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Financial Reform.

Building Trust in Financial Reporting

Thomas C. Redman, Ph. D.

President, Navesink Consulting Group

It is no great insight that the public has grown to mistrust corporate America.  The hundreds of re-stated financial reports each year could be ignored.  But the out-and-out accounting scandals cannot be.  Each week brings a new one.  First Enron, then Tyco, now Worldcom.  Investors are scared and they wonder whom to blame.  Does the fault lie with senior management, with underlings, with auditors, with analysts, with ratings agencies, with a lack of government oversight?

The pallor of doubt spreads to all, the outright liars, those who’ve made honest mistakes, and the squeaky clean.  Lacking evidence to the contrary, all financial reports are suspect.

Naturally there are dozens of calls for change, for someone to “fix it.”  But regaining trust is not like fixing a broken washing machine.  There are no belts to replace, no filters to be cleaned.  You can’t order trust from LLBean or purchase someone’s spare trust on eBay.  Trust must be earned.  And once lost, it is even harder to regain. 

While government and private sector groups have roles to play, the lion’s share of the job falls squarely on the shoulders of each company.  Investors know “you can’t legislate morality.”  And they will not be fooled again by misleading claims to “Trust us.  Our auditors approved it.”  Regaining trust requires better reporting-and solid evidence that the numbers are accurate.

Companies must first recognize investors and others who use financial reports as customers.  To a customer, a high-quality financial report is not one that merely meets GAAP standards (even if those standards are brought up-to-date).  A high-quality financial report is one that helps them make better decisions more efficiently.  It must be:

Companies need to adopt a spirit of continuous improvement in financial reporting.  The first step toward that end is measurement.  Investors expect a more precise statement than “these numbers are the best they can possibly be.”  Are the stated receivables within 1%, 3%, 5% (or “we really don’t know”)?  Financial statements must clearly state the accuracy of each key bit of financial data.

No one expects a financial report to be perfect.  Indeed, people are surprisingly forgiving of flaws and errors, once they understand them.  But investors do expect improvements.  And nothing builds longer-lasting trust than continuous improvement.  If last year’s receivables were within 2%, then companies must make improvements to get this year’s within 1%, and next year’s within a half a percent.  Companies must also report faster.  If last month, insider trades were reported within 90 days, this month they should be reported in 45 days, next month in 21 days, and so forth.

Some may respond that faster reporting and more accurate reporting are incompatible.  This is simply not the case.  Today’s financial processes are error prone.  They produce poor results, and are slow and costly because finding and fixing the errors is difficult, time-consuming, and expensive.  Eliminating errors at their sources yields better, faster, less costly results.  Doing so will require that companies get everyone involved, from the dock worker off-loading supplies, to the middle manager filing an expense report, to the finance executive setting up a special purpose entity.

As noted, it is far easier to prevent errors in financial reporting processes than it is to find and fix them once they have been made.  But that is exactly what auditors are asked to do.  Even when they are successful, they are simply confirming, or correcting, history.  Auditors cannot provide real insights into future financial health.  Auditors do, on the other hand, provide a ready excuse for poor reporting.

Companies must “name names.”   Chairmen, Chief Executives, and heads of audit committees must bear personal accountability for errors in financial statements that exceed stated accuracy limits. 

Each of these steps is challenging by itself.  Taken together, they require a sea change in attitude, belief, and action.  Companies should not underestimate the enormity of the task. 

But the costs of not implementing these steps is even greater.  For in the final analysis, the best way to appear trustworthy is to actually be trustworthy.

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