ACCOUNTING & AUDITING Tinancial reporting The Value of Good Corporate Disclosure By Kenneth F. Fick anual and quarterly SEC filings are a key source of information from which analysts and investors ‘make investment choices. For companies with litle or no analyst coverage, SEC filings may be the only source investors use to decide whether to buy of sell. Improving the quality and level of diselo- sure in a company’s 10-K, 10-Q, and 8-K periodic reports is one of the most over- looked strategies a company can use to decrease its cost of capital and increase its market value. A company's ability © effectively communicate the activities of the business will increase an investor's understanding and consequently lower the investor's perceived risk Various academic studies demonstrate that comapnies with higher disclosure qual- ity will experience smaller bid-ask spreads, ‘greater analyst coverage, more accurate ‘eamings forecasts, and lower cost of debt tnd equity capital. The precise financial impacts of improved corporate disclosure are difficult to quantify and vary by industry and firm. Recent studies have shown that the difference in the cost of ‘equity between the most forthcoming com- ppanies in an industry and the least range Anywhere between less than 196 to almost 10%. There is a similar effect when it ‘comes to the cost of public debt where, all other things constant, companies with ‘mate informative disclosure enjoy approx imately 1% lower interest costs compared to peers. This advantage applies even to private debt, such as bank loans; again, With all other things remaining constant, a ‘company will enjoy an approximately 1.6 basis point lower loan spread for every unit increase in disclosure. Empirical evidence ‘clearly shows that poor corporate disclo- sure can be costly and that by improving corporate disclosures, a company can 40 gain a competitive Financing advantage in the marketplace ‘There are two primary schools of thought on why better corporate disclosure is associated with a lower cost of capital ‘The first suggests that greater disclosure enhances stock market liquidity, therefore decreasing transaction costs and increasing the demand fora company's securities. The second suggests that beter corporate dis closure reduces estimation tisk through ‘improved stock price informativeness and seduced reliance on informal technical ma ket signals. Both schools contend thatthe effect of better disclosure is more pro- ‘nounced in companies with low market capitalization when compared to their mar et pees. ‘Traditionally, investor relations activities hhave not focused on improving periodic reports when launching an investor oueach ‘campaign, under the belief that companies ‘generally already produce a very high level of disclosure. In addition, information abounds inthe public domain from lawyers, ‘accountants, and other experts as to speci ic language and templates to se inthe ere ation of periodic reports. This article will describe certain objectives to help improve both the quality and level of disclosure. When alhered to, these objectives will result in improvements to coporate disclosure and have a lasting effect on a company's cost of capita Common Excuses Even with the vast amount of informa- tion provided by the SEC and available in the public domain as to what qualifies as ‘good corporate disclosure, preparers still ‘provide myriad excuses why achieving bet- ter results is so elusive. Some common excuses include— reluctance to disclose what a compa- ny sees as competitively sensitive infor- mation; OCTOBER 2010 / THE CPA JOURNALdesire to avoid the invasion of per- institutions and over time), and materiali- ments should include individuals with both sonal privacy of employees (typically this ty. This objective is fundamental to U.S, direct and indirect interests in a reporting is in regard to executive compensation GAAP (and to International Financial entity. This ean include vendoes, customers, disclosures); Reponting Standards [IFRS}) and to secu- rating agencies, counteeparties, and credi- tm the belie thatthe current disclosure is sities laws. Beyond this overarching objec- tors. In addition, withthe recent investments {oo voluminous and that no one reads the tive, every company is different and, there- in the private sector by public ens it may reports anyway, therefore the additional fore, the guiding principles used to devel- also be reasonable to include users within time and energy that it would take to op company’s periodic reports should be the federal govemment, including Congress, improve them is not going to yield any customized to meet the needs of the orga- government agencies and maybe even US. additional benefits; and nization and its key stakeholders. All taxpayers. A report user can include any per- ‘m_ concern that providing more than what periodic reports should be written in order son who has an interest in understanding the the existing disclosure rules require expos- to