context for reporting, it is here that the most radical proposals for the reporting system are contained. Three main ideas are advanced: financial statement insurance by auditors, the role of regular increases in share holding as part of management compensation, and the possibility of a corporate insider acting as a market maker for the company's shares. The justification for broadening the discussion to include these issues derives mainly from the problems of the reliability and potential distortions of fair value measures and estimates. It is this point which leads to concern about the incentives for auditors and boards of directors as the ‘gatekeepers’ of the quality of reporting and hence to the proposals in the paper.
Audit Risk Insurers
The first proposal for the constitution of audit firms as audit risk insurers (ARI) is a development of ideas on the role of financial statement insurance that have been advanced in a number of Ronen's papers in recent years. Initially, these centred on an insurer separate from the auditors themselves but with responsibility for appointment, but more recently the ARI approach has been proposed in Ronen and Sagat (2007). The main problem that this proposal is intended to address is the potential lack of independence of auditors from client management and the resulting conflicts of interest that can affect auditors’ decisions on accepting financial reporting numbers. The link between auditing and insurance has been argued in connection with the so-called ‘deep pocket hypothesis’ for auditing (Wallace, 1985) and the audit firms themselves claim to ‘self-insure’ to an extent in respect of liability claims.
One aspect of the ARI proposal is that it is essentially a compensation scheme rather than a penalty scheme. Thus investors would get an insurance payout even if there was no fault in the production of the financial statements simply through the trigger of a restatement, while substandard auditing would not necessarily be punished by this scheme alone if no restatement had arisen. It is debateable whether this approach meets all the expectations of investors and others. The idea that there could be a ‘no blame’ system may not meet all human desires to identify and punish culprits when something goes wrong, and this is often seen as a means of sending a signal that will affect the incentives, and the behaviour, of others.
The detailed aspects of the proposed system of ARI also give rise to questions about the practicalities of how it would work. For example, the use of restatements as the sole, and automatic, trigger for insurance payments and the determination of the insurance payout on the basis of falls in share price are potentially controversial, though it should be acknowledged that reliance on restatements is an experimental beginning for development of the proposals and other triggers could be considered. As is recognised in the paper, part of the problem at present is the ‘subjective conditions that create audit uncertainty’. This subjectivity in reporting will not be removed by the proposed system which potentially means that there could be problems regarding the circumstances which give rise to an automatic requirement for auditors to pay compensation in different types of jurisdiction internationally. The validity of the approach also rests on assumptions that there has been suitable disclosure about areas of subjectivity within the financial statements and that investors can be expected to take this into account appropriately in their interpretation of the position of the company. If they fail to do so, possibly for reasons of market sentiment at the time or because properly disclosed relevant signals are ignored or misinterpreted, the market price alone may not be a sufficient basis from which to determine an automatic and uncontested level of compensation. Additionally, how the situation where inadequate reporting leads to undervaluation needs to be considered. If a shareholder sells following the disclosure of information which subsequently proves to have given a pessimistic view on the position of a company and so is followed by changes which lead to increases in prices, are they also to be compensated for the loss from having sold? While some of these issues are addressed through the assumption of market efficiency, the practical working of the insurance system depends not on the general position on market processes but on the suitability of every individual security price as the basis for automatic compensation in the unusual circumstances that there is a problem with the company's financial reporting.
The proposals include the suggestion that there should be separate disclosure of two elements of the audit fee paid to the ARI, the underlying fee for audit work and the risk premium. Again there are likely to be some practical difficulties with this idea because of the interaction between audit work and audit risk, and also between audit fees and non-audit service fees. An auditor could chose do more work which would result in a lower risk or vice versa, and the distinction between the fee for work done and the risk premium may not be such a pure signal as is implied in the analysis. The split of the payment to the ARI into its component parts could simply become another contested and negotiated area, and introduce a new set of incentive choices.
Many other aspects of the practicalities of this proposal could also be commented upon and tested but can only be mentioned briefly here. For example, does the statement (p. 199) that those investors who have ‘purchased (sold) subsequent to the issuance of financial statements later restated in such a way as to decrease (increase) income and who held until the first announcement of the restatement would be eligible’ to claim compensation for loss ignore the position of those who have simply maintained previous holdings that they might otherwise have sold? How will the practicalities of the circumstances of restatements be organized when the incentives to contest the need for restatement have changed so dramatically, particularly for auditors? Will auditors take more care when their liability is constrained by the structure proposed than at present? Will the ability of the ARI to take action to recover from management damages that they had to meet that were not due to the ARI being at fault simply lead to another contested legal arena and consequently additional inefficiencies in the system? While the robustness of the system advocated by Ronen is tightly argued, there would undoubtedly be issues to observe closely in its practical outworking.
The main conclusion to be drawn from the discussion above is that the ARI idea is not a single proposal but rather comprises several interlocking elements and it is the interaction between them and between the assumptions from which they are derived that will make it workable or not. Certainly it is possible to see aspects of the system where practical implementation difficulties are likely to arise and failure in one element could undermine the intended simplicity of the proposal.
