Willekens, Marleen

English

Research Papers in Economics

Tijdsclxifi voor Ecoiloinie en Management 
Vol. XLVII,  1, 2002 
Financial Reporting? -  It Simply 
Doesn9t  Work 
Views on 'Corporate Reporting Wevisited' 
by J. Hegarty, C. Beckers and E. De Keraleneer 
1  Willekens Marleen 
Departinent of  Appiied 
Econoinics, K.U.Leuven, 
co-holder of the PwC Chair 
"Value and Risl<" 
*  Editorial  assistance  Trol11  Prof  Piet  Sercu,  Depaitment  of  Applied  Economics. 
K.U.Leuven -  the other co-holder  of the  PwC  Cliair - is  gratefully  aclmowledged In this text, Prof. Willekeiis reports on the reflections proffered by the 
chair (Johii Hegarty) and two of the guest speakers (Staii Beckers and 
Eric  De Keuleneer)  at tlie  occasion  of  tlie  secoiid  seiiiinar,  2000- 
2001, of tlie PwC Chair Vnlzle and Risk. Tlie seminar tools place on 
February  22,  2001,  and  its  financial  theine  was  Valzie and  Risk: 
Corporate Repor-tii~g  Revisited. As the title of the present report sug- 
gests, the consensus was not  undividedly in  favor of reportiiig as it 
stands now. 
11.  BAD INFORMATION LEADS T0  BAD VALUATION 
To  John Hegarty, it  is  obvious that  finaiicial reporting does inatter. 
Tliis is iiot a surprising view, perliaps, for a former Secretaiy Genera1 
of the Féderation des Experts Cor~iptables  Ez~ropéens  (FEE). But also 
in his  new role  of World bank officer,  financial reporting reinains 
crucial. Reporting is the basis for proper valuatioii, which theii allows 
one to weigh policy alteniatives, essential in the WB's  fight against 
poverty. Yet,  for  al1 its  imnportance, in  practice  financial  reporting 
simply does not work. Finailcial reportiiig fails rniserably because its 
three essential iilgredients -  recognition, ineasurement and disclo- 
sure -  no longer work. What is beiiig reported is still largely his- 
torie-cost based, which is per definition as backward lookiilg as caii 
Se. Tixe, Fair Value Reporting is gaining in irnportance; b~e  even Fair 
Value Reportiiig  remains too much  focused o11  past  decisions, and 
tlierefore still entirely misses the  input  tliat is crucial for valuatioii 
purposes, tlie coinpany's prospects for the future. 
As balance sheets do not provide the tiue answer, investors turn to 
alteinative sources of iiifonnation (like audit reports,  hut  especially 
analysts'  repoi-ts  aiid  press  coverage,  discussed  critically  by  Stan 
Beekei-s and Eric  De Keuleneer, as reported  below). These are big 
issues of reliability and inteiyretability liere, as again ainplified below. 
Tlie result  of tliis  uil-infomed and  inforinal  valuation  process  is  a 
wide divergeiice between reported  historic value (os, in soiiie cases, 
replaceinent value) on the one hand, and market value on the other. 
Worse, the resulting ii~arlset  values often seem to be uiisustaiiiable aiid 
uiistable. We receiitly saw, for instance, plumineting ICT values with- 
out  any  change  whatsoever  in  the  uiiderlying  fundanientals.  Such volatility in stock iiiarket valuations iiiay lead to instability in finan- 
cial systenis aiid to systeiiiic risk. The true victiins of such fiiiaiicial 
crises are iiot so inuch tlie richer, Westeili investors: these oiily lose 
(soine of) their shirts and then typically bounce back rapidly. Rather, 
the worst off are tlie poor of this world, where financial catastroplies 
too often lead to a collapse of school atteildance and a disniption of 
health system and where, therefore, bounce-back is a matter of a gen- 
eration rather than a few years. 
In the above, one cause of the observed instability in valuation is 
deemed to be the failure of financial reporting -  the outward fiow of 
infonnation geiierated and steered by insiders. Yet  it is by no ineans 
clear that niarltets, wlieii provided witli tlie right infomation, would 
achially do the valuation process correctly and efficiently. The second 
and equally important issue, next to the quality of the infoniiation pro- 
duction, indeed is how valuation is an-ived at by these vesy outsiders. 
Still, the iiatural focus of our reflectioiis, at this seiiiinar, is the inside- 
