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Relative reality.

Looking for clues to your competition's plan? A new study demonstrates how to read between the lines of financial reports.

We live in a world where information overload is the norm. Yet even touring the deluge of print and electronic media and an in-box piled high with financial reports doesn't always provide a clear picture of corporate performance.

A litany of options offers corporations considerable discretion in reporting financial results. Generally Accepted Accounting Principles allow a choice of methods, such as straight-line or accelerated depreciation and valuation of inventories using the last-in, first-out or the first-in, first-out methods. Each option can significantly affect financial statements and distort reality in portraying performance. With such potential for abuse, misrepresentation is an ongoing concern. But flexibility in methods serves a purpose - allowing companies to choose methods appropriate for their industry and to tailor communication efforts to shareholder needs. And, for potential investors, shareholders, and third parties, the accounting choices themselves can serve as vital clues to not-yet-public corporate information.

Still, debate on the issue is heated. Recognition versus disclosure is a topic of contention among the Financial Accounting Standards Board, Securities and Exchange Commission, and leaders in the business community. Recognition refers to the way specific financial figures are calculated, while disclosure refers to requirements to provide supplemental information useful to financial statement readers. For example, the value of executive stock options may be disclosed in footnotes and proxy statements rather than being recognized in net income.

For the most part, accounting regulators seek more stringent recognition. For example, the FASB asserts that: "Footnote not an adequate substitute for recognition. The argument that the information is equally useful regardless of how it is presented could be applied to any financial statement element, but the usefulness and integrity of financial statements are impaired by each omission of an element that qualifies for recognition."

In contrast, management argues that reporting options enable a company to convey unique aspects of performance. Formal and informal methods of communication include financial statements such as annual reports and announcements, as well as management's choices of financing options and organizational incentives.

Furthermore, research suggests that where information is located and how it is presented can have a huge impact on investors' behavior - a perspective consistent with the FASB's position on recognition versus disclosure. Consider the following example:

Economic difficulties force a manufacturer to consider closing three plants and laying off 6,000 employees. The following two plans are proposed:

A: This plan will save one of the three plants and 2,000 jobs.

B: This plan has a one-third probability of saving all three plants and all 6,000 jobs, but a two-thirds probability of saving no plants and no jobs.

Approximately 76 percent of executives participating in a survey administered by Northwestern University's Kellogg Graduate School of Management, choose Plan A, the risk averse (i.e. certain) option. Consider now the consequences of restating the two options as:

C: This plan will result in the loss of two of the three plants and 4,000 jobs.

D: This plan has a two-thirds probability of resulting in the loss of all three plants and all 6,000 jobs, but a one-third probability of losing no plants and no jobs.

Obviously, there is no difference between Plans A and C and between B and D. Still, when the plans are restated as C and D, 86 percent of executives prefer D, or the riskier alternative. Thus, how one presents choices can influence decisions.

But when deciding how to present information, different factors come into play. Another case in point is the FASB's mandate (SFAS 106) that companies use accrual accounting, rather than the pay-as-you-go method, for post-retirement benefits and that obligations accrued in the past be recognized in the financial statements. Meeting this requirement would boost liabilities and cause a corresponding decrease in retained earnings. Companies had a three-year window in which to take this hit and, within that window, could adopt the standard in a single year or over 20 or more years.

Stretching the adoption period to span the maximum allotted time period seemed the most attractive option for incumbent CEOs. Yet, the vast majority chose a one-year write-off in the second or third year. First, because after the one-time write-off, future net incomes would look better. Second, even small losses pain shareholders, so unleashing the bad news all at once was seen as preferable. Third, a one-time hit enabled management to deflect the blame to the FASB, an attribution that would be more difficult to make as the years passed.

This case history shows that flexibility allows corporations to respond to the limitations of their audiences. However, that same flexibility also allows them to mislead audiences - either intentionally or unintentionally. Because potential investors rely on simplified strategies or shortcuts to cope with information overload while making complex decisions, there is an opportunity for misdirection. Therefore, without adequate disclosures, the various reporting options would make it virtually impossible to assess performance.

The widely documented observation that stock prices respond dramatically to preliminary earnings announcements indicates that investors rely almost exclusively on specific pieces of information. These PEAs are followed by detailed financial reports that often generate little stock-market reaction. Thus, evidence suggests that information contained in financial statements remains unexploited by investors.

This propensity of investors suggests a strategy for executives: When reporting bad news, spare the PEA and income statement and put as much bad news as possible in other parts of the financial reports. Such a strategy may have spawned AT&T's insistence on pooling-of-interest accounting in the NCR merger back in 1991. The choice appeared irrational in that it cost $500 million to implement. But if AT&T believed that its shareholders (75 percent of whom are individuals) would have difficulty interpreting the financial statements if purchase accounting were used - thereby reducing net income by $569 million per year for 10 years - then its accounting choice becomes more understandable.

Another possible explanation for the insistence on pooling involves the incentive structure for AT&T executives, which may let accounting choices affect bonuses. But, because managers are typically better-informed about company prospects, even these self-motivated actions can be informative to the astute shareholder. For example, compare AT&T's action with Wells Fargo's announcement on acquiring First Interstate. Wells Fargo reported that the resulting synergies would enable the company to afford to use the purchase method. Obviously, Wells Fargo's announcement was seen as a stronger signal of merger profitability than AT&T's press releases. In fact, these and other signals led investors to bid up Wells Fargo stock prices by some 15 percent while bidding down AT&T's stock by 10 percent.

Observing an unusual amount of soft - or on-paper-only - earnings can signal to investors that a company's prospects are not as rosy as a superficial assessment indicates. In fact, investors regularly bid down stock prices after debt-for-equity swaps, which have no direct cash flow implications but result in soft profits. Such transactions are a precursor to lower "hard" earnings from continuing operations. For the careful' analyst, these manipulations provide considerable information. In short, by analyzing how management exercises its reporting discretion, careful readers of financial statements can glean information held by corporate insiders before it becomes public.

In the absence of standardized financials that exactly compare one company to another, culling both the public and the camouflaged information communicated by companies is crucial for successful investing. And for management, communicating with shareholders and other interested parties is a critical activity. In the end, however, both investing and communicating are rife with uncertainty. Each side has limitations, biases, and incentives that make a superficial analysis misleading. So, while it may be important for parties to have discretion in communication, such freedom raises the demands for vigilance.

Thomas Lys is a professor at Northwestern University's Kellogg Graduate School of Management. Margaret Neale is a professor at Stanford University's Graduate School of Business. Kellogg's Professor Lawrence Revsine and Richard Honack, assistant director of marketing and communication, contributed to this article.
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No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1996, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:analyzing financial reports of competitors
Author:Neale, Margaret
Publication:Chief Executive (U.S.)
Date:Dec 1, 1996
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