Monday, March 5, 2012

Blowing a Breaker on Financial Reporting

Great article by Teresa Iannaconi from FEI.

Financial Reporting: Disclosure Overload - Gaining Control of the Process

A team of graduate students recommended selling Enron stock three years before the company went bankrupt. What does this say about the state of financial disclosure, and would it benefit more from enhancement rather than expansion?

As standard setters, regulators and others seem to continuously call for and deliver more regulations, more standards, more transparency and more disclosure, financial executives are having difficulty keeping up with the volumes of materials that are expected from them. They believe this plethora of statements and documents that they provide to users should already comprise more than enough information, and that should solve the problems of accounting fraud and financial reporting fraud.

Indeed, many relate instances of “looking but not seeing” or “eyes wide shut.” These contradictory statements describe what happens when too many financial disclosures impair their usefulness.

A new study shows than when it comes to financial reporting, quality may be more important than quantity. The report, a joint research project published by Financial Executives Research Foundation (FERF) and KPMG LLP, delved into the effect of increased financial disclosures from 2004 to 2010. Entitled Disclosure Overload and Complexity: Hidden in Plain Sight, the report observed that more financial disclosures are not necessarily better, and recommended financial disclosure enhancement rather than expansion.

A group of students at Cornell University’s Johnson Graduate School of Management likely would agree with that recommendation. In 1998, using publicly available financial information, the students succeeded where professional investment analysts and investors failed. At that time, the students analyzed Enron Corp. and recommended selling the stock — three years before its bankruptcy. The student analysis determined that the stock was overpriced and questioned Enron’s high debt level, its earnings quality and the long-term sustainability of its business model.

The students’ research also caught the attention of author Malcolm Gladwell who discussed the research in his book, What the Dog Saw (Little, Brown and Co., New York, 2009). He devoted a chapter to the Enron implosion, entitled “Open Secrets — Enron, Intelligence and the Perils of Too Much Information.” Throughout the chapter the author notes that each party that deciphered Enron’s financial vulnerability obtained the relevant information from Enron’s publicly filed disclosures, albeit with some level of difficulty. In a discussion of Enron’s use of special purpose entities Gladwell noted, “… you can’t blame Enron for covering up the existence of its side deals. It didn’t. It disclosed them” (emphasis added).

Although Gladwell goes on to question whether the disclosure in Enron’s public documents was adequate for a complete understanding of the transactions, the discussion concludes with an observation based on a research paper, “Rethinking the Disclosure Paradigm in a World of Complexity,” authored by Steven Schwarcz, a professor at Duke Law School, which observes that increasing financial complexity has resulted in the traditional disclosure paradigm of “more is better” becoming an anachronism.

Schwarcz argues that there is no disclosure model that can adequately address the disclosure necessary to understand financial complexity. He says a regulation should be enacted that prohibits material management conflict in transactions that he characterizes as “disclosure impaired.”

Although Schwarcz is unable to identify the precise nature of a disclosure-impaired transaction or arrangement, his recommendation is founded on the concept that some activities of a business enterprise are so complicated that any approach to disclosure will provide either too little or too much disclosure to eliminate buyer-seller understanding asymmetry.

Cornell Students Cite Enron Disclosure Risk Prior to Implosion

The Cornell students were enrolled in an advanced financial statement analysis class taught by Charles M.C. Lee. The conclusions raise the obvious question: How were business students able to figure out something that sophisticated business analysts and journalists were failing to perceive and wouldn’t be able to perceive for another three years? “All the facts were hiding in plain sight,” said Lee.

The content of the Cornell students’ report presents an opportunity to develop additional understanding of the adequacy of disclosure as it existed in 1998 (pre-Enron reform) and how disclosure was approached by those who identified and those who missed the Enron warning signs.

The report provides some insight into potential paths to improved disclosure. Ultimately the question posed by the 1998 report is why was the disclosure available then adequate for this student group to reach a “right” decision, but inadequate for others to discern a seemingly hidden problem?

