Profile of an annual report.

Just what do shareholders want to read in your company's annual report? One survey reveals their wish list.

Are accountants translating economic events into an intelligible and understandable business language? Do accounting reports make any difference? Many people believe the accounting profession is in crisis and the major output of the financial accounting system -- the annual report -- is at the heart of the turmoil.

Since the shareholder is the primary user of the annual report, we asked shareholders what information within the typical annual report they use in making their investment decisions and what additional information would be useful to them in completing that task.

So what do these owners of the corporation think, and how have their thoughts changed over the last two decades? Our recent study reveals some trends you should heed. (The responses came from a random sample of individual corporate shareholders in all 50 United States who own at least one round lot, or 100 shares of one stock, on either the New York Stock Exchange or the American Stock Exchange.) Here goes:

* Despite what you may hear, shareholders are indeed taking a longer-term perspective on investments. They're now far less interested in speculative gains than they were in 1973, the time of the earlier survey, and are far more interested in steady income and the safety of their capital. When asked which items best describe their most important investment goals, 42.5 percent said safety of capital (up from 35.2 percent in 1973), 37.5 percent said steadyincome (up from 23.6 percent) and 18.3 percent said speculative gains (down from 31.5 percent).

* The stockbroker's influence is waning. While shareholders relied primarily on the advice of their stockbrokers for investment decision-making two decades ago, today stockbrokers rank fifth out of six potential sources of information on companies.

* Shareholders believe the annual report is more useful than it once was. While 14.1 percent found the annual report "very useful" in 1973, 21.3 percent find it so today. And 52.7 percent of shareholders now think the report is at least "of moderate use," compared to 40.7 percent in the earlier study.

* The statement of cash flows is more important to readers now, but the income statement is less important. This may be because of the increased emphasis on cash flow, rather than earnings, as a measure of performance. We conducted our earlier study before the 1988 implementation of FAS 95, which established the current format of the statement of cash flows, and our most recent study afterthe implementation. With this regulatory change, shareholders have significantly less difficulty understanding today's statement of cash flows than they did understanding the older statement of changes in financial position.

* Predictably, shareholders find the auditor's report more useful today. In 1973, only 13.3 percent thought the report was at least "somewhat useful," while today that figure has more than doubled, to 29.6 percent. This fact is consistent with the finding that shareholders have become more self-reliant and more interested in the content of the annual report.

* On the other hand, management's discussion and analysis, or the MD&A, has been disappointing. Shareholders don't think this section of the annual report is very useful as it is. In fact, more than 87 percent of the survey respondents want companies to expand the MD&A section to include more forward-looking information.

* Shareholders don't trust management's representations, but do trust that of auditors and want the latter to expand their work. This includes verifying many more items in the annual report and adding some items -- including those tidbits that management is more likely to conceal.

Here are some examples: Seventy-nine percent of the respondents want more disclosure of the status of pending litigation on threatened lawsuits that may have a material impact on the company -- and they want the disclosure audited. Sixty-nine percent want disclosure of unasserted claims that management knows could be made on the company and would have a material impact. And 60 percent want more explanation of the financial information in less technical terms.

Sixty-three percent of the shareholders want outside auditors to audit the MD&A. In fact, when asked about the obligations for disclosure, they ranked the auditors first (above management and the board of directors) when it comes to reporting to shareholders any potential for bankruptcy or significant financial irregularities in the company. Shareholders also want the auditors to provide more assurance that the company's internal control system is adequate and that there's no material misstatement due to error or fraud.

Finally, they want more data on the company's current value accounting, budgeted income statements, management audits and segment information. At the same time, shareholders don't seem to be concerned that this increased disclosure may put the companies they invest in at a competitive disadvantage, with one exception: While shareholders generally want more disclosure of product-line and segment-profitability information, a majority don't want the amount of disclosure in these areas to increase if it would cause a competitive problem for the company.

A NEW PHILOSOPHY

Serving shareholders with information needs that are different from those they've had in the past isn't so easy. It's clear the annual report should help investors evaluate management's stewardship of a corporation's assets. Why not take the same approach you use with customers? Determine exactly what your shareholders want in the report.

Based on our survey results, which are documented completely in our book called The Shareholders Use of Corporate Annual Reports (JAI Press, 1993), we're convinced that companies must begin to view the annual report as a vehicle to make credible communications to its shareholders and to other external users. They should think of it as a part of a comprehensive investor relations program that gives executives a chance to tell the "corporate story," including descriptions of past and current company results as well as events they anticipate will take place.

For example, the FASB's recent proposal on accounting for stock option compensation has generated a lot of controversy. |See page 5, "Letters," for a sampling of the debate over the issue, prompted by an article in our September/October issue.--Editor's note~ Under the new proposal, companies would be required to report the fair value of employee stock options as an expense on the income statement during the period in which the options are granted.However, the U.S. Senate has already held hearings on a bill that would prohibit the FASB from issuing the final version of the standard.

The disclosure of the value of stock options is clearly in the interests of all shareholders and is consistent with the types of information that shareholders are demanding more and more frequently. As the cry for corporate accountability increases, no reasonable explanation can be given to deny the owners of the corporation precise information about employee and executive compensation. The SEC's recent proposal to increase compensation disclosure to include exit pay for departed officers is a step in the right direction. The effect of the new interpretive ruling would be to extend the scope of an earlier SEC regulation that requires additional disclosure of executive compensation information to investors in a uniform and understandable way.

Some people argue that these changes and additions will make the annual report too costly to produce. All indications are that's untrue. After all, well-run organizations already regularly collect market-value information and prepare multiyear plans, budgets and forecasted income statements. They also typically have well-established, long-term plans for growth or retrenchment and have developed working assumptions about the future of the economy, their industry and their company. Plus, they operate on a daily basis with a fixed corporate strategy.

Shouldn't shareholders have access to this same information, albeit in broad terms, to evaluate their investment prospects intelligently and, in turn, to judge the quality of corporate governance? We're convinced that, with such information available, today's typical shareholders will become better-informed investors who are willing to be more patient providers of capital and to take a longer-term approach to evaluating the success of their corporate investments and corporate managers.

Dr. Epstein is visiting professor at Harvard Business School in Boston. Dr. Pava holds the Philip H. Cohen chair in accounting at Sy Syms School of Business at Yeshiva University in New York.