Why invest in company x?

So, you’re ready for a new investment, and the prospectus makes a compelling case for Company X. You’ve done your homework, read the reports, weighed the risks. But do you really know everything you need to know before you invest? Do the financial statements report the full picture? Despite your best efforts, you may not have all the information required.

The CFA Institute Centre for Financial Market Integrity recently released its paper ‘Comprehensive Business Reporting Model: Financial Reporting for Investors’ (available at www.cfainstitute.org/centre), providing in-depth recommendations on how financial data should be reported to investors. Although financial reporting has improved over the past few years, the paper highlights areas where further enhancements are necessary to meet investors’ needs.

Innovation and creativity, globalisation and market convergence, have transformed the way companies conduct themselves. Markets shift and businesses evolve by developing new products and finding new ways to attract and retain customers. To meet investors’ need for evaluating investment opportunities, these changing business practices require that the reporting model evolve as well. Yet financial reporting has lagged behind. Consequently, even sophisticated investors face a daunting task when trying to analyse financial reports and determine the key drivers of businesses.

Among other recommendations, the dozen principles outlined in the paper suggest key areas for change to improve today’s business reporting model.

■ Provide thorough disclosures so investors have the information they need to understand financial statements: The role of disclosures is to provide a comprehensive explanation of events or transactions that have been recognised and reported on financial statements. Although disclosures are not a substitute for the recognition and measurement provided in the financial statements, they are an essential tool in efforts to fully understand the statements. As such, the information and amounts contained in these disclosures need to be as reliable as those disclosed in the financial statements and subject to the same level of audit scrutiny that the numerical items in the statements
receive.

Our paper highlights several key areas that disclosures should provide regarding a company’s business activities and the affect on its operations. They include:

● Current risk exposures to changes in market prices, interest rates, currencies and events;

● Off-balance sheet items including
unrecorded obligations and commitments;

● Accounting policy choices;

● Measurement methods and valuation models used to determined reported amounts; and

● The level of measurement uncertainty in the reported amounts.

■ Determine the materiality threshold based on the investors’ information requirements: Financial statements are prepared for those outside the company who need the information and who base their financial decisions upon it. Consequently, the materiality threshold should be based upon what will affect investors’ decisions. The use of a ‘bright-line’, such as 5% of net income, to determine whether information should be provided does not serve investors well. For example, even a small amount of fraud committed by company managers would likely be considered to be highly material to investors who need to assess the integrity of those to whom they have entrusted their assets. The threshold should be based both on qualitative and quantitative factors.

■ Ensure neutral financial reporting: Companies should tell the economic truth. The form of the transaction or the consequences of its reporting, eg lower earnings per share, should not bias the accounting and thus what is reported. Such biases are not in the investors’ best interests.

For example, in recent stock options expensing debates, those opposed to expensing argued that expensing stock options as compensation would reduce net income, causing companies that employ the model to reduce the number of options granted to employees, thereby making it harder to attract talented employees. The argument was misplaced. In the paper we encourage the practice of reporting all costs of production, including employee compensation, completely and accurately.

■ Recognise economic transactions and events that affect investors’ wealth as they occur: For example, commitments entered into by a company with other parties for which performance is still in progress should be reflected on the financial statements. Keeping such information off the balance sheet distorts the company’s obligations.

■ Report individual line items based upon the nature rather than the function for which they are used: The forecasting of individual line items for use in valuation and other decisions requires that they be relatively homogeneous - that is, represent a single economic attribute or an aggregation of very similar attributes. For example, having reported amounts of labour costs, pension and other benefits, raw materials or energy costs rather than ‘cost of goods sold’ provides more transparency about a company’s expenses. Grouping unlike expenses, which have varying economic characteristics, makes it difficult to understand the changes in reported amounts over time. Indeed, investors currently expend much effort to disaggregate such numbers, exposing themselves to the potential for considerable error.

■ Determine recognition and disclosure based on the relevance to investment decision-making and not on measurement reliability alone: Relevance and reliability may seem simple concepts, though in the context of financial reporting they become quite complex. Essentially, any information that Company X provides is relevant if it would influence your investment decision, particularly that information that helps you evaluate past, present or future events and their impact on your investment. Timeliness is also of relevance; information that is not timely may no longer be relevant. As you consider investing and rely on financial statements to do so, you need to receive all relevant information about Company X from its statements. And if this information is either incomplete or irrelevant it is not reliable. While the benefits of providing some items of minor relevance may not be justified in terms of cost efficiency, we find too often that these constraints serve merely as an excuse for withholding from shareowners.

■ Value assets and liabilities for financial decision-making using the most current and complete information: Decisions about whether to purchase, sell, or hold investments are based upon the fair values of the investments and future expectations. Fair values, by definition, impound the most up-to-date assessments about the value of an investment. Investors need to be able to evaluate how the company’s operations and activities are increasing or decreasing the values of the assets it holds and the obligations it has incurred and in turn, how the value of their investment in the company is increasing or decreasing as a result. However, financial statements based largely on outdated historical costs are less useful for making such assessments.

Our proposed additions and amendments to the business reporting model were not considered lightly. Rather, these enhancements are the result of extensive research, experience, and collaboration with industry experts, standard setters and regulators worldwide, and are based on the changes to financial statements that investors routinely must make in order to use those reports as they now exist.

Clearly, the system needs improvement if investors feel the need to transform financial statements, and the information they contain, before it can even be used. Changes such as those we propose in our paper will promote both market efficiency and effectiveness.

We believe that, when fully implemented, our proposed improvements to the conceptual framework will resolve some of the most pervasive problems in financial analysis. Only then will you have full confidence that Company X lives up to its prospectus and is truly worthy of your investment.

Kurt Schacht is the managing director of the CFA Institute Centre