The students’ report generates some points to ponder:

▪ The report demonstrates extensive and in-depth analysis of the information required to be disclosed using 1998 disclosure requirements.

▪ The research and analysis utilized extensive information found outside of Enron’s public filings. For example, the report cites information about competitors, economic analysis and predictions including government data that are well beyond the information required to be disclosed by any public company.

▪ The report includes the following conclusions that, although they have been lifted from their context in the report, provide an informative backdrop for the general consideration of disclosure:

“The nature of Enron’s businesses requires a significant amount of estimates and assumptions which impact the company’s financials. Nevertheless, both in its exploration and production operations as well as in its financial services operations, Enron uses accounting methods that are in line with industry practice. After close examination and scrutiny, we have found that Enron’s financials provide an acceptable level of disclosure.” (Emphasis added.)

Disclosure Adequacy, 1998 and Now

Considering the extent that disclosure has expanded subsequent to Enron’s demise, how is it possible that the disclosure in the Enron public filings was adequate to identify its investment risks and why did only a few identify those risks on a timely basis?

Further, if it was possible to identify the risks on a timely basis using the disclosure required in 1998, what have the extensive changes in accounting and disclosure in response to Enron and similar crises accomplished?

It is inarguable that adequate financial disclosure must be provided. The 1998 analysis could not have been developed without extensive disclosure. However, as Lee said, sometimes the facts are hidden in plain sight.

The November 2011 disclosure complexity report included the results of a survey of members of Financial Executive International. Responses to Question 12 of the survey indicated that 89 percent of respondents considered the fair value disclosure requirements as a significant source of disclosure overload and complexity.

The reviews of annual reports included in the research showed an increase of 184 percent in the volume of fair value and related disclosures during the six years covered by the report. Interestingly, using a 1998 level of fair value disclosure, the students were able to derive sufficient data about the mark-to-market accounting by Enron to form an assessment of its effect on the quality of earnings. Without questioning the merits of fair value accounting, some may question the merit of the expanded footnote disclosure requirements.

There was obviously some mental process that the students at Cornell invoked that others did not. If the students could develop an understanding of an investment in Enron based on then-available information that was deemed adequate, perhaps the solution to disclosure is not to expand disclosure requirements but to find the means to enhance disclosure presentation to improve access to relevant information.

One objective of the November 2011 disclosure complexity report was to stimulate discussion and consideration of ways to streamline disclosure to improve access to relevant information.

The report listed eight recommendations, including the following two:

▪ The U.S. Securities and Exchange Commission should issue an interpretive release to address the permissibility of cross-referencing and manner of addressing immaterial items to reduce redundant and unnecessary disclosures.

▪ Summaries of significant accounting policies and discussions of newly implemented or soon to be implemented accounting policies should be streamlined to eliminate unnecessary redundancy and patently immaterial disclosures.

During the American Institute of Certified Public Accountants’ Annual Conference on Current SEC and PCAOB Developments in December 2011, presentations by the SEC’s Division of Corporation Finance staff included remarks confirming that immaterial disclosures are not required to be provided. While the remarks do not have the same force as an interpretive release, it was clear that the SEC staff’s remarks were compatible with, and reinforced the themes, of the first two recommendations.

The SEC staff comments offer a glimmer of hope in combating the disclosure challenge. A third recommendation in the November 2011 disclosure complexity report suggested using more tables and graphs to present information.

What stands out in the Cornell students’ report is that the researchers mined the available data to wring out every available piece of information that they could. Much of that information was presented in the students’ report in tables and graphs. That suggests that data was available but may have been difficult to locate or identify.

Additionally, the Cornell researchers had characteristics that distinguish them from the average investor. They were graduate students in a financial analysis course motivated by the desire to achieve an academic goal and most likely a personal knowledge goal. They also perhaps had more time to devote to this project than their employed counterparts would have had.

