A key principle of financial reporting is that “information should be expressed so that substance, not form, governs” [1]. What this means is that “the financial statements and accompanying disclosures of a business should reflect the underlying realities of business transactions. Conversely, the information appearing in the financial statements should not merely comply with the legal form in which they appear” [2].  Managers, accountants, and auditors, who are supposed to be concerned with the long-term viability (going concern) of an entity have to be especially concerned with this principle. Auditors appear to be greatly influenced by litigation risk, the fear of being sued over an alleged improper audit. Litigation risk results in a more conservative audit, i.e., auditor conservatism [3].

Cantoria [4] lists 10 major accounting scandals that significantly altered the corporate world. Cantoria affirms: “In the midst of all these accounting anomalies, the accountancy profession and the role it plays came into focus. Accountants helped in misleading the public by certifying that the financial reports of fraudulent companies were true and correct.” It is apparent that executives often manipulate financial statements, legally and illegally, in order to achieve a desired outcome (e.g., rising earnings per share).

Clarke & Friedman [5] show how the goal of maximizing shareholder value (MSV) wreaked havoc with the world economy and destroyed a huge amount of shareholder value. The basis for this goal is the belief that the price of the stock is the best indicator of the performance of management. The goal of MSV caused CEOs to focus on the kind of short-term profits that ultimately had negative effects on brand equity and the long-term health of their organizations. It led some CEOs to engage in mergers, acquisitions, stock buybacks, or divestitures that would boomerang later. The illusion of financial health was more important than the reality. For example, two financial instruments that made several companies look good in the short term were collateralized debt obligations (CDOs) and credit default swaps (CDS). Millions in bonuses were given to top management because of the huge profits made by firms selling these instruments. Subprime mortgages given to home buyers with insufficient income to service a mortgage may have made Countrywide Financial Corporation (taken over by Bank of America) and Washington Mutual (second largest bankruptcy in American history) seem like solid, profitable entities for several years but eventually destroyed these institutions.

The dominance of form over substance causes organizations and government to make many mistakes that can hurt society. This is why many leaders choose expansion over maintenance. It is not “sexy” to maintain buildings, so many organizational leaders spend huge amounts of money on new buildings and allow older buildings to fall apart. This is what is going on all over the country when it comes to infrastructure such as bridges. A total of 58,495 bridges out of 609,539 (9.6 percent) in the United States are rated as structurally deficient [6]. Seventeen percent of American dams (15,498) have been identified as having a high-hazard potential by the American Society of Civil Engineers [7]. Politicians prefer investing in something new rather than in fixing old infrastructure. By doing this, they are sacrificing safety and reliability forexpansion and growth. If you want to look good for your next job, it is more impressive to say that you built a new bridge, dam, building, or program than saying you maintained the existing infrastructure. Maintenance can never be as sexy as expansion.

New York City is spending billions on new subway stations but is using a signal system that is antiquated; much of it dates back to the 1930s. The signal system was supposed to be computerized in 1991 after a subway derailment killed five people. In 2017, more than 25 years later, only one of 22 subway lines has computerized signals. The deadline for finishing this task keeps getting pushed back and is now estimated to be 2045 [8]. Several governors and mayors kept kicking the can down the road rather than spending money on fixing the signal system. Building a new subway station or bridge provides a politician with more visibility than replacing an obsolete signal system. Similarly, college presidents would rather invest in new buildings, create new schools and departments, or establish new programs than maintain and repair existing buildings.

