Too good to be true.

In performance-reporting graphics, the medium is the message

It's not surprising that the vast majority of corporate annual reports contain charts and graphs. After all, graphics are a visually appealing, concise, effective means of communicating performance information to shareholders, regulators, clients, customers and the media.

When presented properly, graphics can convey useful information for decision-making - information that is understandable, relevant, reliable and comparable. They can readily highlight significant trends and clarify relationships in corporate performance data, such as investment return (earnings per share, cash flow per share), financial strength (debt to equity, cash flows to debt) and management performance (return on equity, return on sales, return on assets).

Despite the benefits, however, using graphics poses numerous pitfalls. Even with powerful computer software packages, most performance-reporting graphics (for example, column, line, bar and pie charts) still are developed largely by intuition. The basis for choosing, designing and constructing them is not widely understood - and they often produce misleading or incomprehensible results.

Canadian companies' concern over potentially misleading graphics was raised recently by Bill Buchanan, FCA, the overall judging coordinator for the 1997 Financial Post Annual Report Awards, which recognize the best performance-reporting models. He says, "The use of charts and graphs has become widespread, particularly in the management discussion and analysis section of reports. This is a significant trend, considering the average MD&A is now 11 or 12 pages. A 1993 study by the Canadian Institute of Chartered Accountants found that many charts and graphs can be misleading because of the way they are designed and constructed. There is evidence that not much progress has been made to date."

Buchanan expressed this concern on behalf of the judging groups which, collectively, represent the key stakeholders in performance reporting in Canada, but the concern isn't restricted to that country. It's an international phenomenon, as evidenced by a 1996 study undertaken for the Institute of Chartered Accountants in England & Wales that examined 300 reports from top companies in Australia, Europe and the United States. It found that annual report graph design and construction often are poor.

Is seeing believing?

According to the study, "There was also evidence of selectivity, measurement distortion and presentational enhancement. Measurement distortions in the company's favour were common in all countries but particularly in France, the United Kingdom and the United States."

The study also found that:

* In France, companies were more inclined to materially exaggerate, rather than materially understate, trends.

* In the U.K., many graphs fail to use proper scaled time axes, scaled performance variable axes and gridlines.

* In the U.S., reports are more likely to include key performance variable graphs when there is favorable rather than unfavorable financial performance.

Many graphics fail to adhere to basic design conventions. This is crucial because readers rely heavily on immediate, at-a-glance perceptions for their understanding. While this instant readability is precisely what makes graphics so effective, it also means poor design and construction can inhibit comprehension and distort content. Even sophisticated readers can be misled, for example, by graphics that make company performance look rosier (or gloomier) than it is. (See the samples on page 36.)

Many graphs in annual reports, for example, are "as obscure as the writing of James Joyce, without the redeeming grace," says Alan Davis, director of tax communications at Price Waterhouse in Toronto and, for over a decade, an international speaker on the subject. "I can't understand why companies that would not tolerate confused, incomprehensible, misleading language seem comfortable publishing confused, incomprehensible, misleading graphs."

Some people might assume that computers are the solution. If anything, the opposite is true. Today, anyone with an integrated software package and a few days of practice can produce colorful business graphics that would have been astounding just a few years ago. But unless these people have at least a fundamental knowledge of graphic components, the results can be disastrous.

A picture's worth a thousand words - or dollars

Following a three-step preparation process can yield considerable benefits. First, determine the message to be conveyed (for example, sales trends over the last five years). Keep the message simple. Cramming a lot of information into a single graphic makes it difficult for the reader to understand the message. In general, if the information can be assimilated without having to be read closely, the chart probably is adequate.

Next, select an appropriate form. Generally, column and line charts depict variables over time; bar and pie charts depict variables at a specific instant. Line charts are particularly suitable for showing changes over an extended period (such as 10 years). Column charts are good for making time-based comparisons. Bar charts effectively compare items with one another, or parts with the whole. Pie charts show component or percentage relationships.

Finally, draw the chart. If the message conveyed at first glance is altered by closer examination, your design and construction are inadequate. Review the five major components (titles and labels, scales, spacing, shading and color, and data display). And take special care when charting negative values.

As a financial executive, you should encourage the use of graphics to help ordinary investors understand performance reporting. Be aware of the common pitfalls and adopt a reader's perspective to avoid misrepresentation. After all, if annual report graphics don't accurately portray the underlying accounting numbers, they erode the reliability of financial statements and undermine effective communication.

J. Paul-Emile Roy, CA, is senior manager, research studies for The Canadian Institute of Chartered Accountants in Toronto. You can reach him at [phone] or via e-mail at [e-mail]. Roy gratefully acknowledges the assistance of William E. Hewitt, CFA, vice president of investments at SunLife of Canada and a member of Financial Executive's editorial advisory board, in the preparation of this article.