Ultimately, as the underlying problem is one of potential lack of auditor objectivity, which undermines the reliability of reporting, the main question for evaluation is whether the ARI proposal provides the most effective and efficient means of dealing with that problem. The points above suggest potential areas of practical difficulty and the possibility that rather than an alignment of interests there will be new areas where interests of the parties conflict and that are therefore contested. In addition, two other summary issues can be mentioned concerning the development of the arguments in the paper. First, greater consideration could be given to comparison with other alternative approaches to enhance auditor objectivity. At a number of points it is asserted that the existing system has proved ‘ineffective’, or that recent regulatory developments have made only a marginal difference to the situation, but a more detailed discussion of alternatives, most of which work on the principle of increasing the penalty or disincentive to inappropriate behaviour, would be valuable. It should be acknowledged, however, that the constraints of space have made it difficult to include such discussion. Second, the current paper only describes the system from the point of view of compensation for investors. This term may include the interests of groups such as employees through their stake as investors through pension funds, but it is questionable whether this gives comprehensive coverage of all parties that may suffer losses as a result of inadequate financial reporting and the protection of their interests may still involve more than just the ARI system.
Compensation Arrangements and a Market Maker
My comments on the other two proposals for changes in the governance context in order to affect the incentives for reliable reporting are more limited. The first proposal is that boards and executive management should be required contractually to make regular quarterly increases in stock holdings and the second is that a corporate insider should act as a market maker in the company's securities. In both cases it seems to me that there is a somewhat paradoxical quality to the proposals when compared to what many people believe to be significant underlying governance problems in some companies.
Firstly, many of the cases of apparent abuses by management, including some quoted in the paper, have involved aggressive accounting to enhance share price because of the value of stock options to executives. It therefore seems strange to suggest that the mechanism to motivate management to produce more truthful reporting is to make them even more dependent on stock for their compensation. Admittedly the proposal involves a different structure for the timing and pricing of acquired stock and the requirement to hold long mitigates against actions to create short-term increases in stock price—if stock holdings have given rise to abuses in the past, why suggest that the solution lies in even more holdings? What this reflects is a belief that we simply need to refine and adjust the incentive mechanism associated with stock compensation. As with the ARI proposal, there are also potential practical difficulties concerning the requirement to hold acquired stock for a relatively long period beyond their tenure in the firm, and the ability of managers to strike the balance between the benefits of a low price (to buy stock) and a high price (to reflect their value as managers).
The proposal that a corporate insider should act as a market maker in the company's securities follows from the rationale that insider information leads to the most efficient market. This too is an intriguing proposal, given that in many environments we in fact find laws explicitly prohibiting ‘insider dealing’ in order to protect the interests of the non-insiders. However, this element of the paper is developed to only a limited extent and there is no discussion of why we have such laws and how the abuse of insider power could be avoided.
CONCLUDING COMMENTS
Ronen covers considerable ground, effectively recommending a complete reporting framework and related system of governance arrangements. It is inevitable that the analysis in some cases, such as the novel idea of the market maker, is not as fully developed as in others. In the comments above I have tried to make points about the specifics of the proposals, their basis and their practical potential. It may also be worth making some additional overview comments. First, this paper is not essentially about the merits or otherwise of fair values or of exit values as such and whether the trend of development towards the use of fair values in financial reporting is ‘good’ or ‘bad’, although many relevant points are made about the nature of these measurements. Rather, in my view, the paper starts from an assumption of fair value reporting and is primarily about how to make such a system informative and reliable, by looking both at the content of information in a fair value system and the incentive arrangements affecting those with most influence over the quality of reporting. In this regard the paper argues for additional disclosure still and additional reporting statements. Second, the approach reflects a fundamental belief in incentives rather than regulation as the means of bringing about suitable quality reporting. Regulatory approaches are dismissed as ‘scratching the surface’ and faith is placed in rational behaviour to align the interests of relevant parties.
Given the reaction of some users to the introduction of more fair values, the approach in attempting to develop a system in which this information can be considered relevant and reliable is extremely valuable. However, in conclusion, I would point out some final issues.
First, the suggestions for the system of governance are not critically linked to the fair value reporting issue. The recommendations on disclosure of expected cash flows, audit risk insurance and management remuneration would be as relevant with other measurement bases as well and their impact on the incentives for truthful reporting is independent of fair values.
Second, the debate between incentives and regulation is not easy to resolve, but it should be acknowledged that in practice it is a combination of approaches that is generally pursued. It will still be relevant to monitor the longer term impact, if any, of increased rules introduced in recent years on issues such as management responsibilities and the joint supply of audit and non-audit services.
Finally, in the same sense that the discussion reflects the principle that the financial reports also have to be related to their broader governance context, there is a question about how far the analysis and the proposals can be transferred across different contexts. Much of the rationale for the proposals is devised around the U.S. environment in which there is a process for restatements to occur, where the financial markets operate in particular ways and where there is primacy on the interests of investors. Will the suggested combination of measurements and governance mechanisms work in all settings? A potential area for further development would be to consider how easily the ideas can be made to apply within very different governance contexts and reporting traditions. Here we must go back to one of the principles outlined at the start of this commentary regarding the link between the system of reporting and the governance context. If that context is important, and different governance traditions, arrangements and solutions exist internationally, then the case needs to be demonstrated that the proposals will be transferable to very varied governance regimes.
