A no-bull market: whether it's imparting good or bad news, an annual report that tells it to shareholders straight will signal the company's integrity and ultimately benefit its share value, writes Brian Henderson. As the deadline for compulsory operating and financial reviews looms, he provides his best-practice guide to narrative reporting.

After several years of consultation, narrative reporting in the UK is shortly to become both compulsory and regulated for the first time. Back in May, Patricia Hewitt, the secretary of state for trade and industry, announced the publication of two documents concerning the operating and financial review (OFR). The final report of Rosemary Radcliffe's independent working group will regulate the OFR, providing "broad principles and practical guidance" on what to include, and it is being used by the Accounting Standards Board (ASB) to create a financial reporting standard. The second document contains draft regulations on the OFR, effecting in detail the guidance contained in the Radcliffe report.

The regulations were due to take effect on 1 January, but many of the stakeholder groups that responded to the Department of Trade aim Industry's consultation, including CIMA, lobbied strongly for an extension. As this article goes to press, the DTI is yet to make a formal announcement, but it is "'sympathetic to the concerns expressed on the issue of timing"--and conscious that the ASB's work on the standard is still in progress. It says that it "does not aim to place companies in a difficult position". It's thought that the likely grace period will last no more than three months, so it doesn't alter the fact that all listed companies will need to prepare their OFRs very soon.

Reading the narrative element of an annual report in conjunction with the financial statements helps with their interpretation, but it can give a telling overview of the company even before these are examined. The chairman's statement (CS) is the most widely read section by the lay investor aim it's also considered highly useful by analysts. Research shows that the content of the CS indicates performance changes or even whether a company is at risk of bankruptcy.

From a practical point of view, narrative also offers many opportunities. For example, Andrew Lennard, technical director of the ASB, says that companies are likely to use the narrative sections to explain the effects of international financial reporting standards. Directors may consider smoothing out results by creatively narrating a bad year into a good year. But there are several "red flag" practices that may point to fundamental problems with a company, and could therefore lead prudent investors to sell their shares. Equally, there are several "green flag" practices that may encourage investment.

Narrative can be improved through simplification wherever possible. Research has shown that more profitable companies use highly readable prose that uses few accounting terms. Readability" can be tested by giving the narrative to employees to read before publication. If they can't follow it, then what chance does an outsider have? Equally, many word-processing programs can now rate the readability of a document.

Warren Buffett, investment guru and chairman of Berkshire Hathaway, includes several jokes in his CS and gives the bad news up front. A straight-talking CS that shows accountability to investors is essential, as is maintaining consistency of reporting from year to year. A "line item" approach to disclosure--ie, a list of separate points is not suitable for the CS. The structure and flow is critical, so it should not be treated as along series of footnotes.

Quantified goals, along with a consistently applied metric for evaluating them, allow performance to be measured and compared year on year. Enron's CS, in the four out of five years that it discussed earnings, used a different financial item to represent this every year, choosing the metric that showed the result it wanted. Enron's stated desire in its 1996 CS to "generate 40 per cent of our net income five years from now" from several new firms it was setting up was not mentioned in subsequent CSs. Similarly, the goal stated in its 1997 CS of growing earnings at 10 per cent a year was never mentioned again.

Many firms' CSs follow Enron's example and fail to cover whether the previous year's promises were met or not. By contrast, Buffett's CS clearly defines his criteria for the assessment of his own performance as the increase in "per share book value" of his company by "a few points" in excess of the Standard & Poor's 500. The metric is unchanging and his performance history is easy to follow, because he shows his annual results against this key indicator going back to 1965.

It is important that the narrative is not unduly optimistic. In the longer term, companies that report the lows as well as the highs will earn far more trust than those that don't. New products and services shouldn't be overly hyped, since these usually take several years to convert into significant profits. For instance, in 2003 Microsoft could have boosted its operating income growth to 15 per cent by working on a proforma basis with a slightly different method of accounting for stock options, but it chose to show this only when required to do so in its annual report. It also didn't mention the 5400 per cent increase in net earnings. The advantage of letting figures speak for themselves and downplaying good performance is that Microsoft's outlook will be seen as pessimistic. The market trusts a pessimist far more than an optimist, and trust will increase share prices.

Avoid using superfluous phrases such as "global presence", "market knowledge" and "financial strength" without quantification. Credible, informative and engaging statements are correlated with higher share prices. The opposite is true for those with more fluff and fewer facts.

Preparers shouldn't be afraid of disclosure--it is a sure warning sign when areas of concern go unmentioned or figures are missing. The Walt Disney Company's 2003 CS states that "we experienced solid earnings growth", but it does not include figures for earnings or the percentage increase. In fact, its earnings grew by 2.5 per cent. Is this really solid growth?

Directors should ensure that the CS talks about earnings, even when the news is bad. It can actually be beneficial if responsibility for poor performance can be taken, rather than attributed to external factors. It's important to use the narrative to "sell" the corporate vision, leadership goals and business model. Buffett uses his CS as an opportunity to promote not only his company but also its products. The provision of information on future projects--particularly spending plans--is highly prized by the market, since it is a rare practice.

It is important that directors do actually write most of the narrative. Using a PR firm or an accountant to produce the whole thing will destroy confidence in it as a communications medium and undermine people's faith in the company, although accountants will of course be highly involved in the process.

Some companies state different figures in their CS from those in the accounts without any qualification. In its 2000 CS, for example, Enron boasted that its "net income reached a record $1.3 billion". But it reported its net income in the accounts as $979 million. Other companies state figures on a proforma basis of calculation, which is not recommended. Although this practice is allowed under Gaap, investors may not understand that proforma figures are being used, or that these may give an overly optimistic view of the business. General Motors' 2002 CL states that it earned "$3.9 billion on record revenue of $177.3 billion ... excluding Hughes and special items". In its accounts, income is stated as $1.7 billion and revenue as $186.8 billion. So, GM's net profit stated on a normal basis will be less than half of that stated on a proforma basis. GM doesn't show how the exceptional costs it excluded from its earnings are broken down, either in its highlights or in its accounts. This makes it impossible to verify" that the exclusions are one-off; rather than recurring, costs.

A recent study of the fortunes of companies using proforma earnings has found that they have lower future cash flows--83 fewer cents of future cash flow for every dollar of exclusions, in fact. As Buffett says in his 2002 CS, "proforma earnings statements show 'earnings' far in excess of those allowed by their auditors. In these presentations, the CEO tells his owners 'don't count this, don't count that--just count what makes earnings fat.'"

Brian Henderson is a lecturer in accountancy at Nottingham University Business School