The solution to the above problem of putting form before substance requires two changes:

(A) Hiring ethical leaders that care about all stakeholders, not just themselves. Indeed, Hess found that the most effective leaders tended to be servant leaders and cared about all stakeholders: suppliers, shareholders, customers, the community, government, the environment, and society [9]. Narcissistic leaders, on the other hand, are concerned with themselves and desire power, wealth, adulation or fame. They are likely to surround themselves with people who are loyal to them: Loyalty is more important than competence. They tend to be toxic to an organization [10]. Contrary to what most boards appear to believe, it is not the egocentric CEO that can transform a company into a huge success.  If an organization is concerned with substance, not form, it will be important to see how well an organization is doing with all stakeholders. CEOs should be rated on factors that enhance the actual long-term health and competitive strength of their firms, not the appearance of long-term health. They should be rated on such factors as proper maintenance of infrastructure, customer satisfaction, retention of creative employees, the provision of meaningful work, employee engagement and satisfaction, the creation of an ethical tone at the top, the building of a strong, positive reputation, and corporate social responsibility (CSR).

(B) Auditors have to focus on the long-term viability of an organization. It is therefore crucial for them to convince top management to embrace maximizing stakeholder value and concern for a company’s long-term health as the preferred philosophy. If buildings are not maintained properly, auditors have, at a minimum, a moral responsibility to indicate this. Several accounting and consulting firms are doing CSR audits. The purpose of the CSR audit is to evaluate and assess how well an organization is doing when it comes to its corporate social responsibility objectives that include impact on stakeholders, community, the world, society, and the environment. Like publicly traded companies, many privately held companies, non-profits and government agencies also have annual financial statement audits. We believe that the financial audit can also be used as a platform for CSR audits. Financial statement audits already include examination of areas other than the financial statements.

If organizations can focus on substance rather than form, there is hope that the devastating scandals and shameful behaviors that continue to plague business and government — Libor manipulation, Volkswagen emissions outrage, Wells Fargo creation of fake accounts, Kobe Steel false data scandal, Equifax data breach, Apple’s slowed down iPhones, Samsung bribery charge, and numerous alleged sexual harassment coverups — can finally come to an end.

REFERENCES

[1] Meyer, P. E. (1976). A framework for understanding “Substance Over Form” in accounting. Accounting Review, 51(1), January, 80-89.

[2] Accounting Tools (2017). What is substance over form?  Accountingtools.com. Retrieved from http://www.accountingtools.com/questions-and-answers/what-is-substance-over-form.html.

[3] Elshafie, E. (2016). Determinants and consequences of auditor conservatism. Journal of Accounting, Ethics & Public Policy, 17(4).  Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2850139.

[4] Cantoria, C. S. (2010, December 30).  Unraveling the details of 10 high-profile accounting scandals. Brighthub.com. Retrieved from http://www.brighthub.com/office/finance/articles/101200.aspx.

[5] Clarke, C. & Friedman, H. H. (2016). Maximizing shareholder value: A theory run amok. i-manager’s Journal of Management, 10(4), 45-60.

[6] Cardno, C. A. (2016, March 15). Analysis reveals 58,495 U.S. bridges are structurally deficient. Civil Engineering. Retrieved from http://www.asce.org/magazine/20160315-analysis-reveals-58,495-u-s–bridges-are-structurally-deficient/.

[7] American Society of Civil Engineers (2017). Infrastructure report card. Retrieved from https://www.infrastructurereportcard.org/cat-item/dams/.

[8] Fitzsimmons, E. G. (2017, May 1). 6 million riders a day, 1930s technology. New York Times, A1, A18.

[9] Hess, A. D. (2013, April 28). Servant leadership: A path to high performance. Washington Post. Retrieved from http://www.washingtonpost.com/business/capitalbusiness/servant-leadership-a-path-to-high-performance/2013/04/26/435e58b2-a7b8-11e2-8302-3c7e0ea97057_story.html.

[10] Kets de Vries, M. F. R. (2014). Coaching the toxic leader. Harvard Business Review, April.  Retrieved from https://hbr.org/2014/04/coaching-the-toxic-leader.

This post comes to us from professors Hershey H. Friedman and Frimette Kass-Shraibman of Brooklyn College. It is based on their recent article, “‘Substance Over Form’: Meaningful Ways to Measure Organizational Performance,” available here