1(b). Types of Information That Investors and Creditors Use and the Relative Usefulness of that Information
As part of its oversight activities, the Oversight Committee of the Financial Accounting Foundation interviewed and requested written comments (collectively, "the interviews") from thought leaders among the FASB's constituencies. There were 107 interviews in total, including 12 with representatives of financial statement users and 17 with regulators (a special class of financial statement users). [FASOversight, p. 1]
While the interviews were not designed to elicit criticisms of financial reporting, in general, or to identify the needs of users of financial information, interviewees did comment on those matters. [FASOversight, p. 1]
Following is a summary of the principal comments received [on the subject] from users and regulators relating to . . . the needs of users. [FASOversight, p. 1]
Comparability and consistency in financial reporting practices over a long period of time, generally 5 to 10 years, is very important in comparing an enterprise's performance and financial position within its industry and across industry lines. [Also included in 2(c)] [FASOversight, p. 2]
Financial information should facilitate assessment of an enterprise's financial position and expected future cash flows. However, no accounting model will provide "scientifically accurate" measures of cash flows, asset and liability values or how such valuations will impact future cash flows. [FASOversight, p. 2]
__________
The first objective of financial statements is to provide information that is useful and informative to several classes of financial statement users. Accounting data are the primary means by which readers assess the financial position, results of operations, and cash flows of economic entities. Individual classes of users may require additional data to serve their specialized need, but such data should be furnished by means that are supplementary to the primary general purpose financial statements. [Also included in 2(c)] [RMA90, p. 3]
__________
[S]ome observers have argued that investment professionals will generally ignore FAS 106 because the new accrual accounting standard has no effect on a company's current cash flows. Most of the survey respondents, however, take a different view. Just under two-thirds (63%) believe that FAS 106 liabilities represent a significant future cash cost that should be reflected in current equity valuations. [Also included in 1(c)] [TOWERS PERRIN, p. 2]
According to the survey, the decision employers make about how-and when-to adopt the new accounting standard will not go unnoticed in the investment community. In general, the survey respondents tend to favor conservative FAS 106 expensing strategies. . . .For example, about half (51%) say the markets will view early adoption favorably. Clearly, early adoption gets the problem out of the way-and gives the investment professionals the information they want about a company's liabilities and expense. [Also included in 1(c)] [TOWERS PERRIN, p. 3]
Similarly, many of the survey respondents (47%) express a positive view of companies that take the transition obligation for past employee service as a onetime "hit," rather than amortizing it. This finding supports the view that investors might be inclined to discount a large onetime charge, particularly because this approach reduces future expense. (For a typical company, taking the hit up front would reduce future annual expense by about 30% and allow the company to show earnings from continuing operations that are more than 10% higher.) [Also included in 1(c)] [TOWERS PERRIN, p. 3-4]
Notably, over half (56%) of the survey respondents say "conservative" (i.e., higher than average) medical trend assumptions will be viewed positively. This finding suggests that, although conservative assumptions will tend to depress earnings initially, investment professionals would rather see a company report the "worse case" at the outset-so that future expense revisions, if any, would take a downward rather than upward direction. [Also included in 1(c)] [TOWERS PERRIN, p. 4]
Interestingly, the money managers in the survey group express slightly stronger opinions about expensing strategy. Well over half (59%) say they view early adoption favorably, while only 42% of the broker group shared that opinion. The money managers are also more positive about conservative medical trend assumptions: 64% express a favorable view of higher-than-average assumptions, while 52% of the broker group take that view. (The two groups offer similar opinions about companies that take the transition charge up front.) [Also included in 1(c)] [TOWERS PERRIN, p. 4]
While the equity experts are clearly concerned about bottom line numbers, the [FAS 106] survey results show that the actions employers take to control future costs-i.e., benefit design and funding strategies-will also have an impact on the investment community's assessment of a company's financial position. [Also included in 1(c)] [TOWERS PERRIN, p. 4]
Most equity experts recognize that full information on FAS 106 costs won't be available until all companies adopt the new standard during the first quarter of 1993. In the meantime, however, more than three-quarters of the survey respondents (77%) say their firms' equity valuation analyses include an examination of a company's footnoted retiree welfare disclosures. (These disclosures are required by the SEC for annual reports and other financial statements.) [Also included in 1(c)] [TOWERS PERRIN, p. 5]
Only about a quarter of the survey respondents (26%) say they use benchmarks in their efforts to estimate the impact of FAS 106. Of those who do use benchmarks, just under half (49%) say they develop liability and/or expense estimates based on a benchmark multiple of current pay-as-you-go costs. Fewer use benchmark reductions in pretax earnings or net worth (28% and 32%, respectively). [Also included in 1(c)] [TOWERS PERRIN, p. 6]
[Regarding adoption of FAS 106] in preparing analyses for a specific company, many of the survey respondents (58%) make adjustments for certain company-specific factors. Most of these equity experts say they look at employee demographics (71%), whether the workforce is unionized (62%) and the nature of the benefit plan (52%). . . .Notably, the brokers in the group look more closely at employee demographics and the benefit plan than the money managers do. Fully 80% of the brokers cite employee demographics as a factor, while 57% of the money managers do; 61% of the brokers say they look at the nature of the benefit plan, while 38% of the money managers cite the plan as a factor. [Also included in 1(c) and 13] [TOWERS PERRIN, p. 6]
Whether FAS 106 will have an impact on corporate credit ratings and borrowing capacity remains to be seen. Credit ratings are based primarily on cash flow and financial flexibility. And since neither will be directly affected by FAS 106, the rating agencies are generally inclined to view the new accounting standard as a "nonevent"-at least as far as specific ratings go. [Also included in 1(c)] [TOWERS PERRIN, p. 8]
In a report released last year, for example, Standard & Poor's (S&P) said that FAS 106 "is not expected to have any widespread impact on debt ratings, since cash flow will not be affected directly." Moody's has also stated that "rating changes are not anticipated" as a result of FAS 106, because "this liability has been factored into our ratings." Moreover, some credit analysts believe that FAS 106 may have positive credit implications for some companies, because it encourages them to limit generous retiree medical benefit plans. [Footnote references omitted.] [Also included in 1(c)] [TOWERS PERRIN, p. 8]
[T]he rating agencies indicate that they will look more closely at retiree welfare liabilities as a result of FAS 106. Moody's say that FAS 106 "will clearly impact the reported financial statements of some companies more than others," and that it "will review carefully the assumptions underlying the numbers." Similarly, S&P says that retiree welfare obligations "represent a substantial and growing burden for many companies" and will therefore subject those liabilities to greater scrutiny. [Also included in 1(c)] [TOWERS PERRIN, p. 8]
Other market observers believe that companies considered "marginal credits" will feel the effects of FAS 106 more than others. Even without a rating downgrade, "increases in reported retiree medical expenses and the disclosure of the cumulative liability may impair market access and cause new issue borrowing spreads to widen" for these companies. These analysts also expect that some companies may violate net worth or leverage covenants in existing debt agreements as a result of FAS 106. But because issuers are likely to factor FAS 106 into future covenant negotiations, future borrowings may not be affected. [Footnote reference omitted.] [Also included in 1(c)] [TOWERS PERRIN, p. 8]
Clearly, employers shouldn't expect institutional analysts and investors to overlook the effects of FAS 106. The Towers Perrin survey shows that, despite the temporary information gap, many investment professionals are paying close attention to retiree welfare liabilities and how companies manage them. In fact, a significant percentage of the survey respondents (47%) say that a company's ability to manage retiree benefit costs is a strong indicator of overall management effectiveness. [Also included in 1(c)] [TOWERS PERRIN, p. 8]
Especially critical are the specific strategies companies develop for managing expense and controlling future costs. While the survey demonstrates that earnings from continuing operations is still the most closely watched indicator of corporate performance, equity experts are also influenced by qualitative factors-including management's approach to valuation assumptions, timing, benefit design and funding. [Also included in 1(c)] [TOWERS PERRIN, p. 8]
The survey results clearly indicate that employers should consider investor expectations when they're making FAS 106 decisions. Expensing strategy is a good example. Following is a closer look at the issues. [Also included in 1(c)] [TOWERS PERRIN, p. 8]
Assumptions. FAS 106 allows employers to develop "best estimates" for key expense variables such as interest rates, expected retirement ages and health care cost "trend" (the rate of increase in per capita health care prices and usage). Assumption decisions can, in turn, have a significant impact on the charge against earnings. For example, if a typical manufacturing company lowered its long-term health care trend assumption by 2%, FAS 106 expense would drop by as much as 30%. [Also included in 1(c)] [TOWERS PERRIN, p. 9]
What's the best approach? The investment community won't look favorably on an unexpectedly large expense-either initially, or later if upward revisions become necessary. Many equity experts probably favor conservative assumptions for that reason. On the other hand, minimizing expense is clearly important. [Also included in 1(c)] [TOWERS PERRIN, p. 9]
So the key is to strike a reasonable balance-i.e., an approach that avoids overstating or understating expense. In any case, a company's FAS 106 assumptions, whether conservative or aggressive, should be consistent with management's general approach to financial reporting. [Also included in 1(c)] [TOWERS PERRIN, p. 9]
