Perennial Questions

The debate over what to include in annual reports heats up


Discussing annual reports, super-investor Warren Buffett once suggested: "Pretend you are writing to your sister. If you don't have a sister, I'll lend you mine." In other words, keep it simple. But does this mean the writer should mention that one of the company's directors is under criminal indictment, or that the company faces 28 civil suits, which it expects to win but which, nevertheless, will eat up $50 million in lawyers' fees? Should he note that the company is plagued by a defective product line that might force an expensive overhaul of its manufacturing equipment or that bickering among directors threatens corporate stability?

Should an "ideal" annual report detail chronic high employee turnover? A decline in customer loyalty? The likelihood of political turmoil in a major overseas market?

Right now, an annual report is highly unlikely to tackle these issues. "If some company executives volunteered to report these noncompliance items in their annual, their lawyers would immediately put a stop to it," asserts Jonathan Pite, creative director of Carl Thompson Associates, a Boulder, Colorado, company that specializes in producing such reports. One big reason: The Securities and Exchange Commission doesn't require such disclosures. Another: Corporate lawyers generally believe that the less a company discloses, the less it can be accused of having misrepresented.

But a 200-page paper published in 1994 by the American Institute of Certified Public Accountants, a professional organization based in New York, takes a much different view. Entitled "Improving Business Reporting: A Customer Focus," it offers a "model" of an ideal annual report for a fictitious company called "FauxCom Inc." And it calls for more disclosure, lots more.

The paper is known as the Jenkins report, after Edmund L. Jenkins, who led the special committee that produced it after three years of study. The accounting institute, whose members stand to reap juicier fees if they have to audit more information, says the proposals would benefit investors, many of whom already favor them. The institute also says that the measures laid out are merely suggestions. That would suit Corporate America quite well, since most U.S. companies bitterly oppose the recommendations.

What has particularly alarmed some corporations is that Jenkins now is chairman of the Financial Accounting Standards Board. And two months ago, he announced that this quasi-governmental body, which sets accounting standards, would conduct two years of research into the institute's proposals, and would publish its own findings in the year 2000.

While Jenkins insists that "no mandatory rules" will come out of the research project, he adds that the FASB hopes to persuade companies to voluntarily do whatever it recommends.


One of the Jenkins committee's most controversial suggestions is that annuals contain a detailed discussion of a company's prospects, and an honest appraisal of the previous year's forecasts. Thus, in the report for FauxCom (supposedly a computer manufacturer), there are six pages of discussion under the bold-type heading "Forward Looking Information." Among a welter of upbeat forecasts, a warning is sounded about the "risk that we will lose market share to competitors; prices could fall faster and reduce gross margins; rapid innovations also pose a significant risk." Looking backward, the same section notes that, while the previous year's annual report emphasized the possibility of a "major acquisition" that would "increase annual revenues by more than 25%," no such deal took place.

For diversified corporations, the Jenkins panel proposes highly detailed, in-depth financial analysis of each business. Though the SEC already requires segment reporting, what appears in an annual report often is vague or perfunctory.

Of considerable concern to corporations is the suggestion that most financial discussions be subject to "some level of 'assurance' " by independent auditors.

As for specifics, the accounting institute wants annuals to include not only detailed financials of a corporation's businesses, but also -- where relevant -- geographic analysis, for both operations and markets. For example, FauxCom breaks out the numbers for its personal computer segment as a whole and, on a following page, gives figures for its manufacturing facilities in Boston and Dublin, and then lists revenues and gross margins in its main markets -- including the U.S., U.K., Canada, France and Germany.

Another key recommendation is for companies to provide separate financials and clear, comprehensive analysis for both "core and noncore activities."

Core activities, according to the Jenkins report, are "usual or recurring operations and recurring nonoperating gains and losses." Noncore are "transactions and events that are unusual; and should include discontinued operations, unusually large transactions not expected to recur, the sale of real estate by a company that rarely sells property, the effects of a natural disaster" and the like.

But to present such information, companies will have to make more judgment calls. For example, is a product recall merely a one-time occurrence, or -- having harmed the corporate reputation for quality -- does it have long-term investment implications?

