The last three decades have been the golden age of disclosure, as both accounting rule writers and regulators have pushed companies to reveal more and more about their prospects to investors, both in the US and internationally. Some of this push can be attributed to more activist investors, demanding more information from companies, but much of it can be traced to accounting fraud/malfeasance, where companies held back key information from investors, who paid a price as a consequence. In response, legislators, the watchdog agencies (SEC and its equivalents) and the accounting rule-writers (GAAP, IFRS) have all responded by increasing the amount of information that has to be disclosed by firms. That should be good news for investors, but here are the contradictions that I see:
- If the objective of “disclosure” laws is to prevent the next Enron, Parmalat or Worldcom accounting scandal, it clearly has not worked, since we seem just as exposed as we have always been to these problems. If anything, companies seem to have become more creative in hiding “bad” stuff, in response to disclosure laws, making it more difficult to detect problems.
- If the objective is to help investors value companies better, it has not worked either. To me financial disclosures are raw data, when I do valuation, and I must confess that I find financial statements more difficult to work with today than I did thirty years ago, when disclosure laws were less onerous.
So, what gives here? Why have these increased disclosure requirements not worked the magic that they were supposed to? While we can point to lots of reasons, including imperfections in the disclosure requirements, I think that the biggest problem is that the disclosure rules have turned financial disclosures into data dumps. To see my point, take a look at the 10K for a publicly traded company, even a small one, and you will see a document that runs into tens or even hundreds of pages. For instance, Procter & Gamble’s most recent 10K runs 239 pages and it is slim next to Citigroup’s most recent 10K which runs more than 300 pages. If you are interested in valuing Procter & Gamble or Citigroup, you have to work your way through these pages, separating the wheat from the chaff, or more specifically, information from data. Faced with information overload, it is easy to get distracted by the legal boilerplate (you might as well throw out the entire section that discusses risk) and the trivial details that clutter modern disclosures. In my estimate, less than 10% (and that is being generous) of a modern financial disclosure has any value to an investor and to find this information, here are some things to keep in mind:
- Read with focus: Know what information you are looking for, before you start looking for it. In other words, reading a 10K, just looking for useful information, is equivalent to digging up your backyard, looking for interesting stuff. Your most likely outcome is that you will end up with a mountain of dirt and little to show for your work.
- Don’t sweat the small stuff: If you are valuing a $ 60 billion dollar company, you can afford to skip over that section that describes in excruciating detail a $25 million real estate lease that the company has entered into or the $50 million lawsuit filed against the company.
- Don’t cater to your inner accountant: We know that accounting has its fixations and that financial disclosure often cater to these fixations. Thus, there are large chunks of these documents that are dedicated to how intangible assets have been “fair valued” or goodwill has been “impaired” (a mythical asset that exists only in the accounting world). Since I don’t trust accounting fair value judgments to begin with and goodwill has but a peripheral role (if that) in cash flow based valuation models, I can afford to skip these sections.
As some of you already know, I do teach a valuation course at Stern and my invite to anyone who is interested in sitting in still holds. Since a key part of doing valuation is learning how to work with financial disclosures, I recently put together a webcast on disclosures, where I used P&G’s most recent 10K to value the company. If you are interested, you can find the webcast with the supporting material (the 10K, my slides and my valuation of P&G). In fact, they are part of set of webcasts I am doing on the nuts and bolts of valuation:
I am afraid that things will only get worse for investors. The push towards more disclosure, well intentioned though it might be, is unstoppable and will create more bulk in annual reports and company filings, and more distractions for investors.
While I am sure that I will be ignored, here are my suggestions to the regulatory and accounting disclosure czars if they truly want to help investors:
- Focus on principles, not rules: The principles that govern valuation are simple and robust, but they seem to take a back seat to rules when it comes to disclosure requirements. To provide a simple example, capital expenditures should measure what a company invests in its long term assets, whether those assets are tangible (land, building, equipment) or intangible (human capital, brand name, intellectual property). Not only are the accounting rules governing capital expenditures unnecessarily complex but they are internally inconsistent, with different rules governing tangible and intangible investments. (Prime exhibit: the treatment of R&D expenditures).
- Less is more: My wife, who is the “organizer’ in our house, has a very simple rule for everyone in the family. For every new item that any of us buys, one item has to be removed (given away or abandoned) from our closets. It is an excellent rule, since in its absence, we would undoubtedly hoard what we already have, on the off chance that we might need it in the future. I would propose a similar rule in disclosure. When companies are required to disclose something new, an old disclosure requirement of equal length has to be eliminated, thus preventing disclosure bloat.
- Target investors, not lawyers: As I browse through financial disclosures, I am struck by how much of the content is written by lawyers, and for lawyers, with the specific intent of shielding companies from lawsuits and/or regulatory backlash. While I understand that companies are gun shy about being sued, and that this protection is necessary, it may be time to allow companies to file two disclosures, one for lawyers and one for investors. Using P&G as my example, I could construct an investors’ 10K, about 20 pages in length, stripped off all the legalese that the full 10K includes.
- Let accountants do accounting (and not valuation): I know that “fair value” accounting is here to stay, but I believe that the push is misguided. By requiring accountants to play the role of appraisers, it asks them to play conflicting roles: provide a faithful recording of what has happened in the past (traditional accounting) while also forecasting the future (a key component of making valuation judgments). In the process, I think that we will end up with financial statements that do neither accounting nor valuation well and that investors will pay the price.
Looking forward, investors will increasingly be tested on their capacity to separate the data that matters (information) from the data that does not (noise or distraction). There is an interesting twist (and I thank Bill, who commented on this post for this insight). The increasing complexity of financial disclosure does open up the possibility that investors who can navigate their way through these disclosures and separate information from data will have a competitive advantage over other investors, who give up in frustration.