Taking the transition 'hit.' As the survey results show, most investment professionals are more concerned about earnings reductions than reductions in net worth, and many would be inclined to discount large onetime charges. And since charging the transition obligation up front substantially reduces the FAS 106 impact on future earnings, most companies will take that approach if they can afford it-i.e., if net worth is sufficient to absorb the onetime charge. (Those whose initial liability amounts to less than 50% of net worth will generally choose to take the charge.) [Also included in 1(c)] [TOWERS PERRIN, p. 9]
__________
Perhaps owing to their skepticism about annual reports, 47 percent of the individual investors said they only skim through annual reports, or don't read them at all. Thirty-three percent reported that they read annual reports, and 18 percent said they study them. [HILL KNOWLTON, p. 7]
While 55 percent of the individual sample find annual reports useful to investment decisions, individuals gave annual reports a low rating as a source of information on buying and selling stock -- ranking them next to last among seven information sources. [Also included in 1(c)] [HILL KNOWLTON, p. 7]
The individual [investors] listed their own analysis of stocks as an investment first, with 87 percent giving this category a "very important" or "somewhat important" rating. Second with individuals as an investment information source are statistical services, such as Standard & Poor's and Value Line, with an 83 percent importance rating. Interestingly, press articles ranked third, with a 79 percent rating, and radio and television business programs were fourth, with a rating of 73 percent. [HILL KNOWLTON, p. 7]
Stockbroker recommendations surprisingly ranked only fifth as an information source [for individual investors], at 70 percent. Annual reports were sixth, with a 66 percent rating, and friends' and relatives' recommendations were seventh, at 49 percent. [HILL KNOWLTON, p. 8]
Professional investors consider the annual report essential to their analysis. All 50 [surveyed] said they basically agree with the statement, "As a professional investor, corporate annual reports are essential to me." (One professional agreed, but substituted the word "meaningful" for "essential.") [HILL KNOWLTON, p. 8]
Among seven information sources, professional investors ranked annual reports second in importance only to individual interviews with company management. They gave management interviews a 92 percent rating, and annual reports an 80 percent rating. Next were Forms 10-K and other SEC-filed documents, with a 75 percent rating; group analyst meetings with managements, 67 percent; financial factbooks, 65 percent; news media articles, 52 percent; and reports from others in Wall Street, 47 percent. [HILL KNOWLTON, p. 8]
While individual and professional [investors] were critical of annual reports, a number of them volunteered that they think annuals are improving. Clearly, some also see the need for further improvement: [HILL KNOWLTON, p. 8]
"Annual reports have come a long way. They're so much better than they ever were." (Philadelphia mutual fund analyst) [HILL KNOWLTON, p. 8]
"They have improved in the past few years. But there is a lack of negative truths. Annual reports protect companies' outlooks." (Chicago investment counseling firm analyst) [HILL KNOWLTON, p. 8]
"Annual reporting is getting better. But they should tell their story accurately, succinctly and clearly. There are too many photographs." (Phoenix bank analyst) [HILL KNOWLTON, p. 8]
"Annual reports have been improving over the years." (Chicago individual investor) [HILL KNOWLTON, p. 9]
Of individual investors, 58 percent find annual reports easy to read and understand. Concerning detail, 47 percent said there is enough, 29 percent there is too much, and 14 percent said there is not enough. Only 24 percent of the individual said annual reports are so detailed they can't find out what they want to know. Thirty-four percent are troubled by too much technical and industry jargon. [HILL KNOWLTON, p. 9]
[Twenty-seven] percent of the individual investors did say it is sometimes hard to tell from an annual report what business a company is in. [HILL KNOWLTON, p. 9]
Professional investors want as much detail from annual reports as they can get. When asked to choose 10 different ways in which annual reports could be useful to them, professionals gave the alternative "disclose as many details and numbers as possible" an 84 percent rating, second only to organizing the report using a business segment format . . ., which had a 91 percent rating. [Also included in 3(e)] [HILL KNOWLTON, p. 9]
[P]rofessional investors place a high value on business segment information in annual reports. [Also included in 3(e)] [HILL KNOWLTON, p. 9]
[P]rofessionals ranked the item "present the business in a segment-by-segment format" first among the 10 ways in which annual reports could be most useful to them, giving it a 91 percent rating. And in rating the importance of various information items in the annual report, professionals placed business segment information second, with a 93 percent rating, right behind the report's financial statements, which had a 95 percent rating. [Also included in 3(e)] [HILL KNOWLTON, p. 10]
The professional investors rated a number of other communications elements used in many annual reports today as less useful to their analysis of a company. This list consisted of: "Use charts and graphs to display quantitative data," 60 percent; "present information that demonstrates the company is a good corporate citizen," 38 percent; "show pictures of management and directors," 26 percent; and "show pictures of production facilities," 22 percent. [HILL KNOWLTON, p. 12]
Here is the complete ranking of the . . . ratings investment professionals gave [12] sections of the annual report:
Section Importance Rating 1.Financial Statements 95 percent 2.Business Segment Information 93 percent 3.Financial Review 87 percent 4.Five- or Ten-year Financial Summaries 87 percent 5.Management's Analysts 81 percent 6.Review of the Year 78 percent 7.Quarterly Summaries 74 percent 8.Statement of Accounting Policies 73 percent 9.Financial Highlights 70 percent 10.Letter to Shareholders 69 percent 11.Dividend Payments (two years) 54 percent 12.Stock Price History (two years) 43 percent
PROFESSIONAL INVESTOR[S'] VIEWS ON THE USEFULNESS OF VARIOUS TYPES OF INFORMATION]
Annual reports are most useful to Percentage Usefulness me when they (Rate on a scale of 0 to 10) -- Rating A.Disclose as many details and 84.1 numbers as possible. B.Present the business in a 90.8 segment-by-segment format. C.Use charts and graphs to display 60.2 key quantitative data. D.Show pictures of production 22.3 facilities. E.Show pictures of management and 25.5 directors. F.Avoid cliches and jargon. 70.4 G.Describe R&D and product 75.6 development efforts. H.Show clearly captioned pictures of new products and R&D processes. 56.8 I.Present information that demonstrates the company is a good corporate citizen. 37.8 J.Present industry and economic 76.4 trend data.
[HILL KNOWLTON, p. 14]
Please indicate the importance of various sections of an annual report when assessing a particular company, using a scale of 0 to 10, 10 being most important.
Percentage Importance
Rating
A.Financial highlights 70.4
B.Letter to shareholders 69.4
C."Review of the year" section 77.8
D.Financial review section 87
E.Management's analysis 80.8
F.Financial statements 95
G.Quarterly summaries (two years) 73.8
H.Accounting policy statement 73.5
I.Business segment information 93.3
J.Effects of changing prices 38.5
(inflation accounting)
K.Five- or ten-year financial 86.8
summaries
L.Dividend payments (two years) 53.7
M.Stock price history (two year). 43
[HILL KNOWLTON, p. 15]
__________
Individual and professional [investors'] information needs differ, but more in the level of detail needed than in the types of information needed. For instance, individual investors express a need to see company financial statements, but do not identify the specific data needed. Professionals, on the other hand, express the need to see the company's balance sheet, income statement, cash flow, and quarterly statements. In addition, the professionals place relatively greater importance on quantified information than do the individuals. [SRI, p. 29]
Individuals seem to focus their attention primarily on the company itself and secondarily on the environment in which the company operates. In contrast, the professionals appear to have a more integrated view, placing greatest importance on information that sheds light on both the company's performance and the environment influencing that performance. [The following two] tables show the types of information needed by investors and the percentage of the respondents who consider each type of information important or extremely important. [Also included in 13] [SRI, p. 29]
Individual Investors' Information Needs
Important/
Extremely
Rank Type of Important
Information
1 Company 78.8%
reputation
2 Industry outlook 78.6
3 Company outlook 78.4
4 Company's stock 70.2
performance
5 Recent company 69.6
developments
6 Company financial 67.6
statements
7 Potential risks 66.9
for company
8 Historical 57.7
financial data
9 Information on 54.5
company's
products
10 Information on 52.0
the economy
11 Brokerage company 42.5
research
12 Advice from 42.4
professionals
13 Business segment 39.5
information
Notes: 1. Findings are based on responses to the question, "For each type of information named, how important is that type of information to you when making a decision to buy or sell a company's stock?"
2. Heavy traders and holders of large portfolios generally rated all information types important or extremely important 10 percent to 15 percent more than the overall averages shown above.
3. There is no statistically significant difference between the first three items on this list, nor between the fourth through seventh items.
Source: SRI International survey, 1986.
[Also included in 13] [SRI, p. 30]
Professional Investors' Information Needs
Important/
Extremely
Rank Information Type Important
1 Recent developments and
outlook for the
company's
industry 82.4%
2 Annual company earnings 82.4
3 Company's position in 80.4
the marketplace
4 Risks to which the 79.8
company is exposed
5 Recent events affecting 79.8
the company
6 Annual company
financial position or
balance sheet
information 79.5
7 Annual company cash 74.0
flow
8 Company goals and 70.2
strategic direction
9 Information on the
major business units
within the
company 67.0
10 Forecasts of company 62.5
performance
11 Company stock 61.2
performance
12 Information on the 60.6
company's products
13 Historical company 58.7
financial data
14 Quarterly company 58.7
earnings
15 Quarterly company
financial position or
balance sheet
information 57.4
16 Outlook for the economy 49.4
17 Quarterly company cash 46.2
flow information
18 Opinions and analyses
of the company by other
analysts
of professionals 35.9
Notes: 1. Findings are based on responses to the question, "For each type (of information), please tell me how important that type of information is to you when analyzing a company or making an investment decision."
2. An additional sixty-nine information elements were specifically mentioned as important by the professionals, none by more than 8.0 percent.
3. There is no statistically significant difference between the first six items on this list.
Source: SRI International survey, 1986.