Perhaps of special interest to investors is the proposal that annual reports offer far more extensive information on the "identity and background of directors and executive management." This should include, among many other things, the Jenkins committee found, transactions and relationships among major shareholders, directors, management, suppliers, customers and the company; information about compensation committee interlocks and insider participation in compensation decisions; the nature of disagreements with directors, independent auditors, bankers and lead counsel, and the identity of any persons who have been convicted of a crime and are known to have some connection to the company.

FauxCom, under the heading "Non-Employee Directors," for example, notes that a "Cal Cronin is president, CEO and director of Micro Dynamics Inc., one of the company's primary suppliers of disk drives. The company loaned Micro Dynamics $15 million to finance the expansion of its manufacturing facility." Whether such a relationship is good for FauxCom is left for the reader to divine, but at least the basic facts are laid out.

The accounting institute's special committee also favors more forward-looking analysis of the competitive environment, a straightforward and detailed explanation of management's assessment of current performance and its thinking on key strategies for the future; a description of investments in unconsolidated entities and other outside investments, including the risks of off-balance-sheet financing and derivatives.

In addition, the proposal calls for a discussion of defective products, the cost of lawyers' fees related to litigation and their impact, if any, on net income; as well as per-share cash flow. Also on the wish list: figures on employee productivity and disclosure of the benefits or costs to the company of foreign-currency exchange changes.

Above all, the accountants call for the use of plain English that the "reader can understand."

Right now, the language of annual reports is often murky, says John Budd, chairman of the Omega Group, a New York City public-relations firm, who claims to have written "enough annual reports to equal a pocket version of War and Peace."

"If a CEO writes: 'We had positive results,' " says Budd, "you know he means: 'We lost less than the previous year.' Or, if he says 'Profits were in our forecasted range,' it simply means the company missed its projected profit targets." When an annual states that the company "faced unprecedented political and structural shifts," what it should say, asserts Budd, is that "it's a tough, competitive world out there."

Likewise, he adds, such long-winded blather as "We had a vigorous turnaround, built a strong foundation or met the challenge of change" might really mean that "coping with change cost the company more than $7.50 in per-share book value."

One key critic of the Jenkins proposals and the possibility that they may be embraced by the Financial Accounting Standards Board is A. Norman Roy, president of the Financial Executives Institute, a trade group based in Morristown, New Jersey, which represents corporate financial officers.

"We are opposed to the FASB getting involved in matters outside financial reporting," he says. "We have qualms about an accounting organization trying to get involved in nonaccounting areas in which they have no expertise." And he maintains: "Management is in the best position to know what to report to shareholders."

On the issue of forward-looking discussion, he observes, "there are risks and exposures any time a company talks about the future." If such a rule comes to pass, "there ought to be some 'safe harbor' provisions" to prevent lawsuits if the company's predictions don't pan out, he maintains. Roy also points out that just which nonfinancial matters are pertinent can vary dramatically from year to year, from industry to industry and from company to company. "How can someone prescribe rules for such reporting?" he asks.

At the same time, some suggestions, notably the call for "per-share cash flows," clash with existing FASB rules. The FASB now explicitly forbids cash flow as an "alternative to net income as an indicator of an enterprise's performance."

In general, the corporate financial officers' position, according to Roy, is that "no amount of regulation is going to prevent deliberate fraud and abuse of the system, any more than a law saying 'Don't shoot your neighbor' is going to stop some guy from shooting his neighbor."

His analysis -- particularly the possibility that predictions might lead to lawsuits -- is pretty much seconded by Frank Borelli, an FEI board member and chief financial officer of Marsh & McLennan, the big diversified New York financial institution. In addition, Borelli fears that the Jenkins plan might force a company to provide information that it wouldn't want its competitors to see. Moreover, he says, "even if every company was mandated to provide the same information, you wouldn't get that ideal level competitive playing field, not in the real world, where everybody isn't forthright to the exact same degree." In other words, some companies might hold back data -- or lie.

