Financial Reporting: You Can't Put a Price on Transparency

Financial reporting standards have come a long way in recent decades. The introduction of generally accepted accounting principles (GAAP) as an industry-standard form for accounting has increased transparency, and it provides investors a way to compare "apples to apples" with different financial reports. However, despite efforts to eliminate skewed data, there are still ways for a company to mislead investors. Those companies with financial transparency, though, tend not only to be better investments but also to survive market tests in the long run.

What Is Transparency?

Transparency is a term that describes the practice of reporting all data--good and bad--to investors. The goal is to give investors a complete picture of the company's financial standing prior to enticing investment. The company provides a series of pieces of information, such as earnings per share, diluted earnings per share, interest coverage ratios and other measures of profitability. According to GAAP, the company includes analysis of outstanding liabilities that may arise in the future, such as pending lawsuits, as part of this financial report. Previously, these items could more easily be left off the report.

How Does It Affect the Market?

According to popular theory, markets behave in a rational manner. This means investors act on all information present in order to make reasonable decisions. With greater transparency, there is more information available to act on. This can be both good and bad for the market, however. Though the theory of rational behavior in the market may hold true in some analyses, there is still proof investors do not always act rationally with the information at hand. Therefore, too much transparency can often cause unnecessary panic or, on the other end, bubbles in the market. These items are not considered healthy for the market as a whole, and they can negatively affect those investors who are attempting to behave rationally.

Why Do Companies Skew Data?

There are a number of reasons companies skew data. There is always the possibility the company is intentionally misreporting information in order to "swindle" investors out of money. This was the case in the infamous Enron collapse. There is also a possibility, though, that companies fear too much transparency can paint a scary picture to the novice investor.

For example, consider the interest coverage analysis factor. Novice investors are taught that a low interest coverage is a bad thing. In some industries, a low interest coverage may not be a bad sign at all. Consider the utilities industry, which can operate healthily with an interest coverage of 1/1. A utilities company may want to post a higher coverage of 2/1 to give investors more confidence. They could do this by failing to report interest that is taken on in the very end of a year. Typically, GAAP would encourage the companies to prorate this interest throughout the year. However, the company would not be lying by simply applying the interest to the following year. As a result, the company would be skewing data, but it would be doing so without ill intention.

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