The overall health of capital markets depends, in large part, on the quality and transparency of financial reporting. Trustworthy information inspires investor confidence, which in turn leads to financial stability and efficiency.
And yet, says Stanford professor of accounting Iván Marinovic, financial statements are becoming less and less relevant compared to other sources of information, such as analysts and news outlets. Perhaps in at attempt to keep pace in the information age, and to tell the whole story of increasingly complex businesses, he says, there is a creeping trend in financial disclosures away from the reliance on verifiable assets and toward more intangible elements of a business’s operations.
Using game theory, Marinovic and Jeremy Bertomeu of Baruch College developed a theoretical framework to better understand the interplay between two competing channels of information in financial disclosures: “hard” information such as revenue or sales that are easy to measure, and “soft” information such as the value of patents or brands that are difficult to quantify.
Here, Marinovic discusses how their findings could help investors, standard setters, and policymakers weigh these different elements of financial disclosures to understand a firm’s overall prospects and credibility.
What is the distinction you make between hard and soft information, and why is it important?
Hard information is information, let’s say about an asset, that the firm took some costly actions to make credible to investors, like hiring an auditor or a rating agency. It’s been certified by a third party that doesn’t have a conflict of interest. Soft information, by contrast, is information that can potentially be manipulated by a manager, like accounts receivables or asset write-downs.
Another important distinction is that while some potentially soft information can become hard through actions like certification, other soft information, like the value of a brand, is by its nature uncertifiable. It can never become hard. It will always be subjective.
This is important because financial statements are becoming more and more soft. They are plagued with soft information that depends on a manager’s expectations about the future and are therefore subject to credibility issues. In other words, financial markets are relying more and more on trust, and the information is getting more and more intangible.
What’s behind the shift toward more soft information in financial disclosures?
Financial statements are moving away from historical cost and toward what people call “fair values,” or “market values.” Essentially, there are two types of accounting systems. The traditional one relies on the notion of historical cost: If you buy an asset for a certain price, that’s the value you would report as long as you keep the asset on your balance sheet. On the other hand, fair values are essentially market values, which in some illiquid markets are not always observable, hence require judgment, and can be considered soft information. You buy an asset whose value is evolving, so you’re not going to use the price you paid but rather the price of similar assets in the market. That’s OK if you can get a price for a similar asset. But typically that’s subjective, and sometimes there are no similar assets. In those cases, accounting reports essentially rely on a manager’s judgment and subjective estimates and things that are very hard to verify. Many intangible assets, such as the brand value of an acquired business, are indeed subjective estimates.
There is the perception that historical cost is old-fashioned, that businesses are moving too fast and are becoming more complex, and that somehow financial statements need to keep up with that rhythm and provide more timely information to investors in the capital markets. Of course, that’s great — to the extent the information is reliable. This tradeoff between reliability and the relevance of the information is a big dilemma among standard setters, who I think are feeling pressure to change the accounting system in a way that provides more information.
Your study explores the idea that hard and soft information send different signals about credibility. What can you tell us about this relationship?
The goal of the model is to explain how the hardness of financial information in capital markets depends on the firm’s credibility, on the perceived honesty of the manager and the integrity of the firm’s reporting system. There is always some uncertainty about the manager who’s releasing the information. He might be honest, which means whatever information he releases, whether it’s soft or hard, will be truthful. But maybe he’s completely strategic, someone who wants to maximize his own interests even if he has to lie. If I am a dishonest manager and need to report an aggregate measure of my firm’s prospects, by manipulating the soft part I’ll be able to essentially tell you anything I want.
It’s a very stark way of describing the world, but it captures the idea that there is uncertainty about the credibility of information because of this misalignment of interests. As investors, the only thing we can do is to try to infer whether the manager is honest based on the information that he is reporting, and also based on the hardness of the information.
One of the main results — and it’s a very intuitive one — shows that when markets don’t trust firms, we will tend to see a shift toward financial statements becoming harder and harder. In other words, when credibility levels are low, we’ll see firms certifying more information to reassure the markets, and relying less on soft information.
Our model also shows that a firm that proportionally provides more hard information is more likely to manipulate whatever soft information it does provide. In other words, you should be more wary about the soft information of a firm that is providing a lot of hard information. Because who are the guys providing hard information? Those who lack credibility, and who will do whatever they can to overcome that lack of credibility.
Should we always distrust soft information?
Some soft information is fully credible all by itself. If I’m reporting something relatively unfavorable, I don’t need to make that information hard. It’s going to be credible. By contrast, if I want to tell you that I’m doing very well and that my prospects are very bright, the only way to make that credible is by investing in certification.
What happens in markets with high levels of credibility?
Our framework predicts that we should expect huge frauds, huge overstatements precisely in settings or markets where there is a lot of credibility. The markets believe the information because they perceive the environment as credible, which encourages more aggressive manipulations from dishonest managers who know they are trusted. In other words, there is a relationship between the frequency and magnitude of frauds, where a lower frequency should lead to a larger magnitude.
To be more concrete, in the early 2000s there were two very big accounting scandals with energy company Enron Corp. and telecommunications giant WorldCom that led to the Sarbanes-Oxley Act. Then there was the Bernie Madoff scandal. One may wonder, why are these scandals happening in the U.S. and not in a less developed capital market? Is it because the market is more corrupt here? Or perhaps these huge scandals actually show the opposite. The reason they happen is precisely because there is trust in the information that people read. And that, of course, provides incentives for more cheating.
What do your findings suggest we should do in response to that type of accounting fraud?
These scandals led to big pieces of regulation. They may be completely justified — and I’m not saying they are not — but one or two big scandals trigger these policy changes that could be pretty costly for the capital market and for society. Perhaps what we should be doing is implementing regulation when we see a high frequency of small frauds as opposed to a low frequency of large frauds. Obviously, this is a very complicated problem, but a few very large scandals could be a sign of a healthy capital market, and could be a sign that we shouldn’t be overregulating that capital market.