[SRI, p. 31]
[Individual and professional investors] . . . place low importance on overall economic information, but high importance on information about the company's industry. Economic information seems too general and nonspecific to be useful, while forecasts by economists are viewed skeptically. In contrast, information about the company's industry is deemed exceedingly important to understand the company's prospects: [Also included in 13] [SRI, p. 29]
Interestingly, "quality of management" did not emerge as one of the important types of information-a significant departure from earlier research studies. Although management quality is extremely important to investors, they believe they can best understand it by evaluating performance, reputation, market position, and other company characteristics. In other words, management quality is an inherent and inseparable aspect of the other types of information. [Also included in 13] [SRI, p. 29-30]
"Company reputation" is a vague concept, not clearly defined by the individuals, but extremely important to them nonetheless. The professionals see company reputation much the same as they see quality of management. Reputation is intricately woven with numerous other types of information and is not a separate category unto itself. Management likewise understands the importance of reputation. [Also included in 13] [SRI, p. 30]
"Company's stock performance" to an unsophisticated investor means long-term price moves and dividend yield. To a semiprofessional, it means security price changes over recent weeks, days, or even hours. [Also included in 13] [SRI, p. 30]
"Recent events affecting the company," which was ranked fifth by both individuals and professionals, represents highly situational information. Although timely knowledge of a major event such an acquisition, sharply reduced revenues, a product breakthrough, or major litigation can prove critical to investment decision making, by and large "recent events" is recognized as an information category that normally does not significantly affect the performance of a security; it merely adds to the cumulative store of information about a company: [Also included in 13] [SRI, p. 30-31]
"Business segment information" is not particularly important to most individual investors, although these data are relatively important to the professionals: [SRI, p. 31]
"Potential risks for the company" are always considered by professionals in their analyses. They want companies to report their own views of the risks they face and how these risks will be managed. Individuals tend to think in terms of a company's past performance and general expectations for the future, but not specifically of risk exposure. When prompted, however, individuals assign high importance to company risk. [Also included in 10(c)] [SRI, p. 31-32]
"Forecasts of company performance" was rarely mentioned by individual investors. Professionals wish they could obtain reliable, unbiased forecasts and would rate them much higher, but their experience has shown that company-generated forecasts are overly optimistic. Professionals tend to generate their own forecasts, lacking trustworthy forecasts from other sources. [Also included in 12] [SRI, p. 32]
"Company financial statements" are important to all investors, but in different ways. Unsophisticated individual investors understand only a few items in the statements, and even fewer in the footnotes. Even so, they place high value on the small amounts of information they can extract from financial statements and therefore rate the statements as important. On the other hand, professionals and semiprofessional individuals understand and highly value financial statements. They rank the earnings statement highest, followed by the balance sheet and the cash flow statement (statement of sources and uses of funds). Because they understand that company managements can present financial data in several (more or less favorable) ways, most professionals very carefully evaluate financial statements, paying close attention to the details in the footnotes. [SRI, p. 32]
"Company goals and strategic direction" are important primarily to the professionals. They recognize the sensitivity of this type of information-and thus a company's reluctance to disclose it- but they value the insights to be gained from a thorough understanding of a company's plans. They have a similar desire for market share and other competitive standing information, for details of a company's internal cost structures, and for other sensitive information, but they also understand the proprietary nature of these kinds of information. [Also included in 13] [SRI, p. 32]
"Brokerage company research" and "advice from professionals" are not types of information at all but sources. Investors revealed, however, that recommendations of competent people and analyses of various kinds are regarded as information types by many. [SRI, p. 32]
Both individual and professional investors use the annual report more than any other information source. After annual reports, individuals rely most on newspapers, the Wall Street Journal, stockbrokers, and general business publications. Professionals depend on the SEC Form 10K, company quarterly reports, other analysts, and company management. [The following two] tables show the sources most used by individual investors. [SRI, p. 33]
Ultimately, all information about a company and its performance originates with the company itself. By the time information reaches the investor it has gone through numerous filters and transformations. The value of information to the investor is thus a function of both its original content and the process it goes through before it reaches the investor. [SRI, p. 33-34]
Sources of Investment Information for Individual Investors
Percent
Rank Source Using
1 Company annual reports 59.3%
2 General newspapers 49.3
3 Wall Street Journal 41.5
4 My broker 28.2
5 General business 27.4
publications
6 Personal contacts 26.1
7 Company quarterly 20.8
reports
8 SEC filings and 14.9
prospectus
9 Investment information 14.7
services
10 Brokerage firm 13.0
analysis/reports
11 Trade 7.1
association/publications
12 My investment advisor 6.6
13 Television 5.7
14 Company press releases 5.4
15 Investment letters 4.5
16 SEC Form 10K 3.6
17 Proxy statement 2.8
18 SEC Form 10Q 2.8
19 Shareholder meetings 2.0
20 Radio 1.2
Note: Other sources with less than 1.0 percent usage were product brochures, company employees, company officers, investor relations programs, company advertising, computer data services, accountants, personal research efforts, attorneys, bank officers, financial planners, and libraries.
Source: SRI International survey, 1986.
[Also included in 1(a)] [SRI, p. 33]
Sources of Investment Information for Professional Investors
Percent
Rank Source Using
1 Company annual reports 84.6%
2 SEC Form 10K 62.2
3 Company quarterly 57.4
reports
4 Other analysts or 54.8
professionals
5 Company management 53.8
6 Investment information 47.1
services
7 SEC Form 10Q 44.2
8 Company press releases 42.6
9 General business 37.2
publications
10 General newspapers 34.0
11 Wall Street Journal 32.1
12 Trade 26.6
associations/publication
s
13 Company fact books 17.6
14 Personal contacts 17.6
15 Analyst 16.0
meetings/presentations
16 SEC filings/prospectus 12.8
17 Other analysts in my 12.5
own firm
18 Investment letters 11.2
19 Company competitors 10.3
20 Proxy statements 9.6
21 Wire services 6.4
22 Company customers 5.1
23 Government 4.8
reports/publications
24 Company suppliers 3.2
Note: All other sources had no more than 1.6 percent usage and included speeches and interviews of company officers, product literature, rumors, employee publications, Quotron, industry seminars, shareholders, credit reports, and former employees.
Source: SRI International survey, 1986.
[Also included in 1(a)] [SRI, p. 34]
Investors value each source of information based on its objectivity, content, accessibility, and timeliness. These components are not weighed explicitly, but valued subjectivity, depending on individual abilities and preferences. [SRI, p. 34]
Virtually all investors want unbiased, candid, unembellished investment information. They do not want sales pitches from brokers, optimistic expectations (or self-serving excuses) from company management, or information distorted by inappropriate interpretation and analysis. Most investors, especially the professionals and the semiprofessional individual investors, think that they can spot biases; some believe that they can filter out the biases to reach some degree of objectivity. If they cannot eliminate the biases for themselves, they place high value on information sources that can do so, either analytically or based on experienced judgment. [Also included in 1(c)] [SRI, p. 34-35]
Many sources provide a minimum of content, such as listings of stock prices or brief descriptions of product lines; others contain dozens of pages of densely packed facts, opinions, and analyses; and some merely provide advice and guidance with few data. Investors perceive the value of these sources based on their individual decision style and their requirement for information content of one or a combination of the following three kinds: [SRI, p. 35-36]
Data-raw facts unprocessed by analysis or human judgment. [SRI, p. 36]
Analysis and interpretation-information that has been processed and improved through analysis, condensation, interpretation, or reformatting. The investor must perceive this process as valid and as applied with competence. [SRI, p. 36]
Guidance and advice-opinions and recommendations that are useful for investment decision making. The value of this kind of information depends on the perceived competence and reliability of the source. [SRI, p. 36]
Investors do not have equal access to information; some do not even know of the existence of many information sources. The cost of information, in terms of money, time, and effort, is a significant factor in its perceived value. [SRI, p. 36]
Some information sources are valued for their timeliness. The major component of the value of wire services, for example, is their timeliness. [SRI, p. 36]
If a company wishes to influence the behavior of its investors or potential investors, it must know which information sources are most valued by investors and hence most influential. Of all the sources used, professional investors identified company management, fellow analysts, and the SEC Form 10K as "most useful" to them in investment decision making. Individual investors found that their investment advisor, brokerage firm analysts, and broker were most useful. The results are summarized in [the] table [below]. [SRI, p. 36]
Importance of Information Sources
Individuals Professional
s
% Most % Most
Source Important Rank Source Important
1 My 89.4% 1 Company 67.3%
investment management
advisor
2 Brokerage 66.2 2 Other
firm analysts in
analyses/ my
reports firm 64.0
3 My broker 64.9 3 SEC Form 60.3
10K
4 Investment 57.8 4 SEC 55.5
information filings/pros
pectus
services
5 SEC Form 53.6 5 Company 55.3
10Q annual
reports
6 SEC Form 52.8 6 Wire 54.7
10K services
7 General 49.5 7 Government 54.2
newspapers reports/
publications
8 Wall Street 46.3 8 Company 52.4
Journal competitors
9 Personal 45.6 9 Other 52.0
contacts analysts or
professional
s
10 SEC filings 42.3 10 Company 51.0
and customers
prospectus
11 Company 37.3 11 Company 50.0
annual suppliers
reports
12 Company 36.1 12 Company 49.4
quarterly fact books
reports
13 Trade 35.2 13 Investment 48.4
associations information
/
services
publications
14 General 31.8 14 Trade 48.1
business associations
/
publications publications
15 Company 25.9 15 SEC Form 47.1
press 10Q
releases
16 Investment 20.0 16 Personal 42.0
letters contacts
17 Shareholder 15.0 17 Analyst 41.9
meetings meetings/
presentations
18 Proxy 14.3 18 Company 36.9
statements quarterly
reports
19 Television 14.0 19 Proxy 30.2
statements
20 Radio 8.3 20 Wall Street 25.9
Journal
21 General 25.8
business
publications
22 Company 23.2
press
releases
23 General 22.6
newspapers
24 Investment 8.9
letters
Source: SRI International survey, 1986. [SRI, p. 38]
"Most used" does not correlate with "most useful." When a source is inexpensive and easy to get, it is widely used even though it may not be very useful. To the few individual investors who use them (6.6 percent), investment advisors are highly important. Corporations do not consider them a productive conduit of information to the individual investor community, however, because they are so infrequently used. Stockbrokers, not surprisingly, are both influential (useful) and used by a significant 28.2 percent of individual investors. Surprisingly, SEC Forms 10Q and 10K appear high on the "most important" list, although many individuals do not even know what they are. These items are used primarily by the semiprofessional segment who value them for their information content and government-supervised objectivity. The general information source preferences of each investor segment are discussed below. [SRI, p. 36]
Buy-and-hold investors rarely trade their securities, know little about securities markets, and are not confident about their investment competence. They want highly processed information and the advice of individuals whose competence they acknowledge. They value easy access (low cost and convenience) and content, specifically, advice and guidance. Hence, they place greatest value on information provided by investment advisors, brokers (individual stockbrokers and brokerage house reports), and investment information services. [SRI, p. 37]
Opportunity-driven investors are alert for investment opportunities; the timeliness of information takes on greater importance with this segment. If they perceive a potential opportunity, they seek more information and confirmation from sources with greater content. [SRI, p. 37]
