My last blog post was about information asymmetry, the notion that corporate managers know a lot more about what is going on in their company than anyone else does. This puts investors, bankers, suppliers, customers, and workers at a disadvantage when they are making decisions about their dealings with the company.
Information asymmetry creates the opportunity, if managers choose to exploit it, to say things about the company’s finances that are beneficial for the managers and hard for anyone else to contradict.
So what does accounting do to counteract information asymmetry?
For starters, the people who make the regulations about accounting (for most of the world, this means the International Accounting Standards Board) impose a lot of constraints on how corporations do accounting. These regulations pertain primarily to publicly traded companies, since that’s where the information asymmetries are worst. (For small, private companies, investors may know the managers personally or be involved in running the business themselves.)
Minimum Disclosures
Regulators require corporations to disclose certain details, like how much its various assets are worth, how much it owes to its creditors, how much revenue it took in during the year, and so on. Corporations are free to disclose more if they want, but the regulators expect at least a minimum set of information.
These accounting disclosures, in the form of a balance sheet and income statement and other financial reports, must be provided to the public at the same time every year. This regularity is actually pretty important. It prevents corporate managers from only publishing their financial statements when there is good news.
Calculation Methods
In addition to minimum disclosures, accounting regulations also insist that specific calculation methods be used. For instance, the cost of assets like trucks and buildings has to be amortized, spread out over the years that the asset will be used to earn money. There are variations on how to do this calculation, but the general idea is to use the original or “historical” cost as the starting point. This is considered reliable because one can always go back to the original receipts to show where the figures came from.
Alternatively, the company can disclose the asset’s fair value, which generally means its current market price. For real estate, which can be appraised, and for financial assets, where the market price can easily be looked up, this makes sense. Fair value is considered relevant because knowing what the asset could sell for today is often more interesting to business people than knowing its historical value. Enough said about that.
Auditors
Regulation by and large has proven insufficient, so someone came up with the idea of hiring another accountant to check the work of the company’s accountant, to see if the regulations were being properly followed. This is called auditing.
Just like regulation, auditing has proven insufficient. The list of modern-day accounting scandals is long: Enron and Worldcom are but two of the more famous.
Accounting is supposed to be a profession, meaning that accountants claim to serve the public rather than their clients. Their track record in this is spotty, to say the least. Accounting firms are loath to play hardball when they are auditing a client because they depend on the clients for money.
In fact, accounting firms have often actively cooperated with their clients to enable unethical behaviour. Recently, KPMG, one of the largest accounting firms in the world, has been accused of helping rich people hide their money from the government, or in some cases, from their spouses.
Management Incentives
Because regulations and auditing are insufficient to ensure honest accounting, companies have turned to incentive alignment to solve the problem. This means making the compensation of senior managers contingent on their achieving goals that suit the interests of shareholders.
These goals are almost always linked tightly to accounting results. Take profits, for instance. If you were to award a company’s managers a percentage of its profits, they would have an incentive to try to earn as much money as possible for the shareholders.
This sort of contract can cause problems if it is not carefully thought through. It is easy, for instance, to show a profit in the short term if the company never maintains its machines and vehicles. So, incentive contracts for senior managers tend to be complicated, to prevent gaming.
Another way of aligning incentives is to award the managers shares in the company. This means that they become shareholders themselves. This can be extremely lucrative for managers. It can also lead to managers becoming extremely powerful. For instance, the CEO of Apple, Tim Cook, is now the company’s largest individual shareholder.
Where next?
I need to write two more blog posts about this topic. One is questioning the assumption that managers are out to line their own pockets. The other is about who owns corporations. Stay tuned!
The banner photo, taken in 2016, shows one piece of the outstanding "Hands of Time" public art installation in Victoria, BC, created by Crystal Przybille.
Photo of the historic King Eddy Hotel in Calgary taken in 2016. Formerly the home of a venerable blues bar, it is now being integrated in dramatic fashion into the new National Music Centre across the street.
Photo of an alignment problem in Bangladesh taken in 2014.