out part, finaiicial reposting. And conundsum is that it may not really 
be possible to provide the right infomiation at all. This is the first of 
the many issues about the future that were raised by Mr Hegasty. 
111.  QUESTIONS FOR FUTURE REPORTING 
The value of a corporation is increasingly based on a nexus of con- 
tacts and contracts. But these coiitracts are not  enforceable, are not 
separable, aiid have no  clcar  owncr. In a serviccs firiii, who is the 
owiier of  tlie  custoiner  relatioiis:  the  coinpany,  os the  employees? 
How can we malte sure that crucial assets do not walk away, or that 
key einployees do iiot walk away with vita1 intangible assets? How, 
then, can one report these assets' values? Also, the risks and uiicer- 
taiilties are veiy different to different stakeholders, even if we con- 
fine ourselves to purely fiilancial stakeholders. When coi~~panies  get 
close to financial distress, for instance,  olie often sees heftier reac- 
tions in bond prices than in stock values. One reasoii is that these two 
types  of  financial claims,  eveii thougli  both  are contingent  on the 
saine underlying assets, are nevertheless quite different derivatives. A 
secoild reason is that  informatioii relevant to boi~dholders,  lilte the 
true current value of individual assets pledged as security to certain 
bonds, is not  always made available  on a regular basis. In light  of 
tliis, it is  still tenable  to  claiiii that  one type  of report -  tlie  one aimed at the shareholders -  als0 provides al1 the infoiinatioii needed 
by other interested parties? Tli~is,  the q~iestion  becomes: who are the 
users of information, and what are their needs? Don't we need flexi- 
bility  hese  rather  than  a  standardized,  centrally  regulated  process? 
And how do we square this need for flexibility with the need for rules 
that guarantee  a certain degree of reliability?  For  instance,  as  Stan 
Beckers amplifies iii his reinarlcs reported below, there have been fla- 
grant examples of eai-ning manageinent, recently. But a related issue 
is the olie ofpro  forma  profit and loss statements, as used in contacts 
with investors: unlike regular financial reports, these forward-looking 
statements are entirely unaudited aiid unstandardized. Is this the type 
of flexibility the market(s) need? 
There  are  other  issues.  First, with  new  (electronic) channels  of 
communication  coming  on  streani,  should  financial repoi-ting not 
become a continuous process rather than the discrete, once-a-quarter 
(os not that long ago, once-a-year) one? Perhaps, when the flow of 
infoilnation has become continuous, one would witness less of the 
iiervousness and alleged ovei-reaction that surrounds the current quar- 
terly earniiigs releases. Second, should auditing still be focusing on 
the financial reports themselves?  Shouldn't tlie attention be directed 
towards the reporting aiid infoimation systems behind those reports? 
Third, w110  should regulate the reporting activities? Is the traditional, 
centra1  regulator  still  the  model  for  tlie  future?  Or,  if  reporting 
becomes much more differentiated across industries  andlor investor 
classes, who is overseeing tlie overseers, aiid who is accountable to 
whoiil? Lastly, bear in ~ili:id that aï, unresohed issue still is wlietlier 
the defects in the market's valuation are mostly based on failures in 
the "inside-out"  infomation process, rather then iii the "outside-in" 
process  of  how  third  parties  ai-rive  at  values  about  the  firn's 
prospects.  This  is,  John  Hegarty  concludes,  the  user  of  financial 
inforination has to do a good job too. 
The  guest  speakers that  cominent  or  expand  on  Jolin Hegarty's 
introductory  statements  are, not  coincidentally,  two  such users  of 
financial information:  Stan Beckers, representing  the  large, instihi- 
tional  investor, and Eric de Keuleneer, a well-known  champion  for 
the rights of the smal1 investors. In his address,  Stan Beckers very 
much  agrees  that  finailcial reporting  does not work.  Yet,  as  Cliief 
Investment  Offices  overseeing  the  manageinent  of  40b  USD,  he 
sorely needs  good  iiiformation. Whence this  failure?  Prof. Beckers 
