The idea investors need to get together so they can get the information they need to “know what they own” has managed to make it into the Harvard Business Review.

Vijay Govindarajan, Shivaram Rajgopol and Anup Srivastava wrote an interesting article in the Harvard Business Review looking at why financial statements failed to capture the value created by modern digital companies.  This is not the first time current disclosure regulations have failed to provide investors with the information they need to know what they own.  The failure of these regulations was made abundantly clear in 2007 and 2008 when investors could not assess either subprime mortgage-backed deals (see BNP Paribas’ August 9, 2007 announcement) or banks (see BoE’s Andy Haldane’s reference to them as black boxes).  The Transparency Label Initiative was started to address this failure.

My reason for calling your attention to the article is the authors confirm why the Initiative is necessary.  They also effectively called for all investors to support the Initiative.

To research their article, the authors interviewed both technology company CFOs and their investment bankers.  They discovered an interesting shortcoming in current financial reporting.

Business students are taught to value a company based on the discounted amounts of future cash flows or earnings. That concept is becoming almost impossible to apply to emerging companies that are run as a portfolio of ideas and projects, each with uncertain lottery-like payoffs. CFOs of these companies themselves admit that they cannot justify their market capitalizations based on traditional metrics. They conjecture that their market values might be the sum of the option values of the projects undertaken, a sum of best-case scenario payoffs.

If the firm’s market value is based on the sum of the option values of the projects it has undertaken, then it is necessary to disclose all of the projects in the pipeline.  This is not required by current SEC disclosure regulations.  However, that doesn’t mean there are not industries that do disclose the projects in the pipeline.  For example, Biotech firms have traditionally disclosed this information.  Not so much other technology firms.

The view from these other technology firms is the

companies see little value in disclosing the details of their current and planned projects in their financial disclosures, even if those disclosures can reduce the information asymmetry between investors and managers. Given the bull market in digital stocks, CFOs believe that they have no incentives to provide any additional information beyond mandatory SEC disclosures, which they consider excessive, tedious, and uninformative and might invite unnecessary scrutiny and litigation.

Confirming yet again companies prefer not to disclose.

At the same time,

CFOs realize the growing limitations of the current financial reporting model. They are, however, extremely pessimistic about whether the model can be fixed within the current regulatory regime. One CFO commented that standard setters enjoy monopoly power and have no incentives to change their methods to be more responsive to investors.

Regular readers know the current financial reporting model cannot be fixed within the current regulatory regime as it has been captured by Wall Street.

The authors concluded

It’s clear to us from our research and from these interviews that the time has come for investor bodies and companies to rethink the financial reporting model from scratch. …  Relying on firms’ voluntary initiatives is unlikely to work because executives told us time and again that they will not disclose sensitive information, unless their competition is forced to do the same.

And this is where the Transparency Label Initiative comes in.  The Initiative bypasses the current regulatory regime and Wall Street.  The Initiative is funded by and focused solely on the investors.  The Initiative works with investors to identify what data investors need in order to know what they own.  Through granting or withholding of its label, the Initiative puts pressure on everyone in an industry to disclose this information.