[Opportunity-driven investors] use a greater variety of information sources than other individual investors, but they particularly value investment advisors, brokers (both individual stockbrokers and brokerage house analysts), and investment information services. Additionally, for scanning purposes, they tend to rely on easily accessible, timely sources such as newspapers, the Wall Street Journal, trade publications, and investment newsletters. [SRI, p. 37]
This highly sophisticated, self-confident segment is more selective in its use of information sources, placing highest value on content and timeliness. For them, access is not an issue (they know what sources they want and how to get them, and the cost is no deterrent to this affluent segment). Objectivity is also not a problem because these investors feel competent to penetrate the biases in such nonobjective sources as annual reports. This segment places highest value on investment information services, brokerage house reports and analyses, selected highly competent personal contacts, and knowledgeable stockbrokers. From these data, the semiprofessionals then make independent decisions. [SRI, p. 37]
The buy-siders place the highest value on data and competently processed information and analyses. The timeliness of information about key events is critical. Access and objectivity are also important, but are not issues for this segment. Using current information provided by their firms, they believe they can arrive at relatively unbiased conclusions. Buy-siders rely most heavily on annual reports, on contact with company managements, and, interestingly, on other professionals. Sell-side analysts are an important source of information to them. [SRI, p. 37&39]
Sell-side analysts are highly visible in the marketplace; many have national reputations in the financial community. Their greatest information need is for reliable raw data and lots of it. They are the most voracious users of investment information and the most independent decision makers, decisions being equated with recommendations in this case. They value content above all and rely on annual reports, SEC Forms 10K and 10Q, SEC filings, company fact/data books, trade publications, and contact with company management. [SRI, p. 39]
Being sales oriented, brokers value highly credible content, specifically objectivity, analysis and interpretation, and guidance and advice. They also favor information packaged for selling. They place highest value on annual reports (despite a perceived lack of objectivity), analyst's reports, investment information services, analyst's presentations and meetings, and contact with company management (for the institutional sales representatives, who have access to management). [SRI, p. 39]
Not only is the annual report one of the most readily available of sources, and certainly a low-cost source to users, but it has the most nearly comprehensive coverage of the types of information most needed by investors. Yet, the annual report has no role in the securities purchase decisions of most individual investors, and only a limited role in the decision to sell securities. It serves primarily as a reference document and, for many, a source of reassurance about their investments. Individual investors rarely even see the annual report until after they own a company's securities. The report is somewhat more important for the semiprofessional individual investors, whose analytical decision-making styles draw from data and financial information found in the annual. [Also included in 1(c)] [SRI, p. 51]
Professional investors are influenced to a greater degree by the annual report, although it still ranks only fifth in its importance to them. As with the individuals, the annual report is the most used source but not the most useful source. Virtually all professionals state that they always obtain both the annual report and SEC Form 10K prior to making investment decisions. Professionals complain, however, that companies often provide professionals with annual reports, but not with 10Ks--a careless omission in their view. [Also included in 1(c)] [SRI, p. 51]
Professionals discard about one-third of the annual reports they receive. Those they keep they use as reference sources for analysis and report writing. On average, each professional receives 324 annual reports per year, with sell-side analysts receiving 439, the buy-side professionals 343, and the brokers 187. [Also included in 1(c)] [SRI, p. 51]
Very few investors read the entire annual report when they receive it, although professionals eventually read all the annual reports on companies they follow. Reading patterns are highly selective, either focused and directed in the case of sophisticated investors who know the information they want and who specifically seek it out in the annual, or less focused for those who go through the report more casually, reading in depth those items that attract their interest. When asked what they do with annual reports when they arrive, investors provided the responses shown [below]. [Also included in 1(c)] [SRI, p. 52]
Reading the Annual Report
Individual
Action
Investors
Throw it away without 3.9%
reading it
File it or save it 3.0 9.4%
without reading it
Skim the whole report
to get a general
impression of the 27.0 21.7
company
Glance through it,
stopping to read
what attracts 34.5 29.8
attention
Seek out specific items 22.7 33.4
of information
Read the entire report 8.6 5.0
Note: Findings are based on responses to the question, "Which of the following statements most nearly describes the way you read an annual report when you first receive it?"
Source: SRI International survey, 1986. [Also included in 1(c)] [SRI, p. 52]
"Reading," to most individuals, seems to include casually looking over the material and drawing some meaning, however, small, from it. To the professionals, reading means going through all the material and paying close attention to it. What the professionals call reading, the individuals might call studying. [Also included in 1(c)] [SRI, p. 52-53]
Professionals read annual reports in two different ways and at different times. When they first receive annual reports they glance through them, reading a few items of interest; then they either discard the reports or keep them for future reference. Later, the annual reports that were retained are read and analyzed in considerable detail. [Also included in 1(c)] [SRI, p. 53]
Individual investors are not nearly as aware of the various parts of the annual report as are the professionals. Individuals tend to think in terms of the front and the back of the annual. The front, consisting of the narrative part of the report, is generally understandable, although not always useful or interesting. The back, consisting of "the numbers," is generally considered important, but not very comprehensible. While not always familiar with specific parts of the annual, individuals have formed opinions on their importance for decision making. The professionals, on the other hand, discriminate easily among the various parts of the annual and find them all understandable. [Also included in 1(c)] [SRI, p. 53]
[The] table [below] shows the importance of various parts of the annual report to both individuals and professionals. Being selective in their reading patterns, professionals focus on those parts of the annual report providing the most relevant information. In virtually all instances, the professionals read the financial statements and the footnotes, while paying varying amounts of attention to the other sections. [Also included in 1(c)] [SRI, p. 53]
Importance of Annual Report Sections
Individual Professional
Investors Investors
Percent of Percent of
Users Users
Rating Rating
Percent Important Important
or or
Who Read Extremely Extremely
Annual This Important Rank Important Rank
Report Section
Section
Income 84.9% 78.6% 1 94.2% 1
statement
Balance 82.1 75.0 2 90.1 2
sheet
Footnotes 51.4 42.9 8 80.4 3
to
financial
statements
Sources and 74.6 72.7 3 76.3 4
uses of
funds
Historical 70.3 46.2 7 69.6 5
operating
results
Quarterly 65.5 39.7 9 68.3 6
reports
Financial 82.3 57.2 4 65.7 7
highlights
Divisional 56.6 55.3 5 63.1 8
or business
segment
reviews
Management's 76.1 51.1 6 56.7 9
review
Chairman's/p 77.8 31.4 12 45.8 10
resident's
letter
General 63.5 33.3 11 44.9 11
company and
product
information
Auditor's/CP 55.6 34.9 10 39.4 12
A's
opinion
List of 59.4 19.8 13 19.2 13
officers
and
directors
Source: SRI International survey, 1986. [Also included in 1(c)] [SRI, p. 54]
Individuals often recognize the importance of sections they might not fully understand and value what little meaning they can extract from those sections. For that reason, even the many individuals who profess not to understand much of the income statement, for instance, place high importance on that statement. Furthermore, they seek interpretation about the company's earnings stream from the other information sources they use and from advisors whose competence they trust. [Also included in 1(c)] [SRI, p. 53]
Somewhat surprisingly, individual investors rate the financial statements as more important than the narrative, less quantitative parts of the [annual] report, for several reasons. Primarily, of course, is the fact that financial performance is most clearly stated in numerical terms--a few simple terms for unsophisticated investors, plus numerous complex and abstract terms for sophisticated investors. For all their variation and occasional inaccuracy, numbers convey an impressions of precision and clarity. The narrative parts of the annual report convey less precision, give more latitude for interpretation by the reader, and allow more room for manipulation by the writer. Importantly, the numbers in the annual report are known to be more closely reviewed by outsiders, specifically, the CPA firm conducting the audit and presenting its findings in the auditor's opinion included in each annual report. In addition, the SEC requires annual reports and other corporate communications to meet certain standards of disclosure. Finally, virtually all investors understand that financial statements are governed, however imperfectly, by accounting principles and conventions. None of these disciplines is believed to be infallible, but few comparable disciplines are applied to the narrative parts of the annual report; hence, the narrative portions are felt to be less reliable sources of information. [Also included in 1(c) and 13] [SRI, p. 53&55]
In their use of annual reports, semiprofessional individual investors behave more nearly like the professionals than like the other investors. They generally score all parts of the annual higher, and their importance ratings reflect a pattern similar to that of the professional analysts. [Also included in 1(c)] [SRI, p. 55]
The four lowest ranked parts of the annual report are the same for both professionals and individuals. These are the chairman's/president's letter, general company and product information, the auditor's/CPA's opinion, and the officer and director information. [Also included in 1(c), 13, and 17(f)] [SRI, p. 55]
Issuers of annual reports inaccurately stress the importance of the chairman's/president's letter. Annual report issuers consider the chairman's/president's letter to be the most important part of the annual report, especially for individual investors. Investors themselves, however, tell us that while they frequently read the CEO's letter, they rarely consider it important for decision making. [Also included in 1(c)] [SRI, p. 55]
Most individual investors do not know much about footnotes; many find them arcane and undecipherable. Even so, a slight majority (51.4 percent of those receiving annual reports) do "read" them. The only segment of individuals to ascribe a high level of importance to footnotes is the semiprofessional segment; 68.5 percent of them read the footnotes, and of those 60.0 percent consider them important. Furthermore, only about a quarter of all individual investors agree with the statement. "I have to read the footnotes to the financial statements to get an accurate picture of a company's performance"; nearly half of the semiprofessionals agree with that statement. [Also included in 1(c)] [SRI, p. 55]
Professional investors, of course, are much much more knowledgeable about and place greater importance on footnotes. Most agreed with the statement, "I have to read the footnotes to the financial statements to get an accurate picture of a company's performance" (only 8.7 percent disagreed). Their ranking of footnotes as the third most important part of the annual report puts footnotes only behind the financial statements they explain, the income statement, and the balance sheet. [Also included in 1(c)] [SRI, p. 55-56]
Investors made several observations about footnotes that might be of assistance to users:
Extraordinary items are often insufficiently explained, even in footnotes. [SRI, p. 56]
The "accounting principles" footnote, while having the appearance of boilerplate, is actually quite important to understanding financial statements. [SRI, p. 56]
Business segment information is often (some said usually) poorly reported. Either important details are omitted, or the business segments reported do not coincide with the way the business is actually conducted. [Also included in 3(a)] [SRI, p. 56]
Although quarterly reports are not, strictly speaking, part of the annual report, they are regarded by most investors as a kind of "interim annual report." Quarterlies are flawed in many ways, but because they are more timely than annuals, they are important to investors who trade securities with some frequency; 55.5 percent of the semiprofessional individuals and 68.3 percent of the professionals rated quarterlies as important or extremely important, compared with only 38.2 percent of the other investor segments. [Also included in 11(e)] [SRI, p. 57]