develops his argument in four steps. IV.  INFORMATION IS INCREASINGLY (i) IRRELEVANT AND 
(ii) UNRELIABLE 
The first obseivation is that accounting is still rooted in the old iiidus- 
trial era, wliere value was very inuch tied in witli tangible assets like 
plant & equipment, work in process, os receivables. Right iiow, how- 
ever, value resides far more in the fii~n's  iiitaiigibles: know-how and 
knowledge, R&D, custoiiier satisfaction, and so on, wliich are hard to 
value (as we just saw). Thus, investors get less relevaiit informatioii 
tlian before. As a result, tliey go for types of inforniation other tlian 
repoi-ted  asset  values,  like revenues,  sales, and eamiiigs,  to  which 
they  zttacli geat value. And "great vahe" is to be read iiot just  as 
great  iniportance,  but  also  as  big  multiples.  Market-to-book,  for 
instance, is now of the order of 6 ratlier than the iiumbers of tlie order 
of 2 that we used to see two decades ago. 
In view of such rnultiples, any surprise in earnings (os sales etc.) 
has a hefiy impact on value. This hyperseiisitivity of market value, 
then -  step two, in Staii Beckers' argument -  creates iiicentives for 
inanagement to  "massage"  eamings. Thiis, information  is not  only 
less relevant than before: it is also less reliable os accurate. Examples 
of inanipulation  os outright fraud  abound, recently:  Lucent, Xerox, 
Waste Mailageineiit, aiid (closer at lioine) Leimout & Haiispie were 
just soine of the inore conspicuous ones. 
\J.  ...  AND THE OIJERSEERS, PRIVATE  OR PUELIC, DO NOT 
REALLY WORK EITHER 
These instances of eamings management are, of course, also instances 
of audit failures. This, then, brings us to the third problem. Whereas 
traditionally the Big8 (os 6 os 5)  accounting firins made two thirds of 
their inoney from auditing activities, this source of revenue lias now 
dwindled to  less than  one-third of total  iiicome. Such ai1  evolution 
raises doubts about auditor iiidependence -  lience the SEC'S plans 
(impleiiiented, in the nieanwliile) to force auditors to divulge, in the 
audit reports, tlieir non-auditing incoine derived froin the auditee. One 
even hears it voiced that, right now, auditing bas become a inere loss- 
leader, an entry to the business that auditing fii~ns  are reully after. 
In the US, the SEC does try to cui-tail potential abuses in the audit- 
ing business. The  SEC has  also dealt harshly with cases  of  easning iiianagenieiit and audit failures. For instailce, three executives of Micro 
Strategies were recently ordered to (personally!) pay fines and dainages 
of iio less tlian USD l l b for abuses in reposting. The SEC also issued, 
recently,  a  level-playiiig-field  nile  that  prevents  coiporatioiis  froin 
favoring (and, some say, controlling) financial analysts: al1 news iiiust 
now be released iniinediately and directly to the entire investing com- 
inuiiity. In Europe, however, we are faciilg Pi-oblein 4: these is i10  SEC- 
lilte instit~itioii  that first and foremost protects the investors, os at least 
none with similar zeal and powers. Iiisider-dealing cases rarely make it 
to court, os fizzle out before tlie beilcli, os let guilty pasties off ratlier 
lightly. Also  tlie  marltet for  aiiditing is  notoriously  non-litigieus,  in 
Europe. Analysts are not indcpeiident coim~entators  eitlier: the porous- 
ness  (os even  entire  absence)  of  Chinese Walls between  investinent 
banking (i.e. placement) and financial analysis prevents analysts froin 
being critica1 about companies. Analysis provided by stock brolters is 
equally partial, aimed at generating turnover rather than infonnation. In 
shoi-t, analysis by the sell side is inherently dubious. 
VI.  THE DIYS ALTERNATIVE 
Facing financial reports that are iiicreasingly irrelevant ai1 inaccurate, 
and haviiig no auditors nor overseers nor independent analysts to rely 
one, big investors have no choice to hirn to buy-side analysis. Thus, 
Prof. Beckers reports, WLB has its own staff of analysts; aiid these 
behave increasingly lilte colporate detectives, looking for clues atid 
signs and signals that may reveal more about the tme state of affairs 
