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COMPANY filings today contain more information than they have at any time in history. But when we talk about things like fair value or intangible assets, it is not entirely clear that we are getting good quality information about the ingredients, much less whether or not they are "healthy" for investors.

A useful place to start the discussion is by asking the question, "Why do we care about financial reporting?" Put simply, we care because capital is the engine of our economy, and information is the oil that keeps the engine running smoothly.

The foundation of financial reporting is the historical performance and financial position of a company as recorded using GAAP. GAAP, however, only provides a starting point for a conversation in the marketplace about the value of a company. GAAP represents an imperfect compromise in conveying information about a business. One thing many investors do not realise is that GAAP reports do not express a company's performance with pinpoint precision. Some GAAP measures employ assumptions that involve a fair amount of subjectivity. Other items that are not quantifiable with a fair degree of certainty may not be reflected in GAAP earnings at all, even though they can have important present and future economic consequences for shareholders.

The task of getting useful information from companies to investors is not an easy one. First, standard-setters promulgate accounting literature to govern reporting; then, a company must interpret the literature and report its financials accordingly. The market then has to analyse and interpret the reported information. And, ultimately, investors have to make judgments based on the reports. It is a road that has many obstacles. It is worth looking at some of these obstacles before we try to come up with solutions.

Company reporting

Ideally, we hope that managers will strive to convey in clear terms the true economic impact of their activities, and not simply choose the accounting treatment that has the most favourable impact on reported GAAP earnings. Beyond that is a more fundamental hope that managers will make business decisions based on the economics, not the accounting. The fact that a transaction increases GAAP earnings does not necessarily mean that it is in the best interests of shareholders. If a transaction provides a short-term GAAP booster shot at the expense of long-term value, it causes both a possibly misleading picture of the company's financial health and a misallocation of capital.

In the reporting process, bad choices can take many forms. You can have the intentional, deceitful disclosure of misleading information — which, undoubtedly, is a very bad choice. But you can also have bad choices that do not rise to the level of fraud, but which nonetheless serve to mislead investors.

Bad choices by reporting companies result in more opaque disclosure, thereby increasing the cost of capital. If the cost of capital increases as the quality of disclosure decreases, then why don't companies provide the most transparent financial reporting possible? More specifically, if there is a strong market incentive to publish quality financial data, then how could Enron — with its convoluted capital structure and impenetrable disclosures — become one of our nation's largest companies in terms of market capitalisation?

Unfortunately, counter-incentives can encourage companies to choose an accounting treatment that makes them look the best as opposed to the one that most accurately reflects their financial condition.

One such pressure is the shift in focus by investors from long-term to short-term performance. In my view, the recent emphasis on quarterly earnings-per-share is a big mistake for investors, not only because it ignores the fundamentals that make for a good long-term investment. It also puts pressure on companies to engage in financial engineering to maximise short-term reported returns, even if it means sacrificing long-term value. As equity prices increase, so does the pressure to manage earnings to meet expectations. However, like any Ponzi scheme, it cannot last forever.

Another counter-incentive is the potential for a race to the bottom in reporting as companies compete for capital. Once a single company has success attracting capital despite opaque disclosure or even deception, there is pressure on others to adopt similar practices or end up competing on a distorted playing field. If the initial actor is not called to task — by the market or the financial reporting gatekeepers — the pressure mounts on others to make similarly bad accounting and disclosure choices. That phenomenon does not excuse the companies that follow suit, but it may explain why practices like round-trip transactions were not isolated to a single company within an industry.

Analysis of information in the marketplace

After a company reports its information, the next stop along the road involves the market digesting that information. Analysts on both the buy- and sell-side play an important role in interpreting and disseminating information, and acting in effect as translators.

In considering ways to enhance financial reporting, we need to take into account the ability of investors and analysts to digest complicated information.

It appears that investors as a group are not confused, at least over the long-term, by accounting choices that affect reported GAAP earnings, but not the real health of the company. For example, they are able to work their way through such issues as straight-line versus accelerated depreciation; purchase versus pooling accounting; expensing versus capitalising R&D costs; and recognition versus deferral of unrealised gains on marketable securities.

However, even if analysts and investors ultimately can parse through to the important information, there is an increased cost as more decryption and interpretation becomes necessary. Less transparency often leads to a greater divergence of opinions regarding the valuation of a company's securities, which itself raises the uncertainty and costs surrounding a decision to commit capital.

Here, too, conflicts raise the potential for bad choices by analysts as they interpret corporate disclosures, and make investment decisions or recommendations.

Biased research analysts or other intermediaries can distort the impact of information in the marketplace, and encourage a misallocation of capital. To avoid this distortion and protect investors, we must recognise and deal with conflicts of interest that can pressure analysts to make bad choices.

Investment decisions

The final stop on the financial reporting highway — and the final opportunity for bad choices — is the investment decision made by investors, the ultimate consumers of company reports. It is through investment decisions that investors engage in the "conversation" about a company's value that I referred to before.

Bad investment choices can skew a company's market valuation as easily as bad information. Unfortunately, even good information cannot protect investors from the ultimate counter-incentive - greed. We are painfully aware that investors may dispense with critical analysis of financial reports because they want to believe that the numbers are real.

Like a child watching Peter Pan, they think they can fly simply because they believe they can, and Neverland becomes a real place. It is worth noting that the Peter Pan syndrome is not limited to small, retail investors, as demonstrated by numerous instances of sophisticated businesses chasing returns without conducting adequate due diligence.

And conflicts of interest again reared their ugly head as some banks apparently made lending decisions on a basis other than the customer's credit-worthiness.

Implications for the future

These obstacles to good financial reporting are challenging under the best of circumstances. They have become even more so as our economy has shifted to companies with intangible assets, the valuation of which is particularly difficult and subjective.

So it is an appropriate time to examine whether there are ways to get different and improved metrics and indicators that are better suited to investors' needs.

(The speech by the SEC Commissioner, Ms Cynthia A. Glassman, at the American Enterprise Institute, Washington, D.C. on September 3.)

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