Reporting rules fail corporate US

The American governance model does not resolve the weaknesses at the heart of the system

Companies are complaining that an American stock-exchange listing is expensive and burdensome. Sarbanes-Oxley, the 2002 US legislation on accounting and corporate governance, has extra-territorial effects. Shell was fined by the SEC for a reporting problem, but its shareholders pick up the bill.
But how did the US reporting legislation get to where it is today? Are some solutions actually creating the disease? Is the problem poor governance, or is the financial reporting system itself creating the governance problems?
The problems stem from a dominant law, the 1933 Federal Securities Act, which confuses financial reporting. Whatever the strengths of corporate America, a weakness is the financial reporting system. Its negative effects create safe havens for mischief in some companies, while creating burdens and complexity for others.
It is easy to assume that the US model for financial reporting is the model. But modern financial reporting
was invented in Britain. Roosevelt's 1933 securities reforms took text straight from the 1929 British Companies Act, but constitutional tension with states prevented the full system being adopted.
The US reporting system is, therefore, an incomplete replica of the British system that Congress wanted to adopt. These omissions have also spawned difficulties in corporate governance.
The shareholders' financial interest in any company is the right to what remains after all other creditors and claims have been paid. That carries risk. For British quoted companies strong rights are attached to shares in order to mitigate the risk - rights to information and rights to vote to effect change.
The US is different. A shareholder's right to information and rights of ownership are limited under most states' laws. The federal system steps in but can only stipulate financial information relevant for the buying or selling of shares. Such information is, therefore, largely about earnings. It is difficult under the law to request anything else.
Companies should be run for shareholders to achieve appropriate returns on capital. To monitor that objective requires a display of earnings and capital, not just earnings taken out of context - but that is what American law allows.
As John Plender, the FT columnist, recently suggested, the US publicly quoted company model is not actually capitalism. The 1933 law created federally regulated "earnings-ism". This drives financial reporting and capital market behaviour.
Risk is diversified by investors, but investment risk in the US is not wholly commercial in origin. Some risk is actually created because the federal and state systems do not fit together in harmony. This includes the risk of having poor, but legally correct, reporting.
Take Enron. Earnings could be generated from "nothing" because reporting of the capital side of the financial equation could be avoided within the law.
"Earnings-ism" has other
technical faults. A stock may be correctly priced, but legally hidden inefficiencies or dubious expenditure may be hidden inside the company even though these damage shareholders' interests.
Britain's financial reporting system can reach the parts the US system cannot. It regards the shareholders' interests as paramount. It is conceptually simple and hot unnecessarily legalistic. This should help preparers and readers of accounts, especially auditors.
In the UK, shareholders legally appoint auditors. Shareholders' needs set the purpose of the work. Purpose and power flow from the shareholders' interest in the enterprise, not the dead hand of a constitutionally limited regulator.
In the US "earnings-ism" is not a clear goal for accounting so standards setters have had to resort to rules to cover both capital and earnings in the round. This is a major weakness in a legalistic society where law is tested to the margins.
American auditors report differently - to boards not shareholders. They have little power - their goals depend on the politics of standards setting and enforcement often depends on the funding levels of the
regulator. They are the piggy-in-the-middle between boards, regulators and lawyers. They are poor cousins of the UK auditor but carry the same name.
The American reporting and governance model was designed to kick-start an economy in a deep depression, with the aim of enabling companies to raise money. This model was almost bound to create problems once the US reached economic maturity.
By the 1990s, many companies did not issue new stock, other than to insiders by way of in-the-money share options. The challenges now are not so much pricing new issues of stock but corporate efficiency. Inefficiency, however, can be hidden.
Sarbanes-Oxley does not resolve the weaknesses at the heart of the US system. To adopt aspects of that system in the UK is especially unwise given that the US system is a pastiche of Britain's.
Convergence carries a risk of a reporting system dominated by incomprehensible accounts, written by lawyers for lawyers.