in tlie compaiiies. Fiiiancial reports have become like swiinsuits: the 
interesting bits behind them are the ones that reinain covered, not the 
ones that are revealed. 
VII.  COMPANIES AND ANALY  STS FUDDLE..  . 
Eric de I<ez~leneer  appears to be on inuch the sarne wavelength. The 
probleiii  is  that  the  infoimation  provided  by  coinpanies  is  hard  to 
understand  to the  average investor. Thus, coinpanies target  analysts, 
and their main conceni in this is that the information be pleasing to the 
analysts, not that it be relevaiit. Thus, we receive distosted infoi-nlation 
rather than fair reporting. For example, the firrn's press release inay stress a rise of rehlni on equity following an acquisition, glossing over 
the details of how the coiisolidation with a low-growth firn1 is respon- 
sible for the rise rather than, for instance, geater internal efficieiicy or 
improved sales. Or the true cost of an acquisition may be covered up. 
Or inergers  are presented  as  triuinphs  of synergistic coininoil sense 
even wlien the true purpose  is  to  elirninate a competitor -  which, 
suprisingly then, regulators occasioilally object to. Potential coiiflicts 
of interest are covered up, or poorly reported. In inany reports the tnie 
cost of option plans, for instance, is hard to find out. 
Al1 this would not be a serious probleni if financial analysts would 
be able aild eager to read between the companies' lines and, in their 
own investment digests, let in the liarsh light of reality int9 the firrns' 
smoke-filled books. That is, however, too inuch to hope for. Analysts, 
in a disconcertiiig syinbiosis witli the corporatioiis they follow, seem 
to be bent on pleasiiig their firins rather thaii producing infonnation 
that  is relevant to the ultiinate investor. Tlieir laiiguage is "coded. 
Analysts say "stroiig buy"  when they iilean "iiot bad at all",  or say 
"biiy" when they are agnostic. "Accumulate"  really means "sell",  and 
"hold"  sigiials a recommendation to dump asap. A "sell" reconmien- 
dation reflects imminent corporate demise. A SEC survey reported 
that, at tlie peak of the 2000 inarket, with prices at all-time-high inul- 
tiples, only two percent of the recominendations were "sell";  eiglity 
percent were "buy"  or "strong buy". 
Thus, analysts are not  independent  of the  finns they  follow, for 
they depeiid oii the latter for the iiiforination they need to cut-ad- 
paste into their own reports. Nor are aiialycts independeiit from their 
bosses, the investment bankers os inarket ~iiakers  or  stock brokers: 
Chinese-wal1 niles are absent, or not enforced. Nor are analysts criti- 
cal aiid original: glassy-eyed, tliey al1 repeat the saine received wis- 
doms and inantras: the oiily thing that  matters  is   nark ket  share and 
website  hits,  consolidation  is  the  only way  forward, and  IIrst  and 
foreinost the modern investor wants a olie-stop shop. In short, tliere 
is no primary research and no independent reflection. 
VIII.  ...  AS DOES THE (LOCAL) PRESS 
Fortunately, there is tlie press -  if olie lives in the US or the UK, that 
is. It was the Wal1  Street Journal, not a local newspaper, that raised 
eyebrows when a leading world-class innovator's  South-Korean sales went  from zip to one-third  of world  tuinover  in two years. Local 
reporters,  like  the  local  analysts,  seemed  blinded  by  feelings  of 
national  solidarity os adoration  of the  local  supennen. There is no 
priinary research  and i10  independent reflection in the Belgian press 
either, Mr De Keuleneer concludes. 
IV.  ACCOUNTABLE? 
Al1 this raises an interesting  question: wouldn't  matters iinprove if 
analysts and the press became accountable for their deeds, or at least 
for the qua1it.y  of their processes? 

Financial reporting? - It simply doesn't work. Views on 'Corporate Reporting Revisited' by J. Hegarty, C. Beckers and E. De Keleneer.

https://lirias.kuleuven.be/bitstream/123456789/123005/1/TEM2002-1_9-16p.pdf

Financial reporting? - It simply doesn't work. Views on 'Corporate Reporting Revisited' by J. Hegarty, C. Beckers and E. De Keleneer.

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