Relative reality - analyzing financial reports of competitors

Chief Executive, The, Dec, 1996 by Thomas Lys, Margaret Neale

Looking for clues to your competition's plan? A new study demonstrates how to read between the lines of financial reports.

We live in a world where information overload is the norm. Yet even touring the deluge of print and electronic media and an in-box piled high with financial reports doesn't always provide a clear picture of corporate performance.

A litany of options offers corporations considerable discretion in reporting financial results. Generally Accepted Accounting Principles allow a choice of methods, such as straight-line or accelerated depreciation and valuation of inventories using the last-in, first-out or the first-in, first-out methods. Each option can significantly affect financial statements and distort reality in portraying performance. With such potential for abuse, misrepresentation is an ongoing concern. But flexibility in methods serves a purpose - allowing companies to choose methods appropriate for their industry and to tailor communication efforts to shareholder needs. And, for potential investors, shareholders, and third parties, the accounting choices themselves can serve as vital clues to not-yet-public corporate information.

Still, debate on the issue is heated. Recognition versus disclosure is a topic of contention among the Financial Accounting Standards Board, Securities and Exchange Commission, and leaders in the business community. Recognition refers to the way specific financial figures are calculated, while disclosure refers to requirements to provide supplemental information useful to financial statement readers. For example, the value of executive stock options may be disclosed in footnotes and proxy statements rather than being recognized in net income.

For the most part, accounting regulators seek more stringent recognition. For example, the FASB asserts that: "Footnote disclosure...is not an adequate substitute for recognition. The argument that the information is equally useful regardless of how it is presented could be applied to any financial statement element, but the usefulness and integrity of financial statements are impaired by each omission of an element that qualifies for recognition."

In contrast, management argues that reporting options enable a company to convey unique aspects of performance. Formal and informal methods of communication include financial statements such as annual reports and announcements, as well as management's choices of financing options and organizational incentives.

Furthermore, research suggests that where information is located and how it is presented can have a huge impact on investors' behavior - a perspective consistent with the FASB's position on recognition versus disclosure. Consider the following example:

Economic difficulties force a manufacturer to consider closing three plants and laying off 6,000 employees. The following two plans are proposed:

A: This plan will save one of the three plants and 2,000 jobs.

B: This plan has a one-third probability of saving all three plants and all 6,000 jobs, but a two-thirds probability of saving no plants and no jobs.

Approximately 76 percent of executives participating in a survey administered by Northwestern University's Kellogg Graduate School of Management, choose Plan A, the risk averse (i.e. certain) option. Consider now the consequences of restating the two options as:

C: This plan will result in the loss of two of the three plants and 4,000 jobs.

D: This plan has a two-thirds probability of resulting in the loss of all three plants and all 6,000 jobs, but a one-third probability of losing no plants and no jobs.

Obviously, there is no difference between Plans A and C and between B and D. Still, when the plans are restated as C and D, 86 percent of executives prefer D, or the riskier alternative. Thus, how one presents choices can influence decisions.

But when deciding how to present information, different factors come into play. Another case in point is the FASB's mandate (SFAS 106) that companies use accrual accounting, rather than the pay-as-you-go method, for post-retirement benefits and that obligations accrued in the past be recognized in the financial statements. Meeting this requirement would boost liabilities and cause a corresponding decrease in retained earnings. Companies had a three-year window in which to take this hit and, within that window, could adopt the standard in a single year or over 20 or more years.

Stretching the adoption period to span the maximum allotted time period seemed the most attractive option for incumbent CEOs. Yet, the vast majority chose a one-year write-off in the second or third year. First, because after the one-time write-off, future net incomes would look better. Second, even small losses pain shareholders, so unleashing the bad news all at once was seen as preferable. Third, a one-time hit enabled management to deflect the blame to the FASB, an attribution that would be more difficult to make as the years passed.

This case history shows that flexibility allows corporations to respond to the limitations of their audiences. However, that same flexibility also allows them to mislead audiences - either intentionally or unintentionally. Because potential investors rely on simplified strategies or shortcuts to cope with information overload while making complex decisions, there is an opportunity for misdirection. Therefore, without adequate disclosures, the various reporting options would make it virtually impossible to assess performance.