“The Selective Financial Misrepresentation Hypothesis” By Lawrence Revsine

The selective misrepresentation hypothesis states that management has learned that they can manipulate the perception of their entity’s financial position. This is due, in part, to the increasing complexities of business which means that financial reporting is no longer based on direct observation of events but rather on summaries of these events. Additionally, financial reporting standards are often “arbitrary, complicated, and misleading.” These things have led to flexible financial reporting rules that allow for opportunity for management to misrepresent their company’s financial performance. The article looks at who benefits from these misrepresentations and what should be done to change it.

The first party that benefits from these misrepresentations is management. Often management compensation is directly related to a company’s earnings. This creates a natural incentive for management to increase profits. In addition to higher bonuses, managers can manipulate earnings numbers to impress shareholders and protect their jobs. One of the methods used by management to achieve desired income is to manipulate the LIFO inventory method. This method allows management to dip into the LIFO “reserves” and to make carefully timed year-end purchases. Efforts to change accounting standards to those that are closer to reality have been rejected as being unauditable or too volatile.

A second beneficiary of these loose accounting standards is the shareholders. Misrepresented financial statements generally make earnings appear smooth and less volatile than real earnings patterns. This lowers the market’s perceived risk of the firm and, in turn, increases the firm’s value.

Additionally, auditors benefit from flexible reporting rules. Auditors seek to have standards that provide the most benefit to their clients. These benefits can be seen in two ways. The first way is by having “rigid standards that make no pretense of capturing economic circumstances” such as the immediate expensing of research and development costs. The other way is by rejecting accounting methods that accurately depict financial position in favor of methods that allow slack that creates a manipulatable cushion for their clients.

Standard setters are the fourth beneficiary of flexible reporting rules. Their motives appear to be self-protective and altruistic in nature. This can be seen during the savings and loan crisis, where the regulators continued to allow standard setting practices that allowed for misrepresented bank capital. These actions avoided a baking capital crisis and allowed for credit availability and allowed the banks to remain in business. This was beneficial not only to the regulators, but also to management, shareholders, auditors, and the public.

Several measures are needed to correct these standards. One of the keys is public education. The general public needs to understand the losses that are caused by these misrepresentations. Once the public understands the true consequences of these flexible reporting rules, more stringent controls will be put into place to control management’s actions. Additionally, there should be improved selection and monitoring of the standard setting board. Further, there should be greater independence of the regulators. In order for standards to accurately depict financial results, the regulators must be able to create rules without the influence of those who stand to benefit. Finally, it is suggested that there be new funding arrangement for the FASB. This issue has been addressed and is no longer relevant.

In conclusion, standards must be altered to improve efficiency in financial reporting. They should never be allowed to distort financial statements for economic gain. In order to promote transparent financial reporting, stakeholders must take actions to insure that these practices are changed.