What investors still want from financial reports
Friday, 06 August 2010

This is the third part in a series on business reporting by the International Federation of Accountants. In this part, IFAC interviewed six specialists with close ties to the investment community to get their recommendations on how to improve business reporting. To read the complete interview transcripts, including summaries of interviewees' recommendations, see the IFAC website at www.ifac.org/frsc.

Financial reporting by publicly traded companies still leaves a lot to be desired, according to experts interviewed by the IFAC.

Start with the complexity that has arisen from managers' efforts to skirt onerous accounting rules. Respondents to IFAC's previous studies from March 2008 identified complexity as one of the main difficulties in financial reporting. According to interviewees, complexity continues to pose a challenge.

"Things like off-balance sheet accounting, warehousing of financial instruments, mark-to-market valuation, and all those other issues that made financial information so opaque have increased the complexity of financial accounts, observed Tanya Branwhite, executive director, strategy research at Macquarie Securities. As a result, Branwhite adds, "it has become difficult for many investors to trace the financial performance of a business." She warns that "if financial accounts are not prepared with the users in mind, then we risk a whole area of unaudited 'shadow reporting' being provided directly to investors that doesn't go through the rigorous financial accounting process."

Managers and directors who ignore this problem do so at their own peril, warns Michael McKersie, assistant director, capital markets at the Association of British Insurers (ABI), the largest single group of investors in the UK.

"If complexity is masking real issues," says McKersie, "that might result in less confidence."

But experts said more information needn't add to complexity. "Investors don't necessarily think bulkiness is an issue as long as can they can find what they need," McKersie adds.

Branwhite concurs, indicating that reports are long by necessity: "As the accounting standards themselves have gotten more complex, analysts have needed more information to understand the numbers that they are looking at. Hence, you then end up with about 400 pages in financial reporting, so that analysts are able to peel back that information."

What of complaints that much of the information is useless? "We hear frequently from preparers who say that the expanded disclosures aren't used by investors," acknowledges Matthew Waldron, director of the Financial Reporting Policy Group at US-based CFA Institute. But, Waldron adds, "When we go to roundtables or in other forums, investors frequently ask for more quantitative and qualitative disclosures."

Another key ingredient is fair value, the experts say. "Fair value accounting is very important, certainly on the fixed assets side," says Hong-Kong-based investor and shareholder activist David Webb, adding that "we need comparability between companies in a sector, between companies in a market, and between companies in different markets."

Waldron also strongly favors fair value. In fact, he "believes that it is the most decision-useful measurement basis for investors."

The reliability of fair value is an issue, the experts acknowledge. But Waldron thinks that problem can and should be overcome with better disclosure. "Investors feel that relevance has primacy over reliability," he notes, "so combining high-quality disclosures with the fair values presented in the financial statements presents more decision-useful information."

The experts also say the direct cash flow method might help investors, especially retail ones, better understand the performance of a company. The direct method-where cash flow from operations is computed by addition and subtraction of cash received and paid, instead of through adjustments from the balance sheet to net income reported on the income statement-is useful, the experts say, because it helps investors evaluate the quality of a company's earnings.

The direct method, says Carlos Madrazo, head of investor relations at Mexico-based Grupo Televisa, allows one to "better distinguish the impact on earnings that results from changes in fair value, versus those changes that we see from the day-to-day running of the business." That observation is echoed by Branwhite, who contends "the wider investor community will be able to see more clearly the operating performance of the business, the investing decisions being made by the business, as well as how the business is being financed and any changes in the value of the assets and liabilities."

Management commentary is also desirable but still has a ways to go, according to the interviewees. "Investors like directors to talk in good faith on how they see matters in order to make better quality investment decisions," says McKersie.

But Webb contends that current commentary must be taken with a large grain of salt because of governance issues. "If we had an independent election system for independent directors, then they would have more authority," he says. In that case, he says he would favor giving them their own section of the annual report and an obligation to report any issues that they are concerned about, and any issues on which they have disagreed with the rest of the board.

The interviewees held mixed views on the usefulness of sustainability reporting. "Investors are increasingly seeking information on a company's environmental, social, and governance performance because they see these as indicators of good overall corporate management and often superior performance," says Madrazo.

But Webb dismisses the importance of such reporting. "Sustainability reporting is of no real value to investors," he says. "We shouldn't expect companies to try to make the world a better place at the expense of their shareholders."

Instead, that job belongs to governments: "If everybody is required to clean up their waste, companies will economically price it into their products."

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