Transparency: Definition, How It Works in Finance, and Example

What Is Transparency?

Although the term transparency is not a financial term or metric per se, it has become increasingly important to consumers and investors over the last several years. 

Transparency is the extent to which investors have ready access to required financial information about a company, such as price levels, market depth, and audited financial reports. Investors also require transparency with investment firms and funds surrounding the various fees that'll be charged to them.

Transparency can also include clarity for consumers regarding the fees that bank charges or the rate that consumers will ultimately pay to their credit card company.

Understanding Transparency

Financial decisions are typically made based on an assessment of a financial situation.

Investors analyze a company's financial statements to determine if the stock is worth buying. On the other hand, consumers choose a bank or investment firm based, in part, on the costs or fees. Adequate disclosure of fees, interest rates, and penalties are important for making sound decisions as to what credit card or loan to apply for as well as what bank account to open or what mutual fund to invest in.

Because investor decisions as to what security to buy are based on a company's financial reports, the reports should be as transparent as possible.

For example, assume two companies have similar debt levels, size, market risk exposure, and earnings. One company operates with transparency concerning its financial reports while the other company runs multiple businesses with complex financial reports. Investors may gravitate to the first company since they can easily understand the company's fundamentals and risks involved. However, investors who put their money into a company with a complex structure might miss critical financial details that could lead to the company performing poorly and a loss on the investment.

As a result, it's important that transparency rules are followed by all companies. The critical nature of transparency and consistency to the financial markets is why publicly traded companies on exchanges, such as the New York Stock Exchange (NYSE) are regulated.

Required Transparency

The U.S. Securities and Exchange Commission (SEC) is the federal government agency responsible for regulating the financial reporting for corporations.

The primary goals of the SEC are to protect investors by ensuring a fair and orderly functioning of the financial markets. The SEC requires publicly traded companies to report their quarterly financials (called a 10-Q) and their year-end financials (called a 10-K).

Companies must also file an annual report as well as interim reports such as 8Ks, which contain pertinent financial information and developments. Below are some of the financial statements required by the SEC as outlined in their Financial Reporting Manual.

Income Statement

The income statement shows the profit and loss of a corporation. The statement outlines the revenue on the top line. Operating expenses are listed, such as the cost of goods sold, as well as operating income. Also, other expenses include overhead or selling, general, and administrative expenses (SG&A) as well as interest expenses and taxes paid. The profit or net income is listed at the bottom of the income statement.

Balance Sheet

The balance sheet shows a corporation's assets, liabilities, and stockholders' equity or shareholders' equity.

Assets can include fixed assets, such as machinery or equipment, while liabilities can include short-term payables and long-term liabilities, such as debt.

Cash Flow Statement

The cash flow statement measures all of the cash inflows–or credits-as well as any of the cash outflows–or debits–to cash that a company experienced during the period.

The statement of cash flows also shows any investing activities, such as purchases of equipment that would help the long-term by day of the company. Financing activities are also listed, which include any cash inflows or outflows regarding the financing of the company, such as loans, bond issuance, and stock issuance.

Statement of Stockholders' Equity

The statement of stockholders' equity records all the changes to shareholders' equity, which occurred during that period.

These changes might include any share buybacks, stock issuance, and dividends paid out to shareholders. Dividends are typically cash payments made to investors as a reward for owning the stock. However, dividends can also be paid out as shares of stock.

Statement of Comprehensive Income

The statement of comprehensive income list other types of income, which can include items such as foreign exchange gains or losses, hedging, and pension activity.

Importance of Transparency

Transparency helps reduce uncertainty and wild stock price fluctuations because all market participants can base decisions of value on the same data. Companies also have a strong motivation to provide disclosure because transparency is rewarded by the stock's performance.

A strong indicator of future growth is how a business invests its money. When an investor cannot find information stating where a company invests, the investor is less likely to invest in the business. Opaque financial statements could hide a company's debt level, for example, while the business is struggling with insolvency.

Investors should be aware of the underlying investments that compose their portfolios. For example, owning a single stock means investing in one company while owning a mutual fund means investing in a basket of securities or companies. Transparency helps to shows investors how much risk is involved with buying stocks, which can aid in making more informed investment decisions.

Investors should compare their investment returns with those of related securities, benchmarks, and other asset classes to help determine how their investment is performing. If a stock, for example, is underperforming while the industry is doing well, it might be a red flag. In other words, market participants might be concerned about the company's financial situation, revenue outlook, debt load, or the ability of management to run the company effectively.

Investing limitations, such as liquidity restrictions—meaning it's difficult to readily buy and sell shares—as well as the fee structure for funds and investments, should be made available.

Example of Transparency

In February 2016, six groups at a Tyson shareholder meeting spoke with the chair of the board John Tyson about the lack of transparency the company provided on its financial reports.

The International Brotherhood of Teamsters noted that contributions to the American Beef Federation, the National Chicken Council, and state and local lobbying efforts were not readily available. Multiple shareholders noted that Tyson's chemical spill of acidic wastewater in Monett, Missouri killed over 100,000 fish in the city's waterways.

Shareholders wanted more information on the company's planned improvement of water quality in plant areas. Additionally, shareholders asked for an annual report showing plant safety records to ensure the records improve over time. Tyson's family members controlled the company's voting rights and did not approve of what was being asked of them. As a result, all six proposals were voted down.

However, Tyson Foods was later fined $2 million in early 2018 by the U.S. Justice Department as originally reported by the Associated Press. As part of the settlement, the company was required to hire an independent auditor to review their environmental compliance procedures, conduct training, and make improvements to their poultry facilities.

The Bottom Line

As investors, we base our investment decisions largely on the financial statements that each company provides. Therefore, it's crucial to stick with companies that are transparent about their financial reporting and avoid ones that obfuscate the numbers.

If management isn't transparent, it's virtually impossible for investors to be sure about that company's real risk/reward tradeoff.

Transparency FAQs

What Is Corporate Transparency?

Corporate transparency is simply the extent to which a company's actions, financial statements, strategy, and other issues are visible to outside observers.

What Is Price Transparency?

Price transparency is the extent to which all information regarding a stock's price (such as its bid prices, ask prices, and trading quantities) is available to traders.

What Does Transparency Mean in Blockchain?

In the world of blockchain, transparency is an especially important concept. Because of the decentralized nature of Bitcoin's blockchain, for example, all transactions can be viewed on a public ledger. This makes it difficult for hackers to extract Bitcoins without being traced.

What Does Transparency Mean in Government?

Government transparency is the extent to which a given government prioritizes honesty and access to information in order to allow for effective public oversight. Transparency is often seen as a major tool for citizens to hold public officials accountable and to combat corruption.

What Is Workplace Transparency?

Workplace transparency is the extent to which managers and employees of a particular company value openness, communication, and honesty in the workplace.