Professionals complain about the inadequacy of quarterly reports and the absence of information on extraordinary items (e.g., losses, write-offs, sales of assets) and on results from continuing operations. In particular, many professionals decry the quarterly report's lack of detail (e.g., reporting sales and earnings without the cost components), which is especially frustrating because the detailed information is known or earnings could not have been reported. [Also included in 11(e)] [SRI, p. 57]
Financial reports are important but not dominant providers of fundamental information [for sell-side analysts.] Discussions with management seem to users a most important source of information for analysts, although somewhat underplayed by them. Some analysts reports largely are transcriptions or summaries of a management presentation. One analyst reported on a "conference call" to discuss earnings with management and other analysts. Another reported on presentations and discussions at a company's annual meeting. [Also included in 1(c)] [PREVITS, p. 11]
A standard, if somewhat simplified, approach taken by most analysts in forming recommendations is as follows. Disaggregate the company's operations into as fine a set of operating units as possible and develop earnings forecasts for each unit. This reduction is much finer than GAAP. For example one report commented that a company "reports two lines, but there are actually three". Analysts regularly discuss the above matters with respect to each operating unit. For example, one waste removal company was analyzed by individual landfills; a gaming company was analyzed by individual casinos, etc. [Also included in 1(a), 1(c), and 3(e)] [PREVITS, p. 12]
Analysts tend to employ annualized data but . . . [it is] inferred that they prefer more timely data whenever available. They employ a "rolling" four quarter analysis to annualize data as soon as the new quarterly data appears. Whether or not the issues related to so-called "4th quarter adjustments" taken at fiscal year end are properly anticipated is not clear. [Also included in 1(c) and 11(e)] [PREVITS, p. 12-13]
Of course sell-side financial analyst reports contain extensive nonfinancial information. The nature and recent history of the company, its products, product pricing (particular pricing changes or promotions), customers, suppliers, industry, the national and international economy, and the company's competitive position (especially market share) are common issues. Market related phrases such as "customer(s)", "market(s)", "demand", "economy", and "competitive" occur approximately 9,500 times. A company's production capabilities, technologies, and marketing and distribution system are often evaluated. This includes new information systems for inventory management, order processing, product design, marketing and sales, etc. Superior production technologies are usually given extensive coverage. Expenditures for research and development, including basic research, are evaluated. [Also included in 13] [PREVITS, p. 13]
The quality of management is regularly addressed [by sell-side analysts]. More attention is given to management when major changes in management have occurred, and in such cases there are considerations of anticipated changes that the new management will bring. It is common to see references to specific key personnel. Some reports discuss the organizational structure of the company. However, management compensation or bonus provisions are rarely discussed. [It is] interesting that there was no trend to provide "pay for performance" analysis. Labor productivity is also infrequently addressed [by sell-side analysts]. However, upcoming labor union negotiations are noted. [Also included in 13] [PREVITS, p. 13]
Analysts extensively disclose and evaluate corporate and management strategy (revenue growth, cost management, marketing strategy, competitive positioning, etc.). Analyst use code phrases in such cases, for example, reporting that "we believe that management is focused on shareholder value." Analysts frequently appraise a company's competitors, and rank an individual company with its competitors on the themes above. Similarly, the potential effects of new, competing products or technologies are discussed, as well as the potential entrance of other companies as competitors. [Also included in 13] [PREVITS, p. 13-14]
Additional analysts interests include:
(1) withdrawal of a public offering
(2) significant litigation or negotiation over contract settlements,
(3) long-term contracts, and
(4) regulatory issues. [Also included in 13] [PREVITS, p. 14]
The effect of product changes or new products, even when not yet marketed, are almost always assessed [by sell-side analysts], particularly as to the company's ability to compete, and upon competing products, projected demand, revenue, and costs. [Also included in 1(c) and 13] [PREVITS, p. 14]
Major projects, including modernization, acquisition, expansion, divestiture, and restructuring plans are evaluated [by sell-side analysts], and their estimated effects are also used in forecasting future performance. Major expenditures on plant, property and equipment are evaluated, particularly in terms of product costing and capacity expansion. Downsizing plans, and plans to reduce the size of the labor force, are also addressed by the analysts. Analysts also report on the effect of share repurchase plans and planned issuances of new securities. [Also included in 1(c) and 13] [PREVITS, p. 14]
Phrases which focus on acquisition occur about 1,500 times in [sell-side analysts'] equity reports studied. Acquisitions are studied in several pro forma dimensions, including earnings and cash flow effects of financing the acquisition, the strategic fit, scale economics, and earnings contribution. [Also included in 1(c) and 13] [PREVITS, p. 14]
Finally, analysts use recent and proposed PP&E expenditure levels as a measure of the quality of the company's assets. They evaluate the effect of new contracts (particularly long term) and licensing agreements on EPS. [Also included in 1(c) and 13] [PREVITS, p. 14]
Discussion of income statement items dominate equity sell-side analyst reports. Income statement related terms or phrases appear nearly 60,000 times in the full sample, far more frequently than references to balance sheets terms (c. 16,000) or cash flow terminology (c. 6,000). Earnings, earnings per share, profit[ability], and net income are the most frequently occurring income statement terms. [PREVITS, p. 15]
[Equity sell-side analysts'] attention . . . is given to revenue change, particularly as a result of product pricing, volume, and demand, and product mix. Production and sale volume information is analyzed. Expenses are only analyzed at a general level usually in terms of "margins", (c.4,200 times), or less frequently in terms of "operating costs", or "SG&A expenses." [Also included in 1(c) and 13] [PREVITS, p. 15]
[Equity sell-side analysts give] more detailed attention to noncapital expenditures sometimes . . . in the areas of research and developments expenditures, depreciation, materials and labor. Consistent with their general approach, analysts often estimate expenses by operating unit (segment) and sources of possible cost efficiencies are noted. Relative cost levels are compared across companies and management efforts to reduce costs are noted and evaluated. [Also included in 1(c) and 13] [PREVITS, p. 15]
Most [equity sell-side analysts'] reports contain both historical and forecast quarterly and annual income statements or summary information. The most common approach to estimating future EPS is to disaggregate the company into its constituent LOB's and/or geographic regions (both of which are frequently more detailed than GAAP requires), and to then develop forecasts of the performance of individual units which are reaggregated for a company EPS estimate. [Also included in 1(c), 3(b), and 11(e)] [PREVITS, p. 15]
[O]perating revenues and expenses are often assessed [by equity sell-side analysts] for individual segments of a company. Performance analysis by significant product or individual location is common. For example, analysts may evaluate the performance of hotel companies in terms of specific U.S. or international geographic regions, or even specific hotels, while mining companies are evaluated in terms of individual mines. Similarly, consumer goods manufacturers are often evaluated in terms of their individual product lines or products. Some analysts carefully consider the effect on the entire company, industry, and economy as well as revenues and costs in forecasting the results for each reporting unit analyzed. [Also included in 1(c) and 3(e)] [PREVITS, p. 15]
A principal approach of many [equity sell-side] analysts for estimating a company's earnings per share involves the disaggregation of the company into as fine a set of reporting units as possible, followed by an earnings analysis and reaggregation. Segment related phrases appeared more than 20,000 times in the selected reports. This frequency was larger than any other grouping of related words and phrases except for income statement related phrases. Analysts use a variety of phrases to refer to the operating units of corporations, including "lines", "areas", "businesses", "divisions", "units", "segments", and "subsidiaries". [Also included in 1(c) and 3(e)] [PREVITS, p. 15]
[Equity sell-side] analysts employ a literal definition of nonrecurring income statement items, which are usually referred to as "one time" items. They take notice of reported nonrecurring items as listed below continuing operations and also note the effect of new accounting rules. One report contained a section entitled "Non-operating earnings - A Source of Confusion in the Past". [Also included in 1(c), 5(a), and 5(d)] [PREVITS, p. 15]
[Equity sell-side analysts] also identify "potential" nonrecurring items contained in continuing operations, and often report EPS net of these items, as in the case of the analyst who noted "several unusual items" included in continuing operations. Correspondingly, a number of analysts report operating earnings per share, which of course is not required under GAAP, or compute an "adjusted earnings" number which includes all items judged to be nonrecurring, and corresponding EPS. Restructuring charges are an example of one common item often removed in analysts EPS reports. Occasionally analysts identify a nonrecurring cost but are unable to estimate an amount. In one case an analyst was unable to determine the amount of a corporate relocation charge buried in continuing operations. In another report the relocation charge of the company was identified in continuing operations and removed in calculating EPS. [Also included in 1(c), 5(a) and 5(d)] [PREVITS, p. 15-16]
[Equity sell-side] analysts discuss a company's "earnings power" or "earnings momentum". One report, for example, commented on a firm's "strong accelerating growth". This appears to be something different than the earnings growth rate reported, which is linear, and suggests a nonlinear growth component. [Also included in 1(c)] [PREVITS, p. 16]
The "stability" of a company's earnings is addressed by [equity sell-side] analysts who frequently assess the degree of uncertainty of future earnings, often in terms of "risk". Analysts do not, however, provide explicit evidence that they identify discretionary accruals of management to smooth income. One the other hand, as noted in the discussion of "earnings quality", analysts are attentive to some accruals. [Also included in 1(c) and 10(d)] [PREVITS, p. 16]
[Equity sell-side] analysts occasionally report Beta [the relative volatility of the particular stock to the market in general], but almost never discuss it. [PREVITS, p. 16]
[Equity sell-side] analysts define "earnings quality" differently than [was] expected. To financial analysts, a company with high earnings quality is one that uses very conservative accounting principles; for instance a company that has accrued reserves against future losses, write downs, etc. One analyst, for instance, reported earnings quality as high when a firm had an "aggressive" policy towards establishing reserves. Another substantiated an assertion of high earnings quality for a company by stating that "the company is over-accruing foreign taxes as a way of managing earnings." A third supported its assertion of high quality earnings by noting that "the opportunity to 'manage down' earnings exists". A fourth argued that a financial company's earnings were more 'credible' because the company applied "more aggressive accounting" methods in writing down assets. [Also included in 1(c) and 5(a)] [PREVITS, p. 16]
This suggests a possible analyst preference for secret reserves. [Also included in 1(c) and 5(a)] [PREVITS, p. 16]
[Sometimes,] earnings quality . . . seem[s] to be related to "representational faithfulness," and management's forthrightness in disclosure. For example, one analyst reported that an extreme drop in the reported tax rate of a company "caused some to doubt the quality of (its) earnings". Another expressed concern about earnings quality on the basis of the amount of costs included by a company in the determination of cost of goods sold. [Also included in 1(c), 2(b), and 5(a)] [PREVITS, p. 16]
Other income analysis factors:
- Analysts see a "strategic acquisition" to be one which reduces a company's short term earnings but increases longer term earning potential.
