Sarbanes-Oxley Means Opportunities and Challenges for Companies and IROs

CPA Journal, The, Sep 2005 by Thompson, Louis M Jr

In the eyes of Congress and the SEC, the new rules resulting from the SarbanesOxley Act (SOA) were designed to restore investor confidence. Several regulations were designed to increase transparency of corporate information by providing a more accurate picture of a company's value and to restore confidence in the accuracy of financial information reported to the SEC.

But from an investor's perspective, more information is not necessarily better information. "Transparent" means the information must be clear and understandable. But corporate investor relations officers (IRO) often struggle with legal counsel and accountants about how to present information that is truly transparent.

Many companies seem to have fallen into a "compliance by checklist" mode with respect to disclosure and corporate governance. While this mentality may provide assurance that a company is following the rules, it is debatable whether investors are better off for it.

According to a National Investor Relations Institute (NIRI) survey, the reconciliation requirements of SEC Regulation G, Conditions for Use of Non-GAAP Financial Measures, have caused a 10% decline-from 69% to 59%-in the number of companies reporting non-GAAP information since the rule took effect. While this rule was necessary to correct some of the abuses of pro forma reporting, some companies go overboard in assuring compliance. A Fortune 500 company IRO said his company had 25 people involved in preparing the Management's Discussion and Analysis (MD&A) part of a company's financial statements, and that, while he believed the end result was fully compliant, he acknowledged that it was far from transparent.

In the SEC's December 2003 guidance on MD&A, it called on companies to communicate information as seen "through the eyes of management" and in plain English. The release encourages companies to create an MD&A executive summary that allows one to get the essence of management's analysis of the results and key trends going forward; an investor can then get more detailed information in the body of the document.

Some lawyers advise against an executive summary, saying it might subject a company to a shareholder lawsuit for errors of omission should the executive summary be found to have omitted a material item. An sec official I spoke with said this is an overreaction, and recommends that the company's IRO either write the MD&A or be intimately involved in the process, to ensure that the information is consistent with what the company is telling the investor community.

The SEC also urges management to discuss key nonfinancial value drivers, which often constitutes a major component of a company's market value. This presents companies a significant opportunity to move the market from a short-term focus on earnings to a more complete valuation model.

Nonfinancial Factors

Since the early 1990s, many observers have recognized that a company's nonfinancial factors or intangible assets play a key role in how the market values its prospects for performance. New York University Stern School of Business professor Baruch Lev determined from 1989 NIRI-sponsored research that about 40% of the average S&P 500 company's market value could not be explained through the financial statements. This led him to search for the factors that drive this valuation component.

Soon thereafter, the AICPA formed a committee under Ed Jenkins, who later became FASB chairman, to explore how nonfinancial factors might be disclosed through corporate reporting. In the mid-1990s, Carolyn Brancato, director of the Conference Board's Global Corporate Governance Research Centre, created a special Conference Board committee to further explore disclosure of nonfinancial performance measures. Concurrently, Sarah Mavrinac, a researcher specializing in strategic performance measurement, reported a groundbreaking study for Ernst & Young, "Measures That Matter," on the importance that mutual fund managers placed on nonfinancial factors in making investment decisions.

More recently, books on how intangibles drive corporate valuation have been published by such authors as Baruch Lev; Jonathan Low, a research fellow at the Cap Gemini Ernst & Young Center for Business Innovation; Pam Cohen Kalafut, a sociologist now with consulting firm Predictiv; former Harvard professor Robert Eccles; and former PricewaterhouseCoopers partner and current FASB chairman Robert Herz.

Another new development is the creation of the Enhanced Business Reporting Consortium, funded in part by the AICPA, a private-sector initiative with the goal of developing a business reporting model incorporating nonfinancial factors. NIRI is a charter strategic partner in this effort; its interest is in developing models, probably along industry lines, for communicating information about nonfinancial factors to the investment community.

The desire on the part of companies to shift the market's focus to more long-term valuation is still complicated by analysts' pressure on companies to provide quarterly earnings guidance. According to a March 2005 NIRI survey, 71% of companies provide earnings guidance, and an increasing number, 61%, of those issuing earnings guidance provide annualized guidance, quarterly guidance, or both; 93% update their guidance if it changes materially.