Disclosure for the Average Investor

A perennial question persists about the identity of the average investor: What are the characteristics of the audience to whom disclosure is directed? We appear to have gotten beyond the notion that the audience is our elderly sweet aunt and have embraced the notion that the audience should have some level of financial literacy.

Presumably, professional investment advisers and institutional investors have the same tools and capabilities as the graduate students at Cornell. There is also a large audience of investors who can generally read financial statements and footnotes but do not have the skills or motivation to devote the same level of effort as the Cornell researchers.

If disclosure is directed to that audience, the Cornell students’ report may lead us to conclude that the disclosure enhancements that are appropriate may be critical financial statement analytics. Rather than presenting more detailed information, enhanced disclosure could consist of tabular or graphical information that enables deeper financial analysis and understanding. After all is said and done, a deeper understanding is what disclosure is all about.

The Cornell students used a wide variety of information that was available 14 years ago. They used all of the basic financial statement information including an in-depth look at each of the categories of cash flow. They read and apparently understood the financial statement footnotes well enough to determine the extent to which revenue growth was coming from acquisitions and the extent to which earnings changes were derived from non-cash mark-to-market adjustments.

Returning to the theme of the disclosure complexity report, a very real possibility is that disclosure is adequate but so mired in excessive, redundant and immaterial disclosure it is difficult to find the relevant and significant information.

The Cornell research incorporated extensive information obtained from sources outside of Enron. The students obviously went to the public disclosures of Enron’s competitors and obtained and compared information including relative performance, financial position, leverage and cash flows. The research also incorporated economic and government data. This raises a very important consideration: no matter how robust a company’s disclosure may be, that disclosure must be complemented by other external data.

Prospects for Improvement — FASB’s Disclosure Framework Project

The disclosure complexity report recommends that the Financial Accounting Standards Board should accelerate consideration of its Disclosure Framework Project to establish a systematic approach to disclosure that properly balances disclosure considerations with the required cost and effort. The current FASB project agenda indicates that a discussion memorandum will be issued in the first half of 2012. Additionally, other international organizations are examining ways to improve disclosure efficiency, including the United Kingdom’s Financial Reporting Council’s Cutting Clutter project.

The efforts of standard setters and support of regulators for improvements in disclosure efficiency offer the hope that the critical disclosures that investors need to understand investment opportunities will not continue to be buried in a haystack of marginally useful or useless disclosures.

Investor Education

The accomplishment of the Cornell students may be beyond the capabilities of the average investor, but their tools are universally available. The research techniques can be replicated to a lesser degree by average investors if the relevant information is available in an accessible form that facilitates analysis.

Investor education is fertile ground for standard setters and regulators to consider in exploring a better approach to disclosure. Various organizations have undertaken programs that are characterized as investor education, but most focus on issues such as avoiding fraudulent schemes and general investment education.

A relevant question to ask is whether those initiatives go far enough. An admonition to read the financial statements and related footnotes is ineffective if the investor does not understand the richness of the data. Investor education initiatives rarely provide insight into the wealth of information that is already provided in public filings.

Instead, efforts should assist investors in understanding where and in what form information is available and how that data can be used in financial statement analysis. Disclosure policies and regulations should include consideration of information accessibility and investor education.

For many, investment decision-making is one of the most critical activities of their financial lives. Whether the user of disclosure is a professional investor or is a non-professional investor performing financial analysis for a personal portfolio, the ability to find and understand relevant information is critical.

Disclosure policies and regulations that result in indefinite expansion of detailed disclosures fail to serve users well. Standard setters, regulators and preparers all must pursue disclosure policies that enhance the ability to find and use disclosures effectively. It is also necessary to pursue initiatives that educate investors about the richness of existing disclosures and how they can be used to gain insight into the quality of potential investments.

Accessible information that is easily digestible and provides insights on significant issues in the hands of informed users must surely be the recipe for efficiency in the capital markets.