Changing the Focus of the Financial Reporting Model

Over the last several months, as regulators, politicians, analysts and the media have scrutinized different aspects of the Enron Corp. bankruptcy, it seems the financial reporting process has received the least critical review. Why? Because people regard the reporting model as too amorphous and difficult to change.

Under our current financial reporting model, short-term earnings are the key focus. We’re all too familiar with the “earnings game” where the rules mandate a severe hit to the company’s stock price if the quarterly earnings are a penny below the market’s expectation, even if there are signs of improvement. These rules defy logic. We all know there is more to a company than its short-term earnings. Yet too many company executives find themselves as players in the game—a never-ending and highly dysfunctional spiral focused on short-term earnings and the ability to manage expectations. The game’s final score is information that relies too heavily on market gossip, leads to excessive stock price volatility and inaccurate valuations, and ultimately reveals very little about future stock price performance.

Blue chip companies, while not immune to the game, have prevailed because of their sound, strategic play, developing a game plan that subscribes to longer-term value. The blue chips try to provide their investors with meaningful information, measuring key indicators such as customer satisfaction and employee retention and recognizing the value of their brand as well as other intangible assets.

However, traditional financial reporting fails to adequately account for intangible assets and the non-financial value drivers that indicate future financial success. Managers often use this information for internal decision making, so why not provide it to the marketplace, too? Better information may not only help solve the problem of inaccurate stock price valuations, but it could also moderate volatility as well.

In 2001, the cumulative market-to-book value ratio for the S&P 500 was approximately 6.7. For pharmaceutical companies the ratio jumped to 30. A couple of decades earlier this ratio was 1.3. Clearly, the market puts less stock (pun intended) in companies whose financial performance is based solely on historical book values.

Of course, my comments come as no surprise. The accounting profession is well aware of clients’ other value drivers, which are used for consulting purposes. Yet we haven’t changed our focus of reporting. We remain stubbornly unwilling to consider reporting any information that goes beyond the historical financial statements. With our green eyeshades pulled low, we ignore other value propositions and are only willing to measure financial performance.

There is significant research that suggests investors (and some financial executives) desire more relevant measures of performance. However, there appears to be a large gap between the information that investors would like to have—more non-traditional performance measures—and the information that they actually are given through companies’ published reports and their websites.

It doesn’t take a rocket scientist to realize that if a pharmaceutical company is trading at 30 times book value, the market believes strongly in the company’s research and development (R&D) pipeline. To better serve investors, maybe we should start looking beyond the historical cost model. While earnings, cash flow, costs and capital expenditures remain important measures of performance, investors look for the following measures, which through improved disclosure and corporate reporting could help close the information gap:

• R&D investment amounts
  
• Segment performance
  
• Statements of strategic goals
  
• New product development
  
• Market share

A bridge should be built that spans the divide between traditional financial reporting and the modern needs of investors, and addresses the manner in which companies measure and manage their performances as well as how they convey those performances to the public. The bridge should lead to transparency, making sure investors have a clear window into companies, their strategies and their future direction.

As we build the bridge, there are many aspects to take into account. These include: management’s perspective on industry dynamics and marketing position—its own vs. its competitors’; management’s assessment of the business climate and general economy; the regulatory environment; and the status of current and future technology. A company’s business strategy and different lines and strategic implementation of business, as well as a company’s prime components and changes to its shareholder value, actual income statement and balance sheet results, benchmarked against both its own targets and its competitors’, should be disclosed too. Lastly, information on non-financial elements of value, such as a company’s customers, brands, reputation and employees, as well as its intellectual capital and innovative projects, should be reported.

Better disclosure creates increased management credibility, more long-term investors, greater analyst following, improved access to new capital and higher share values. Credibility of information, including non-financial information, is critical, and the accounting profession can play a vital role in its conveyance.

Non-financial drivers present a great opportunity for our profession; it only seems odd that we have not already embraced our role in their reporting. This seems especially peculiar when you consider that the American Institute of CPAs has invested significant resources to further the growth of assurance services. CPAs now have an attestation model that works with different types of information to meet shareholder needs and make capital markets more efficient. Why are we, and corporate America, so unwilling to move in such an obviously beneficial direction?

president@nysscpa.org