As Clear as Mud: Financial Reports Lack Transparency

Newswise — In the wake of corporate financial scandals, the Security and Exchange Commission (SEC) has increased its efforts to improve the usefulness of financial reporting for shareholders. However, University of Arkansas researchers Rod Smith and Carolyn Callahan have found that less than 17 percent of the information disclosed in these reports meets the existing SEC requirements aimed at keeping shareholders informed.

"We doubt that the managers in these firms would tolerate receiving reports that are as vague and unclear as they provide to investors," said Smith, assistant professor of accounting in the Walton College of Business.

Smith, Callahan, professor and Doris M. Cook chair in accounting, and Ph.D. student Amanda McNeely examined the nature and adequacy of current financial disclosures by analyzing the content of annual 10-K reports filed with the SEC between 1994 and 2001 from the largest companies in four diverse industries: banking, electronics manufacturing, airlines and pharmaceuticals.

According to Callahan, they wanted to measure and assess the adequacy of actual financial disclosure practices and examine whether the disclosure practices are transparent. Transparent reporting gives shareholders enough information to let them accurately assess the firm's financial condition and future prospects.

The SEC requires qualitative discussion and analysis in financial statements. According to Smith, the SEC intends this discussion to be forward-looking, clearly communicating the company's strategy, success factors, competitive environment and future prospects.

"In general, we did not find that firms clearly convey adequate information to allow investors to assess future prospects," said Smith. "Most of management's discussion is historical in perspective, and the future-oriented items are generally vague and difficult to assess from the investor's viewpoint."

The researchers conducted a content analysis of the management discussion and analysis section (MD&A), as well as the descriptions of the firm"šs business, property and legal proceedings from the annual 10-K reports. Although there is little consistency in reporting formats either within or across industries, these required components provide a way of comparing companies and industries. In addition, these components are more credible because they are formally regulated by the SEC, which makes the costs of misrepresentation higher.

Their study included 71 companies, representing the largest companies in the four industries, with an average of six years of data per company. Company market values ranged from $8 million to over $344 million and 60 percent met the minimum for inclusion in the Standard and Poor's 500.

Although the SEC specifically requires the MD&A to present forward-looking information, over 83 percent of the items discussed only past performance. Those firms that addressed future performance were more likely to present forecasts of operational items.

A striking exception was the airline industry, where firms are significantly more likely to present forecast information. The researchers speculate that this is due to the nature of the industry, which is labor and capital intensive, heavily regulated and constrained by labor agreements and capital structure. These elements may allow management to predict future performance with more confidence.

"Firms in the other industries are clearly reluctant to forecast performance," Smith added. "Their forecasts represent less than 13 percent of the items on average."

When they attempted to assess the impact of the disclosed items of future firm performance, the researchers found that the situation became even more murky. Impact was classified as favorable, unfavorable or undetermined. Overall, 52 percent of the items were favorable, 29 percent were unfavorable and 19 percent could not be determined.

However, these numbers changed according to category and industry. In the pharmaceutical industry, for example, almost 41 percent of the strategy items and 31 percent of the financing items had an undetermined impact.

"The disclosure measures based on operations, strategies, intangibles and financial categories are not significantly related to either future financial or current market performance," Smith explained. "This indicates that investors either do not or cannot use this information to assess the prospects for future performance."

Callahan and Smith recommend that firms increase the transparency of their financial reporting at three levels. The broadest level is compliance with generally accepted accounting principles and the second level is adherence to accepted industry reporting standards, where they exist. Because such standards often do not exist, it is difficult for investors to compare performance among competing firms. But firms could improve the transparency of their reporting by consistently adopting and reporting measures common to their industry.

The researchers find the greatest opportunity for improvement at the firm and segment levels. They note that firms frequently focus on the legal entity at the expense of economic reality and suggest that reporting transparency could be improved by "describing the cause and effect relationships that drive their performance and clearly explaining how their actions and strategies affect those relationships."