- Analysts report sales backlog (at company or operating unit levels) and use these as a basis for estimating future performance.
- Average tax rates are calculated for most companies with income data on a comparative and trend basis. Current and deferred portions of income tax expense are often disclosed.
- Regulated companies reported "statutory" or regulatory income compared with GAAP income. [Also included in 1(c) and 5(a)] [PREVITS, p. 16]
The balance sheet receives far less attention than the income statement [by equity sell-side analysts], and the occurrences of balance sheet type words and phrases occur far less frequently [in analysts' reports]. Much of the attention to balance sheet items comes in the form of liquidity and cash flow analysis. For example, reports may assert balance sheet strength on the basis of a company's free cash flow. While several income statements are almost always presented, many reports contain only summary balance sheets. [Also included in 1(c), 5(b), and 5(c)] [PREVITS, p. 17]
Long term productive asset values on the balance sheet are nearly always evaluated at cost [by equity sell-side analysts]. The effect of inflation on such assets rarely is explicitly considered. However, for some companies, a supplemental analysis of assets' market value is conducted. This is undertaken for firms analysts consider to be poorly understood by other analysts and investors, and particularly where latent significant off-balance-sheet or hidden assets may exist. [Also included in 1(c), 4, and 5(b)] [PREVITS, p. 17]
[A]nalysts asserted that a cable television company had substantial off-balance-sheet assets in the form of residual payments to be received in the future. They calculated the value of the company using several methods, one being the present value of the anticipated cash flows from these residuals. One analyst stated that "balance sheet recognition of . . . hidden asset values . . . will occur in future years". Other examples include inventory and reserve valuations of extractive industry companies. For instance, in gold mining companies, a market value appraisal is included of the reserve values by ore type. [Also included in 1(c), 4, 5(b), and 5(c)[PREVITS, p. 17]
[Equity sell-side] analysts periodically examine the quality of assets, particularly in troubled industries such as banking and insurance. Here, attention is paid to nonearning assets, non-performing assets, and the quality of assets (loan portfolios) and investments. [Also included in 1(c) and 5(b)] [PREVITS, p. 17]
Liabilities are usually addressed in a summary fashion, often in a simple analysis of the capitalization of the corporation. Extensive attention to liabilities usually only occurs for companies that are highly leveraged and typically in conjunction with a cash flows analysis. [Also included in 1(c), 5(b) and 5(c)] [PREVITS, p. 17]
Cash flow analysis [by equity sell-side analysts] displays considerable variety in format and content. Many reports present and/or discuss cash flow extensively. Cash flow information is sometimes presented by segment or operating unit. Some reports make no mention of cash flow at all. Cash flow type phrases occurred about 6,000 times in the full sample. [Separately, dividends are mentioned over 2,000 times.] [Also included in 1(c), 3(c), and 5(c)] [PREVITS, p. 18]
Although cash flow per share calculations are not permitted in audited filings under SEC rules nor by SFAS 95, cash flow per share and operating cash flow per share are almost always calculated by analysts when they provide any cash flow data. Analysts also calculate "fully diluted cash flow per share" and some provide "distributable cash flow per share", "excess cash flow per share", "discretionary cash flow per share", and "free cash flow per share." [Also included in 1(c) and 5(c)] [PREVITS, p. 18]
Some [equity sell-side] analysts compute a price to cash flow ratio, and present a comparison of this ratio with other companies in that industry. Others assess the relationship between cash flows and earnings. For example one report stated that the value of a company was "compelling" because "operating cash flows are 4.3 times 1990 earnings". Another analyst encouraged purchase of a major tobacco company's stock because of its "tremendous surplus cash flows". [Also included in 1(c) and 5(c)] [PREVITS, p. 18]
Cash flows seem to be more important to [equity sell-side] analysts in evaluating smaller companies, and less so in evaluating larger companies, with the exception of highly leveraged larger companies or ones in which a dividend cut is possible. One report, for example, states that "The important figure . . . for evaluation of smaller petroleum . . . companies is operating cash flow per share." Another stated that in comparison with cash flow "historical financial results of [the company] are irrelevant". [Also included in 1(c) and 5(c)] [PREVITS, p. 18]
Examples of unorthodox cash flow formats [presented by equity sell-side] analysts in addition to free cash flow and discretionary cash flow arrangements are: [Also included in 1(c) and 5(c)] [PREVITS, p. 18]
Net income
+/- all effects except cash interest
= cash flow available to common
- cash interest
= net cash flow
Direct operating cash flows
- priority outflows
- discretionary outflows
+ financial inflows
= change in cash
[Also included in 1(c) and 5(c)] [PREVITS, p. 18]
It was also intriguing to discover an example where the "foreign exchange cash flow" in a statement of cash flows was presented outside the three traditional categories of the SFAS 95 format. [Also included in 1(c) and 5(c)] [PREVITS, p. 18]
[Equity sell-side] analysts distinguish between valuations based upon the company's continued existence in its present form: so called fundamental value, and valuations based upon acquisition or breakup of the company. Analysts use several approaches to valuing companies based on fundamentals, most typically in terms of the present value of the company's cash flows, its earnings, or balance sheet valuations. In this approach analysts also distinguish between a company's "Public market value" and "private market value". For example, one analysts measures the fundamental value of a company in terms of:
1) Private market value
2) Price/revenues
3) Price/book value
4) Price/long-term earnings
5) Growth-driven valuation composite
6) Contrarian composite [e.g. Bearish Sentiment Indicators]
7) Earnings momentum composite
8) Technical ranking
9) Beta
[Also included in 1(a), 1(c), and 4] [PREVITS, p. 19]
Another analyst valued companies in terms of revenue, cash flow multiples, and net income. And yet another analyst valued a cable TV company with purported off-balance-sheet assets on three basis:
1) present value of cash flows,
2) appraised value of assets and
3) the company's liquidation value.
[Also included in 1(a), 1(c), and 4] [PREVITS, p. 19]
Another analyst evaluated the same cable TV company by analyzing each of the many limited partnerships with which the company was related in order to estimate the long-range cash flows of each to the company. [Also included in 1(a), 1(c), and 4] [PREVITS, p. 19]
Analysts label valuations of a company based upon it acquisition or breakup as it "buyout value", "breakup value", "takeover value", "theoretical breakup value", and so forth. Examples of computed break up value include the following:
1) Estimated breakup value = asset values at market price less liabilities.
2) Adjusted breakup value takes the above and adds other "likely" assets.
3) Possible breakup value adds other "possible" assets to all of the above.
[Also included in 1(a), 1(c), and 4] [PREVITS, p. 19]
_________
[Context] The AIMR position paper provides the following summary of the section (pages 6-11) entitled "Financial Analysis and Financial Reporting
This section provides primarily descriptive information. It discusses the interrelationship between the efficient market hypothesis (EMH) and other theories of financial economics and the role of financial analysis in making markets efficient. It presents a description of the analytic process to the extent that generalizations can be made in that area. It lists and describes the vast variety of information sources used by analysts, of which financial reports are an indispensable part of the whole. It then describes in more detail each of the financial reports analysts rely on in their work. [Also included in 1(a) and 1(c)] [AIMR/FAPC92, p. vi]
One of the most important points made in this section is defining the distinction between financial analysis and financial reporting. We believe that financial reporting should be concerned with presenting the economic history of specific economic entities and that it is best done when managements also are willing to disclose and discuss their strategies, proposed tactics and plans, and their expected outcomes. Forecasts of the future and similar material enhances financial report usefulness, but must be separated from and not confused with the financial statements themselves. The function of analysis is to allow those who participate in the financial markets to form their own rational expectations about future economic events, in particular the amounts, timing and uncertainty of an enterprise's future cash flows. Through this process, analysts form opinions about the absolute and relative value of individual companies, make investment decisions or cause them to be made, and thereby contribute to the economically efficient allocation of capital and clearing of the capital markets. [Also included in 1(a) and 1(c)] [AIMR/FAPC92, p. vi]
[Context] Those two paragraphs introduce the following excerpts and relate them to excerpts from the same section included in 1(a)-Investors' and creditors' objectives and approaches and 1(c)-Investors' and creditors use of information to achieve their objectives.