be meaningful t0 all users, minimally operations, performance, and financial {es the firm to potential litigation, complex, and t0 provide transparent and condition of a company. Excuses are primarily based on either fear meaningful information to the investor. ‘Minimally complex. Complexity in or lack of resources. When preparers are Meaningful all users. Many comp- financial reporting ean be lossy defined pressed a 0 what information may be too nes havea vrynarow inerettion ofthe asthe difficulty a repo user asin fly Competiively sensitive or an invasion of identity of the users of its periodic epons understanding the economic results and an employee's ivy. they willmastcom- and, when asked, refer tothe wellknown position of a company. This complexity monly concede tha the information they “essonable invexoc” standard from Staff can be greatly reduced by following the think would be oo sensitive ialeadywide- Accounting Bulletin (SAB) 99 asitaplis SEC's guidance on the use of “plain Iy known to their competitors and industy to materiality. A much broader usergroup English” in all periodic repos. Waiting peers A lick of resources is avery con is supported by the accountng iteraure, in plain English can in some ways be thon excuse for many diferent cerporste however, FASB Concepts StementLindi- the most important guiding principle, iniatives and although atypically valid cates dha pteial uses of financial te- cause disclosures ar ineffective i users excise, especially in smalet companies, theresa common misconception tha qual- ity corporate disclosure is syonymens with pfsecopete coe ic | the Big D tainly not the case. Finally, there is the mpress is Ig ogs thro gation excise Tiss tse on te assumption that that if company pro tides to muh information ints emp Nothing impresses management or clients like fate disclosures, itis at greater risk of w= finding anomalies not previously detected. Suis filed by agressive atlomeys. Yet the USS. legal and regulatory stuctue pre- deominaly only allows legitimate lawsuits ‘with suficient merit against companies to 20 10 tia, Akhough this may not always be the case, by focusing onthe quality of corporate discourse and the level of dislo- sure when compared to market peers, a company can actively work to mitigate any poten litigation sk and increase is chances of prevailing in cour if ial is unavoidable Identify control and transaction issues before they become a problem for your organization or client with IDEA* — Data Analysis Software. ‘Access and analyze large volumes of data in seconds to: «+ Identify errors and detect fraud + Extend your auditing capabilities + Meet documentation standards os @)IDEA Quality of Corporate Disclosure By simply following effective report writing guidelines, anyone can produce ‘move useful periodic reports. They should be prepared with the overarching objective of providing information to aid investors in making investment, credit, and similar resource allocation decisions while incor- Porating the fundamental qualitative char- acteristics of comprehensiveness relevance, timelines, reliability, comparability (across Data anaes Sofware Fora free demonstration CD of IDEA, Prenarereth OCTOBER 2010 / THE CPA JOURNAL a1do not understand the information pro- vided. This article does not attempt to summarize of repeat all the SEC's spe- cific instructions here, but urges careful tnd periodic consideration of the SEC's ‘guidance on this goal. Fundamentally, reports in plain English should provide concise, comprehensive, ‘and meaningful descriptions of the opera- tions, cash flows, liquidity, and financial positon of a company. This does not mean ‘excluding complex information to make the roport easier to understand. Comporate disclosure inevitably entails discussion of ‘complex transactions and issues, and deter- ‘mining the appropriate assumed level of reader sophistication is critical. Paragraph 34 of FASB Concepts Statement 1 states that the information included in financial reports “should be compeehensible to those who have a reasonable understanding of business and economic activities and are Willing to study the information with tea- sonable diligence Transparent and meaningful infor ‘mation, Numerical presentations, accom- panied only by factual descriptions of those numbers, are insufficient to ade- ‘quately explain material information to Feport users. Management's analysis and interpretation of the current information, including explanations of how it ditfers from past periods and how matters may ‘change inthe future, is critical. Additional disclosure must be provided “through the eyes of management” for an investor to judge the quality of earnings, the like libood that past performance is indica- tive of future performance, and how the issuer's financial condition has changed and could change in the future. In short, ‘corporate disclosure should explain what keeps management up at night. The use ‘of this type of qualitative disclosure is ‘most commonly presented within the ‘management discussion and analysis section of a periodic report, but careful tention should be given to provide qual- itative explanation wherever quantitative information is provided. AIL t00 often, periodic reports do not provide sufficient contextual information to completely convey management's per- spective, the analysis ofthe financial con- ition of the company, and its future prospects. Instead, the focus is based on reporting financial information thats quan- 42 titatively accurate but not enlightening to extemal report users, Level of Corporate Disclosure Disclosure levels tend to be positively correlated with company size. For exam ple, smaller companies with limited resources may choose to disclose les infor- ‘mation than larger competitors. This has the unintended consequence of increasing information asymmetry, therefore shifing more company-speciic risk t0 insiders hile shifting market risk to outsiders, This {is magnified by the fact tha investors inter- ested in small publicly traded companies are typically left to their own resources, with limited other available sources of information Different industies display different pat- tems of cisclosure, making it almost impos- sible to create a uniform outline for com- panies 10 follow. For example, the bank- ing industry remains highly regulated in the United States and requires specific disclosures related to types of loans, securities held, and amount and type of leverage used, not all of which may be applicable to other industries. Previous aca- demic studies relied onthe disclosure rat- ings provided in the Annual Review of Cosporate Reporting Practices compiled by the Association of Investment Management and Research (now the CFA Institute), ‘whieh was last published in 1997 How does a company know if tis pro- viding a sufficiently high level of disclo- sure t investors, without adversely impact- ing its cost of capital? Ideally, a company ist diselose enough information in an effective enough manner that informa- tion-gathering costs and agency costs are ‘minimized, A company’s level of disclo- sure is based on what is appropriate for its industry peer group. Therefore, by analyzing the periodic reports of larger companies, which a smaller company may aspire to become, one ean determine what additional information would be useful to include in future comporate disclosures. Unfortunately, there i no ard-and-ast rule ‘when it comes to an appropriate level of disclosure. Investors will always demand more, and management must strive to achieve an appropriate halance among, what is competitively appropriate, is legally com- pliant, and meets capital providers” infor- ‘national needs Adding to financial reporting complex- ity isthe need to convey information on ‘an entity that is constantly changing and ‘evolving. The nature of any business is not static but requires adaptation t new eco- nomic scenarios, business methods, cus- tomer preferences, and government inter- factions. This means periodic repocs must evolve along with the business itself in ‘order to meet investors" informational needs. The effective communication ofthe ‘economic drivers ofthese businesses is rit- ical in minimizing the natural information asymmetry that exists between business managers and investors. Further Tips for Clear Disclasure In order to produce better periodic ‘reports, preparers should consider starting with a blank slate and not use the prior periodic report as a starting point. This will allow preparers to create an outline based on the most recent economic eon- ditions and global, regional, and industry forees as well as other factors affecting the company, without the constraint of What happened in previous periods. In addition, they should avoid using boiler- plate language as much as possible, they should have one senior-level executive be solely responsible for the final report in ‘onder to create a single voice and writing style, and they should cross-check all qualitative and quantitative information Within the report to ther public disclo- sures (such as press releases and investor ‘presentation) to ensure there isa consis- tent quality of information provided ‘throughout all channel No matter how substantial periodic ‘reports are, they will never speak for theme selves. They require interpretation by uses and remain only one element in a broad- er repertory of channels for communica- tion and accountability between a compa- ny and its stakeholders. Written effective ly, periodic reports will go along way in ing market uncertainties regarding a company's future prospeets and therefore lower its overall cost of capital, minimize litigation, and inerease the overall value ofthe enterprise. a ‘Kenneth F. Fick, CPA/ABVICFF, is man ‘aging direcior at the Oakleaf Group, LLC, based in Washington, D.C, OCTOBER 2010 / THE CPA JOURNALReproduced with permission of the copyright owner. Further reproduction prohibited without permission