Another worry is the sheer magnitude of the Jenkins proposals, "the quality and quantity of information and the cost to prepare it versus the benefits to the reader." He points out that "if we produce a voluminous annual, people will tire of reading it; nobody will look at it."

In fact, Borelli advocates streamlining annual reports, rather than expanding them. But that seems quite unlikely. Three years ago, the SEC proposed allowing the use of abbreviated financial statements in annual reports. Barely six months later, the flood of negative comments from investors persuaded the agency's chairman, Arthur Levitt Jr., to scuttle the idea.

On the other hand, the investor community has generally greeted the Jenkins proposals warmly.

One proponent is Patricia McQueen, a vice president at the Association for Investment Management and Research in Charlottesville, Virginia, which certifies chartered financial analysts and portfolio managers.

McQueen observes that more disclosure would raise credibility questions: "How believable is the information going to be? How financially significant are these revelations?" But she insists that "retail investors would certainly want discussion of these matters, audited or not."

McQueen further argues that the Jenkins committee's proposals would create a "level playing field" between institutional and individual investors. "Once you require nonfinancial matter in the annual report," she adds, "the retail investor knows as much as the professional securities analyst, who regularly picks up all this information over the telephone from a company's CEO or CFO. The retail investor won't need the expensive research of a big wirehouse or need to incur the cost of one or all of the securities databases" to interpret the data.

William Dunk, head of William Dunk Partners, a management consulting firm in Chapel Hill, North Carolina (who also produces a yearly commentary on annuals), favors more extensive discussion about corporate managers. "It's foolish to read an annual report for the numbers," Dunk contends. "You primarily read an annual report for an appraisal of management. Who is the executive team? Not just the CEO, but the other seven top officers of the company." After all, Dunk adds, "Wall Street is endlessly meeting with management in order to appraise them -- not to get numbers. Just like Wall Street analysts, you want to learn about the credibility of management."

Dunk also would like more balance-sheet data. "We're still reporting on earnings at a time when the balance sheet has become more important... . It would be a clearer world if more of cash flow could be discussed," he says. To Dunk, the macro is more important right now than the micro. "Is your market in Asia drying up? Are you saturating the market with PCs? Just consider that endless companies are hitting a brick wall on the revenue line; they're just not growing. Why? Because the world markets are tough. For example, Compaq has been riding high; now it has saturated its market. Who would have ever thought that Compaq would hit a brick wall?"

George Putnam III, scion of the family that founded the mutual-fund group of the same name and publisher of the Turnaround Letter, agrees that annual reports should contain more details on company officers and directors. "It's currently very hard to get any information about management and, in my experience, managers make or break a company," he says from his office in Boston.

Laura Martin, an analyst with Credit Suisse First Boston in Los Angeles, has a peculiar problem, owing to the companies she follows: Hollywood entertainment outfits. "In this business, money is hard to follow," Martin observes. "I'd like to see more disclosure on net investment in films, cash cost and amortization." She'd also appreciate more detail on businesses within segments, now hard to come by in Tinseltown. For example, Walt Disney had fiscal 1997 revenues of $23 billion, but it breaks down its reports into only three segments: broadcasting, theme parks and movies. "They have so many businesses within each segment"' Martin says, "yet they don't give me enough internal segment breakdown to find out what Disney is really doing."

Assuming additional financial disclosure does become a reality some day, the biggest winners might not be investors, but rather the nation's accounting firms, which would reap a bonanza from the additional auditing it would involve to determine the plausibility of, say, a company's forecast of the competitive environment.

In fact, says Thomas Ray, the American Institute of Certified Public Accountants director for auditing standards, the group "undertook a project three years ago to enable auditors to provide 'assurance' on management discussion and analysis" and provide "a moderate level of assurance." But, adds Ray, "our accountants are certainly concerned about their ability to judge and measure these things. We are trying to circumscribe what we will audit and what responsibility we are willing to accept."

In truth, the controversy over what should be included in annual reports may just now be starting to heat up. How it will play out is uncertain. But one thing seems clear: Whatever information is offered -- audited or unaudited, concise or verbose -- serious investors want more of it. Whether they'll get it won't be known for a couple of years.