Financial Reporting

by Stephen E. Roulac

   Business decisions in modern economics depend on numbers. Investors commit their money in reliance upon numbers. Advanced, modern economies are distinguished from emerging and developing economies by the sophistication, reliability, and trust associated with the numbers upon which business and investment decisions are based.
   The emergence of managerial and investment decisions based on numbers is a primary cause of major advances in modern economies. With more sophisticated analytic techniques and information processing resources represented by advances in decision science and computer technology, quicker and more accurate decisions can be made. Investors readily and confidently commit capital to companies' common stocks, which capital commitments fund investments to expand companies, grow economies and produce profits.
   The capital formation system of this country is supported by a system of security regulation and institutions that are intended to promote economic growth and protect investor's interests. At the core of this capital formation system is trust in the numbers that are the basis upon which business and investment decisions are made. Central to creating and sustaining trust in numbers is the disclosure of material financial information.
   Fundamental to the securities laws of this country is management's responsibility to disclose material financial information. All too often, executives and their advisors rely on compliance with form, rather than an emphasis on compliance and substance, by pursuing disclosure that falls far short of the spirit of disclosing material financial information. As a case in point, consider the disclosure of a public hospitality company, in its form 10Q, of June 2002:
   "We estimate that the cash flow benefit from these modifications will be approximately $8 in 2002 and increase to approximately $25 by 2006, of which approximately two-thirds is related to cost reductions and other benefits and one-third is related to reduction in incentive management fees."
   Then, in the next quarter, this company reported:
   "The monetary effect of the changes will depend on future events such as the operating results of the hotels. We do not expect these modifications to have a material financial impact on us."
   The fundamental question must be asked is whether these disclosures fairly and appropriately inform investors of material financial information? One of the three great lies told by any senior executive is, "We do not expect X to have a material impact." Would an investor represented by savvy, diligent, sophisticated advisors reach the same conclusion?
   Materiality often is in the eyes of the beholder. Some executives' view of materiality is to meet the minimal standards. But this shortsighted thinking mistakenly interprets the fundamental purpose of materiality. The question that must be asked is, who is the audience for materiality? The audience is the investor and materiality should be considered from the investor perspective. Materiality should emphasize what the investor really would wish to know, not management's self-serving, aspirational interpretations.
   One of the central considerations in addressing materiality is the question of the accounting concept of realization. Realization in accounting involves recognizing and determining when an event has really happened. Expressing this idea in another way, when is a sale a sale? And, when is an expense an expense?
   Much of the litigation involving accounting issues concern companies recognizing expressions of interests - or even a division's sales forecast -- as a realized sale. If a sale has not met the appropriate test of realization, then it should not be recognized as a sale. Similarly, on the expense or liability side, hoping that something may not happen or that a very adverse outcome might not be realized, or that somehow, someway the company can avoid the liability of cost associated with a claim or a problem, is the flip side of realization. Many companies, in their financial reporting, may be engaging in violations of the realization concept.
   The dubious interpretation of the realization concept results in financial reporting of revenues being higher and/or expenses lower and profit higher, than would result from a more reasoned and reasonable interpretation. Today's reduced stock prices reflect society's wholesale mistrust of numbers. Lacking trust in the numbers, investors are discounting the prices they are willing to pay for stocks, from the level of prices they would pay for stocks of companies whose numbers they trust.
   Managements who violate the trust the economic system places in them to produce trustworthy numbers, end up being featured on the evening news -- CEO prep walk and named as defendants in civil litigation. Investors appropriately look askance at companies whose numbers are untrustworthy and invest elsewhere. But the pervasive lack of trust in numbers is a drag on the stock market and the economy's recover.
   Companies that seek higher stock prices can achieve them by producing trustworthy numbers. Investors who desire prudent investor approaches can seek companies with trustworthy numbers. After all, if you can't trust a company's numbers, then what part of the company can you trust?