Sources of Information
Economic and Industry Reports
A common starting point in the analytic process is to assess the state of the economy and the various industries within it. Information to do so comes from a variety of sources. Economic reports and prognoses are available both from the government and from private sources. Many financial firms have their own in-house economic experts who provide continual updating to the rest of the firm, its customers and sometimes to outsiders. [AIMR/FAPC92, p. 5]
Industry-specific data come from the government, trade associations, the business press and a variety of other sources. Often it is obtained indirectly from companies within the industry. It usually requires analysts who follow a particular industry to participate in meetings, conventions, trade shows, and other industry-wide events. They also must keep up to date on technological advances and other industry changes. [AIMR/FAPC92, p. 5]
Company-Specific Information
Financial reports are the beginning and ending points in obtaining information about individual companies. As a starter they provide an overview of the company's business, its status and its performance for a series of years. It is difficult to think of a better primer than the combination of an annual report to shareholders, complete with the Chairman's letter to shareholders, financial statements, management's discussion and analysis of them, as well as other descriptive material; plus a Form 10-K with all of its detailed description of business, facilities, risks, contingencies, and other mandated disclosures. At the end of the information gathering process, financial reports are used to corroborate the vast array of company specific data assembled from the various sources described next. [Footnote reference omitted.] [AIMR/FAPC92, p. 6]
Many of the data used by analysts come directly from companies themselves. Sources include press releases and other announcements, including preliminary earnings numbers. Information is received orally from company executives, sometimes in analysts' meetings, other times by telephone or during analysts' visits to the company's premises. Plant visits and field trips allow analysts to compare the company's written and oral representations to the reality of its operating conditions and atmosphere. Many companies entertain analysts, usually in groups, in order to present their stories in the most favorable circumstances. One of the tasks of an analyst is to sort through all of the favorable information to discover and weigh the facts that are most germane to assessing a company's future prospects. [AIMR/FAPC92, p. 6]
The business press provides substantial amounts of information about individual companies, much of which is now captured in databases. In some instances, a clipping service may be used to gather data on a particular company. Almost every major industry and many subdivisions of them are covered by specialized publications. These are must reading for industry specialist analysts who use them to gather intelligence, not only about the state of the industry, but also about the performance and status of the individual firms it comprises. [AIMR/FAPC92, p. 6]
Finally, a good amount of information about individual companies may be obtained through government documents and filings. One example is the call reports filed with the United States Comptroller of the Currency by banks. Another is the filings by insurance companies, public utilities, and other regulated companies with state and federal commissions. These are indispensable documents to analysts following those industries. Individual company pension plan filings with the United States Department of Labor are another example. Government Accounting Office studies and testimony before the Congress and regulatory agencies are other important sources of information. Under some circumstances, shareholders holding as little as one percent of a company's shares may obtain copies of its Federal income tax returns. Since enactment of the Freedom of Information Act more and more specific company data have been available to the public. In a number of cases however, the incremental value of the available data may be less than the cost of the effort necessary to obtain it. [AIMR/FAPC92, p. 6]
Financial Reports Used By Analysts
The use of financial reports will differ from analyst to analyst, depending on the purpose of the analysis and the analyst's personal style. . . . The depth of an analyst's study of financial reports is in inverse proportion to the number of companies he or she follows. To some extent, that depth also is a function of the analyst's interest in and understanding of financial accounting and reporting standards and disclosures. [AIMR/FAPC92, p. 7]
At the top of every analyst's list is the annual report to shareholders. It is the major reporting document and every other financial report is in some respect subsidiary or supplementary to it. That is one of the reasons AIMR and its predecessor, the Financial Analysts' Federation, is and has been totally opposed to companies issuing what is called a "summary annual report." Financial analysts expect the annual report to shareholders to contain a complete set of financial statements. Even though, for such companies, a full set of audited financial statements must be included in the proxy statement, it may not be received routinely by a non-shareholder analyst. Furthermore, the financial statements contained in a "summary annual report" are incomplete and may well mislead less sophisticated investors who are unaware of that fact. [AIMR/FAPC92, p. 7]
The annual report on Form 10-K is automatically regarded by most analysts as an essential complement to the annual report to shareholders. It contains several important types of supplementary financial schedules. In addition, it provides detailed descriptions of the business and contains a record, available nowhere else, of other available documents incorporated by reference. [AIMR/FAPC92, p. 7]
Other than the financial statements themselves, perhaps the most useful single part of the annual report is the management discussion and analysis (MD&A) mandated for inclusion by the SEC. Its information content varies from company to company, but it provides for all companies insights that are not apparent from the financial statements alone. It discloses items that tend to make year-to-year income numbers noncomparable. It provides narratives to accompany the factual disclosures in financial statement notes. It has been less effective in giving management the opportunity to discuss the company's plans and prospects, information of utmost relevance to analysts. Although it is less than perfect, we have detected progressive improvements in the MD&A over time, many of which can be attributed to the efforts of the SEC to enhance its quality. [AIMR/FAPC92, p. 7]
Analysts are constantly updating their projections and need timely financial reports to assess how well they and the companies they follow are doing. Quarterly reports are vital to the analytic process, particularly the detailed reports provided on SEC Form 10-Q, which include a mandated MD&A section. Many analysts also find helpful the management representations contained in the briefer quarterly reports to shareholders. For reasons set forth in detail later in this report, we oppose the movement in certain quarters to eliminate or otherwise attenuate interim financial reporting. [AIMR/FAPC92, p. 7-8]
Many companies publish and distribute on request additional financial and statistical information beyond that contained in their annual reports. These "fact books" or similar documents are used extensively by analysts. The proxy statement provides information about compensation of the company's senior management and the shareholdings of directors and officers. Forms 8-K give information on major current developments affecting the company. There also are a variety of special financial reports, peculiar to particular industries and/or companies that analysts find useful in their work. [AIMR/FAPC92, p. 8]
Use of Databases and Quantitative Techniques
More and more financial data are to be found in databases, some of which are publicly available while others are proprietary. Of the publicly accessible databases, one extreme is represented by COMPUSTAT, which contains financial statistics on over 10,000 U.S. companies, organized by industry code and arranged in a standardized financial statement format. At the other extreme, is NAARS (National Automated Accounting Retrieval System). It contains the actual text of the financial reports of over 5,000 companies. Both of those databases include several years of data. In between are an unlimited variety of specialized databases offered by all sorts of vendors, including, among others, the FASB itself. [Also included in 16(a)] [AIMR/FAPC92, p. 15]
Use of databases varies from analyst to analyst. Some analysts ignore them and continue to obtain all of their company and industry information from more traditional sources. Others may use them to screen a large universe of companies to weed out those that do not meet certain criteria. The screening process often involves the use of financial ratios and the program employed is generally concerned more with processing large quantities of data rather than performing sophisticated computations. Another group of analysts will use highly complex quantitative techniques to make portfolio selections and as a guide to other market transactions. [Also included in 16(a)] [AIMR/FAPC92, p. 15]
[Context] Discussions of seven "Broad Topics of Current Importance to Analysts" constitute about half of the AIMR position paper and are related to each other and to the rest of the paper. Not only does the rest of the paper provide a basis for discussing the seven topics but also uses aspects of the seven topics as examples in discussing the relationship between financial analysis and financial reporting, the changing world and its implications for analysis, and the qualitative characteristics of financial statements.
The following excerpt begins the section entitled "Broad Topics of Current Importance to Analysts," introducing the seven topics as a group and listing them individually. Numbers and names in the brackets identify the category(ies) in the Special Committee's database containing the bulk of the text quoted from each of the seven discussions.
In this section we address several financial reporting matters that are of current and continuing importance to investment managers and analysts. Some of the subjects considered herein embody difficult questions for both financial reporting and financial analysis. On some of those questions financial analysts hold strong and unified views. On others, opinion among analysts is divided, although the views may be no less strongly held. The topics for discussion are: [AIMR/FAPC92, p. 23]
"Mark-to-market" accounting. [4-Value information]
Accounting for intangible assets, both purchased and self-developed. [7(a)-Goodwill; 7(b)-Other intangible assets; 8(c)-Leases and other "executory" contracts]
Frequency of reporting, with special reference to quarterly reports. [11(a)-Frequency of interim reporting; 11(c)-Content of financial statements and related disclosures]
Disaggregated financial information. [3(a)-Compliance with and criticisms of Statement 14; 3(b)-Basis of disaggregation; 3(c)-Types of disaggregated information disclosed]
Form and content of both income and cash flow statements. [5(a)-Income statement, including core earnings and comprehensive income; 5(c)-Cash flow statement]
The transition from old to new accounting standards. [2(c)-Comparability
. . .; 16(a)-Databases]
The standard-setting process and its critics. [18(a)-International harmonization of standards; 18(d)-Investor and creditor involvement in setting accounting standards; 18(e)-FASB]
[AIMR/FAPC92, p. 23]
[Context] The AIMR report's introduction to the section entitled "Summary of Important Positions and Guide to Future Actions" begins and ends as follows:
Much of this report relates to the present state of the art and implications for future developments in financial reporting. Righfully, so do most of the positions stated in this section . . . [T]hey all build on positions taken by AIMR in the past . . . [Also included in 1(d), 3(d), 4, 5(a), 8(c), 11(a), 12, 18(a), 18(c), and 18(d)] [AIMR/FAPC92, p. 59]
We expect the positions set forth below to build on the precedents of the past. That does not prevent them from breaking new ground, but they do not introduce significant inconsistencies with previous AIMR positions. To the extent that they do establish new stances those are largely the result of the changing world that we describe earlier in this report. [Also included in 1(d), 3(d), 4, 5(a), 8(c), 11(a), 12, 18(a), 18(c), and 18(d)] [AIMR/FAPC92, p. 60]
Those two paragraphs introduce the following summary of a position taken by the Committee.
Set Financial Information in Its Business Context
In order for financial analysts to make sound judgements and draw rational conclusions, they must judge the performance of individual business enterprises. Performance appraisal is largely a matter of evaluating how well the management of an enterprise has achieved its goals. Businesses are for the most part operated according to plans, either explicit or implicit. Investment professionals aspire to allocate capital to those plans that seem most likely to succeed. In order to do so, they need information of two types. [Also included in 1(d)] [AIMR/FAPC92, p. 61]
First, management should explicitly reveal its strategies, plans and expectations. Much of this must come in the form of narrative descriptive material. Dollar amounts of budgeted and other anticipated amounts are useful for expressing plans in more concrete terms. Goals for growth rates in revenues, market share and the like should be stated. Analysts need anticipated amounts of key ratios, such as the return on total invested capital or on equity, the ratio of debt to equity and so forth. Factors that are expected to affect those ratios should be divulged, eg. major financing or capital spending plans. [Also included in 1(d) and 12] [AIMR/FAPC92, p. 61]
Second, results need to be reported in a manner that is consistent with the organization and management of the firm. Different entities, even within the same industry, may organize their operations in totally dissimilar ways. Financial analysts need information in formats that allow them to compare those firms both against each other and against their own business plans. The task of devising accounting and disclosure standards to mandate dissemination of information in the fashion we advocate is perhaps not totally surmountable. Thus we look to business enterprises themselves to act with goodwill and in their own interests to explain themselves and their operations in "user friendly" ways even when it is not strictly required. [Also included in 1(d)] [AIMR/FAPC92, p. 61]
__________
[Context] Meeting of the Investor Discussion Group on October 16, 1992. When asked about their objectives and approaches to evaluating equity securities, some investors referred to the types of information they used to achieve their objectives.
