(05/07/12) The Myth of Transparency

Account rules and regulations only give us a false sense of security. We have to look a little deeper and not put our faith in regulations that don't always work in investors' interests, writes Richard Lehmann of Income Securities Investor.

Accounting is the language of finance. As with the spoken word, it is a language with a lot of nuance and room for broad interpretations.

When I started my career, it was in accounting, and a popular joke was about the accountant who got his job by answering correctly the question, “How much is two plus two?” The correct answer being “How much do you want it to be?” Accounting has come a long way since then in terms of tightening the rules, but not always for the better.

The popular mantra today is transparency, and to that end, management’s judgment and leeway has been severely restricted to the point of criminalizing errors in failing to disclose matters which, in times past, were considered immaterial. This in turn has led to media reporting that plays up all adverse reporting, no matter how trivial, because it is news. Likewise, hedge funds and daytraders do the same to create volatility, the source of much high-speed trading profit.

Investors should be aware that accounting and reporting is still subject to wide variances and self-serving interpretations. While they may not be sophisticated in interpreting what is significant and what is hype, they should be as skeptical of bad news as of good.

Since we have several hundred security recommendations still active, we receive weekly notices of adverse events which cause an immediate drop in the price of a security. Since we are income-oriented, we are usually more focused on the debt securities of a company than its equity shares.

Hence, when a piece of bad news comes out, our evaluation is generally focused on whether the news damages the company’s growth prospects or its financial health. The market tends to ignore this distinction initially, selling off all the company’s securities.

We often find the answer is that the financial health has been little affected by the news. It can even be improved if it slows down a company’s rapid growth. In this case, the bad news becomes a buying opportunity for the debt securities, something the market will correct much more rapidly than the sell-off in the equity shares.

Accounting rules sometimes play a major role in the decision-making process of a company or of government. This is a real danger, since this can often lead to very bad decisions.

The recent financial crisis was made worse by bad accounting on several occasions. When the mortgage market collapsed, no buyers could be found for the then questionable securities. Under mark-to-market accounting rules, banks and other financial organizations had to write down the value of their holdings to market prices—a market which did not exist.

In days past, they could have opted to decide to hold those securities to maturity and thereby be allowed to carry them at cost, but no such flexibility was instituted until a year later. Hence, firms such as Bear Stearns and AIG collapsed, and their portfolios were bought up by the Federal Reserve at written down values. We now read about the profits the Fed made on their sale of such holdings, as we read about the Treasury Department’s profit on Fannie Mae paper they bought.

While these entities praise themselves for their good crisis management, my take would be that they exploited the accounting rules to buy assets at a discount rather than lend those companies money against the same assets. After all, the Fed is there to provide liquidity in a crisis, not to exploit a profit-making opportunity.

Government is one of the worst at complying with accounting rules and transparency. Witness Treasury Secretary Paulson assuring us that Fannie Mae was solvent barely two weeks before he took it over. Witness governments at the state and local levels passing budgets that are in balance only because of accounting tricks corporate officials would go to jail for.

The most egregious violation by governments nationwide has been their failure to recognize the costs for retirement and health benefits promised to their employees. This failure has led to a national budget crisis which can only end badly. It is rooted in a failure to properly account for such costs, which led to promises that cannot be kept.

Transparency is a noble concept in finance, but it is limited by the fact that accounting is as much art as science. Government can pass legislation mandating behavior by public companies, but accounting still is what it is. Crooks can only benefit from a gullible public which doesn’t keep a salt shaker close at hand.

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