May 30, 2012 7:51 pm
End short-term financial reporting fudges
Over the past 20 years or so, executive compensation has been increasingly tied to stock prices as directors have pursued the laudable goal of aligning managers’ and shareholders’ interests. The unintended consequence has been executives attempting to boost their stock prices by maximising short-term results, irrespective of the long-term implications. Short-termism played a role in the corporate accounting scandals and the global financial crisis of the past decade and is setting up society for more pain. If businesses and politicians do not address it, more financial woes may be in store and companies will continue to bypass opportunities that only pay off in the long term. Earnings management is one of the worst symptoms of short-termism.
.
.
Today’s financial reporting falls far short of giving investors the information they need to value a company’s shares. The tinkering at the edges that the International Accounting Standards Board and the Financial Accounting Standards Board have done is insufficient. We need more fundamental change.
.
Companies and investors fret over shortfalls of a few pennies in earnings per share even though the earnings number is incomprehensible – because it mixes realised cash flows with subjective estimates of highly uncertain future outlays. Single estimates for these uncertain items make the earnings number even less useful because they ignore the wide range of possible outcomes. Earnings per share create an illusion of certainty that fails both investors and companies. There is a better way. We need to adopt a corporate performance statement that is transparent and relevant for assessing value. This should include two separate sections: the cash flows the company realised during the reporting period and estimates of the company’s future cash flow commitments. The statement begins with revenue and deducts cash outlays for operating expenses and capital investments to arrive at free cash flow. This is the cash available to pay interest and dividends and gives investors a baseline from which they can assess the company’s prospects. Clearly stating the individual items that determine free cash flow is the best way to serve investors.
The second section presents estimates of the cash flows that the company anticipates it will need to satisfy future financial commitments, such as pension liabilities. Reporting a single estimate to capture an uncertain amount leaves investors in the dark. This corporate performance statement presents a most likely, an optimistic and a pessimistic estimate for each account. Management’s discussion of the factors driving the estimates and the likelihood of each enables investors to form their own expectations in an informed fashion.
The corporate performance statement would have been useful, for instance, in informing the debate over how to value mortgage-backed securities during the subprime lending crisis. Critics argued that forcing banks to write down their long-duration securities to fire-sale prices understated their value and exacerbated the financial meltdown. Other observers maintained that the low prices fairly reflected the poor decisions companies had made, and that investors were entitled to know the unvarnished truth. This type of controversy vanishes when there are three estimates. Fire-sale prices are appropriate for the pessimistic estimate if it is likely that creditors or regulators will force the bank to sell assets to stay afloat. The optimistic scenario reflects the present value of holding the securities until market prices recover. The most-likely estimate lies in between. This disclosure acknowledges that there is no right answer, only a range of possibilities.
When investors and creditors have the information they need to manage their risks, they lower the rate of return that they demand. A lower cost of capital allows companies to invest profitably in more projects, leading to stronger economic growth.
.
Investors, managers and accountants are all heavily invested in the current accounting model. But this corporate performance statement offers benefits too great to ignore: not only more useful information, but greater trust in public companies and capital markets.
..
The writers are chief investment strategist at Legg Mason Capital Management and professor emeritus at Northwestern University’s Kellogg Graduate School of Management
Copyright The Financial Times Limited 2012.
0 comments:
Publicar un comentario