Participant I-1
Under the fundamental approach, you are overlaying more judgment to the numbers. So you are concerned with the markets, the customers, the critical variables, all the things you don't generally get from financial reporting. I find historical financial statements to be virtually worthless as a fundamental analyst. I could virtually not have the front part of the financials if you put notes disclosing significant litigation, asbestos liability, unfunded pensions plans: that is probably the most I get out of the historical statements. You have to start some place, but I'm not sure that gets you too far. [Also included in 1(a)] [TI 10/16, p. 4-5]
Participant I-4
I think historical numbers are necessary but not sufficient to do fundamental work. The people here from the investment field are probably all fundamentalists. We do special situation work, we are trying to determine what is the real corporate value of companies which we are analyzing or buying. We attempt to analyse cash flows and/or redundant assets, and then putting some kind of capitalization rate on that growth. So it is important for us to look at what we think is real generation of cash flows; for that, you need historical data but also a lot of judgment work. Once we determine what value is, we attempt to find whether the company agrees with us in realizing value. A lot of the value comes out because corporate activity occurs, not because the stock market goes up or down, but because someone internally realizes that values in a real world are substantially higher over time than what the price is in the marketplace. [Also included in 1(a) and 1(c)] [TI 10/16, p. 5]
Participant I-9
We have about $20 billion under management and a research department of about 7 or 8 people. It used to be that an institution of that size would have about 30 analysts; those days are over. Which means that the job of the financial reporting community has become more important; the analysts cannot know the industries in the same depth they did before. We never make an investment unless we have audited financial statements of the company and we don't make an investment unless we meet the management of the company. Our approach is fundamental; the valuation starts with the financial statements and then our projections going forward, based on what management tells me and what we see in the trends of the company. The other aspects are psychology and momentum; the accounting profession cannot help us with that. Sometimes, we rely heavily on the information provided in financial statements, at other times that's not what is going to lead us to make the right investment decision. [Also included in 1(a) and 1(c)] [TI 10/16, p. 5-6]
Participant I-2
Your client base in accounting is dealing with a dynamic system, not only with changes in the economy, but also the secular changes. For example, the accounting opinion on inflation years ago; it turns out it was so difficult that it ended up not being terribly useful. For the last five or six years, we're seeing companies doing things we never thought they could: massive layoffs, wage givebacks, etc. As a fundamental analyst, you need the ability to get inside the company and understand what makes it tick. So you want to understand sources of cash flow and how the business works (and that on a quarterly basis). What if scenarios are very important to us; we need the detailed information to do those "what if" exercises because it is a very important element of our job. [Also included in 1(a)] [TI 10/16, p. 6-7]
Participant I-8
Earnings is the starting point. But there is another layer which is the external setting (how the company is perceived). [Also included in 1(a)] [TI 10/16, p. 8]
Participant I-6
Earnings are the common denominator, much more than cash flow. But I don't want to dismiss the importance of cash flow. You can't forecast cash flow without forecasting earnings. For an analyst, some industries' cash flow is much more critical than earnings. Other industries' cash flow is important but that's not the common denominator. In the marketplace, most people talk about P/E ratio, not cash flow multiples. And in many of the discussions with portfolio managers who focused on cash flow, not more than half a dozen agree on the definition of cash flow. Until we get a standardized definition of cash flow, we are deceiving ourselves in some respect to say that we can look at a cash flow statement and come up with a meaningful number. Cash flow is an important number in fundamental analysis, but it comes after the earnings. [Also included in 1(a)] [TI 10/16, p. 8]
__________
Participant I-12
The purpose of external reporting is to give some basis to look at the value of a company today and a basis to look in the change and potential change in that value. [Also included in 1(a)] [TI 10/16, p. 16]
[Context] Meeting of the Investor Discussion Group on October 16, 1992. Investors were asked about the types of information they use to achieve their objectives and the relative importance of that information. Page 12 of the meeting materials listed the following general categories of business information regarding the company and its environment that the Committee believes investors use in following the fundamental approach:
General economy:
Social, demographic, technological, political, and regulatory trends
Historical and projected macroeconomic data
Each industry in which the company participates or plans to participate:
Definition and boundaries of the industry
Industry structure (bargaining power of customers and suppliers, threat of substitute products and new competitors, and intensity of competition) and outlook
Historical and projected aggregate financial and operating data
Company:
Company mission
The company's strategy and strategic alignment
The company's ability to innovate, adapt to change, and continuously improve
Competitive advantages managed at the company level
Opportunities and risks managed at the company level
Historical and projected financial and operating data related to the company
Each industry segment within the company
Description of the segment's business
Segment mission
The segment's strategy and strategic alignment
The segment's position within the industry
The segment's ability to innovate, adapt to change, and continuously improve
Competitive advantages and disadvantages managed at the segment level
Opportunities and risks managed at the segment level
Historical and projected financial and operating data related to the segment.
Investors were asked two questions in reference to the above list:
Do you currently use business information in each of the categories listed?
And conversely, do you use business information in categories not listed?
Participant I-7
I use much of the information listed here. What I don't see is programs aimed at giving us information from a marketing, merchandising, distribution point of view. [Also included in 13] [TI 10/16, p. 17]
Participant I-1
Our approach is starting with the basic 12-page due diligence list, recognizing that you only get half a page of that out of conventional external reporting. The rest of it is digging the information around. A good part of what is on your list has to be obtained from non-external reporting sources; for example, talking to customers and suppliers. You may not get some information from the company you're talking to, so you have to go around it. In other cases, you may have tremendous concentration in the customer base and that may not be evident from the external reporting (although the footnotes may give some concentration disclosures but not as much as we would like). Probably 80% of the information you need has to be obtained either away from the company or have the company sit down and have a candid conversation with you. There is disparity in what company will tell people. We tend to focus on midcap-type of companies which generally enjoy the opportunity to sit down and talk a lot, compared to the Fortune 1000 where it's more institutionalized. Even within those companies, they migth tell person A something different than what they tell person B. So there is a tremendous amount of variability in the other types of information that is disseminated. [Also included in 1(a)] [TI 10/16, p. 17-18]
Participant I-11
One of the ways we measure the course of business activity is through financial statements. But the statements are the measurement and not the activity itself. The most important things to evaluate a company and the prospect for its stock are the company's strategic plan and the tactics it has for putting this plan into action. I don't get any of that from financial statements because that's not what they are for. [TI 10/16, p. 18]
For example, when I look at companies in the wholesale distribution area, I'm interested in their vision in how their business is evolving and how they are positioning themselves to deal with the changing environment. Then I go back and say what this implies in terms of earnings, sales, expense ratios, cash flows, and other financial issues. But the most important things aren't in the financial statements at all. [Also included in 13] [TI 10/16, p. 18]
Participant I-6
Thinking about the purpose of financial reporting reminds me of an annual report of a mining company a few years ago where two-thirds of the chairman's letter in the report talked about gold. Yet the financial statements did not disclose any financial data on the gold operations. One of the things not clear to me is whether the financial statements are just the audited portion or the report as a whole? [Also included in 13] [TI 10/16, p. 18]
We use most of the information listed here. [TI 10/16, p. 18]
Committee/Staff/Observer
One of the things we would like to know is: what information that is not in financial reporting that you are going to other places for would you like to see in financial reporting? [TI 10/16, p. 19]
Participant I-6
A lot of production data or industry-type data that help rank the company within their peer group. You can find a lot of that in reports by other mining companies elsewhere around the world, but not in the U.S. [Also included in 13] [TI 10/16, p. 20]
Participant I-5
More segment breakout is a critical thing (consistently presented). Also, as for information that you can get externally that could be provided in the financial statements, if you can get the aggregate statistics for an industry from the government or some statistical service or some trade organization, I think you're better served doing that than relying on the company's annual report, because you are going to some kind of an objective benchmark outside the company. [Also included in 3(b) and 13] [TI 10/16, p. 20]
Participant I-7
I head a subcomittee that looks at investor information in the electrical equipment industry. The disseminated information is very uneven. A major effort was made over the last 5 years to get some consistency in FAS 14 reporting; probably 75% of my companies do not report sufficiently on a FAS 14 basis. The other point that is absolutely critical is giving out meaningful industry information. In the more mature industries, you can get government statistics, but in a lot of cases, those statistics are 12 to 24 months old in time. If I can get some consistency in reporting in the annual report on industry information, that is, total statistics, growth by segments, and market share, the truthfulness of that information can be checked by playing one company off against another. That information is very critical. [Also included in 3(a) and 13] [TI 10/16, p. 20-21]
We don't get good FAS 14 disclosure in the annual report and we get less from most of our companies in the quarterly reports. FAS 14 is just an abomination at least in my industry from a quarterly point of view. I also heard the argument about the expense of creating this information. There isn't a reasonable size company that doesn't have internal reporting and the people inside the company get a report card, if not monthly certainly quarterly, and that's the kind of information that is readily available that I would like to see. One of the things that should be discussed somewhere is: what the information that we as outside investors should not be permitted to get from a competitive point of view? They all know internally what their competitors are doing and yet they don't want to provide certain information to us for competitive reasons. It's vital that the accounting profession decide what kinds of information are competitively harmful and others that aren't. [Also included in 2(d), 3(a), 3(b), 3(d), and 11(c)][TI 10/16, p. 21]
Participant I-6
I totally agree with [participant I-7]. Sometimes you go at conferences and you hear companies bragging about their position in the industry and that's the kind of information that they didn't want to give to you before. [TI 10/16, p. 21]
Coming back to cash flow, I think it's important but I don't thin