Firms with complicated financial statements have to bear much of the responsibility for the complexity, no matter how strong or weak the accounting standards are. This is because accounting standards establish a floor on what has to be revealed and not a ceiling.
Firms that want to reveal more to their investors can always do so. Infosys, an Indian software firm, for example, has financial statements that are more transparent than those provided by most U.S. firms, even though Indian accounting standards on disclosure are much weaker than U.S. accounting standards. In this section, we consider some of the reasons why firms may choose to make their financial statements more diffuse and difficult to understand.
Control
Many incumbent managers fear hostile takeovers, since they will lose their power after these takeovers. They attempt to preempt hostile acquirers by structuring a bewildering array of subsidiaries and holding companies to hold their assets and by creating new financial securities – common stock with different voting rights, for example. How do these actions keep hostile acquirers away?
First, information that is not available to investors is also unavailable to potential hostile acquirers, making it difficult for them to detect when a firm’s assets are being poorly managed and under valued.
Second, the complicated holding structure and financial instruments used by the firm can make it difficult to gain effective control of the firm. In Asia and Latin America, for instance, family run firms have used cross holdings to effectively cement control in the hands of family members. By not providing complete information on the cross holdings, they make it difficult for stockholders who want to ask them relevant questions about the profitability and value of these investments.
Tax Benefits
Firms can sometimes reduce their tax burden by creating holding structures in lowtax domiciles. For instance, it is not uncommon for firms in the United States to have subsidiaries in tax-exempt locales such as the Cayman Islands and to funnel income into these subsidiaries.[12]
Complex holding structures also allow firms to shift income from one subsidiary to another, using transfer pricing and inter-company loans. In other words, firms cannot afford to be transparent with shareholders if they prefer opacity when it comes to the tax authorities. As a general proposition, complexity in tax laws will generate complexity in financial statements. Legislators who bemoan the latter should consider their role in creating the former.
Deceit
We have saved the most odious of the reasons for complexity for last. Firms sometimes create complex structures to fool investors into believing that they (the firms) are worth more than they really are or that they owe less money than they truly do. In many cases, what starts as a small evasion mushrooms over time to become a large one, and when the truth comes, as it inevitably will, there are large economic and social costs.
The executives at these firms will complain mightily about the accusations of deceit, and they will usually find ways to rationalize their actions.[13] Note, though, that investors and analysts should not be relieved of their responsibility when firms pull off these con games. For the deceit to work, you often need analysts who look the other way and do not ask tough questions of managers, and investors who base their investment choices on past history and little analysis.
12 There is clearly the sensitive issue of when tax avoidance becomes tax evasion. We do not hav the legal expertise to make that legal judgment.
13 We just took the debt of the books to reduce the interest rate that we pay, they will claim, but we did mention it in a footnote. In response, we would argue that investors should not have to troll through footnotes to find out how the firm owes.
Prof. Aswath Damodaran
Next: Measuring Complexity
Summary: Index