Posts Tagged ‘Transparency’

Transparency: does it work?

February 26, 2009

The Economist in this week’s (21/02/09) Economics Focus looks at whether transparency in financial markets is really beneficial. Transparency is currently one of regulator’s and governments’ most popular words, everyone seems to be demanding more of it.

In the recent past many in the financial services industry were calling for opacity, arguing that not having full-transparency allowed them to fully exploit the potential of secret trading strategies and that with full disclosure they would have little incentive to correct market inefficiencies through arbitrage. No one seemed to mind in the good years when everyone seemed to be benefiting.

So you can understand the attraction that greater transparency has in the current economic and social climate.

The Economist article says:

Yet transparency is amorphous; it can, frustratingly, be anything but transparent and, implemented wrongly, may harm the very interests it is supposed to serve.

When we think of financial markets and transparency we probably think of annual reports, interim trading statements etc. (in other words information disclosure). But the desire to provide full disclosure often results in “incomplete, irrelevant or outright incomprehensible” information for the user to understand. I can’t imagine Joe Bloggs on the street without training being able to understand it and make an informed decision based upon it. Maybe even most institutional investors don’t know what it all means with their poor record of investing other people’s money!

Does transparency improve liquidity?

Transparency of information and liquidity in markets are closely linked, markets are effectively based on an investor’s belief that they have better knowledge than everyone else, thus when investors start thinking that other people are privileged to lots more relevant information and that they have an unfair disadvantage they are likely to resist activity in the market.

So “[s]ymetry, not the amount of information, matters” (Economist, Feb 2009).

What does Richard think about this?

Calling for transparency through full-disclosure of information is all very well and it sounds right at first glance, but I believe that this full-disclosure can result in less transparency than you had to begin with, if the users of information are overwhelmed by the sheer volume of it, and its complexity, then you actually have a retrograde step. I would argue that regulators must instead focus on ensuring that when information is disclosed it is reliable, accurate, and relevant to its purpose. Anyone can pump out tons of information, but unless it is accurate and relevant then it is a pointless exercise.

Only time will tell what the world’s financial regulators will do…

Update: some links from the Economist.com article page.

Bengt Holmstrom, an economics professor at the Massachusetts Institute of Technology, has published a paper examining transparency. Another article on the subject is by by Marco Pagano, an economics professor at the University of Naples Federico II, and Paolo Volpin, a finance professor at London Business School. America’s government publishes the Sarbanes-Oxley Act of 2002. George Akerlof discusses writing “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism”.

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We must maintain transparency in financial statements

February 26, 2009

With governments and regulators scrambling around trying to appear active, and looking to implement populist changes to rules, and in particular financial regulations, will we see poorly thought out changes having a detrimental impact on businesses and investors? In particular, will changes to accounting rules reduce transparency?

The International Accounting Standards Board‘s (IASB) Conceptual Framework sets out, among other things, the objectives and characteristics of financial statements. It identifies four key characteristics:

  • Understandability
  • Relevance
  • Reliability
  • Comparability

Transparency is, in my opinion, important to all four of the above characteristics, but in particular understandability and comparability.

Understandability

Information should be presented in a way that is readily understandable by users who have a reasonable knowledge of business and economic activities and accounting and who are willing to study the information diligently. [F.25]

Comparability

Users must be able to compare the financial statements of an enterprise over time so that they can identify trends in its financial position and performance. Users must also be able to compare the financial statements of different enterprises. Disclosure of accounting policies is essential for comparability. [F.39-42]

So it goes without saying that I wasn’t surprised to hear Sir David Tweedie, head of the IASB, talk recently about ensuring that changes to accounting standards do not result in less transparency for the users of the financial statements, in particular within financial services.

With financial regulators under pressure from governments to do something, an often talked about change is to introduce “dynamic provisioning” or pro-cyclical policies — forcing banks to put aside funds in provision reserves during profitable years to reduce the impact of bad years.

Sir David, and other accountants, are concerned that this sort of accounting, if not implemented properly, could result in “cookie jar accounting” where companies mask their performance in poor years through the use of such provisioning (cookie jar accounting is banned by the SEC for public companies).

What does Richard think about this?

If the purpose of financial statements is to allow users of them (investors and many other groups) to make rational economic decisions “both by (a) helping them evaluate past, present, or future events relating to an enterprise and by (b) confirming or correcting past evaluations they have made. [F.26-28]” (IAS Plus) then it requires the finanical statements to provide a clear picture of the organisation’s performance over the period (Income Statement) and its current financial status (Balance Sheet).

Anything that provides scope for companies to mask their true performance through some creative accounting should be opposed at all costs.

On this basis, I am concerned that the EU will try to exert pressure on the IASB to implement what EU finance ministers want rather than what might be best for everyone (if you believe that the IASB acts in everyone’s best interest). As we saw just last month with the EC proposing to provide substantial funding to the IASB in an attempt to gain leverage and influence over the international standard setters.

What is the point of financial statements if they don’t reflect reality? I don’t see any, do you?

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