May 28, 2017

True and fair? No, annual reports are as clear as mud

Modern annual reports are pretty useless documents. Prospectuses are not much better. Public companies publish vast quantities of this type of financial information, but most of it is not fit for the purpose of helping investors make better decisions.

Unfortunately, statutory accounts have become increasingly complex and obscure — and therefore impenetrable, even to professionals.

Investors, analysts and lenders rely on the financial statements of plcs to understand their creditworthiness and performance. Yet I suspect fewer people than ever actually read these expensively prepared tomes. They are put off by the arcane content, which is primarily designed to comply with the ever-expanding rulebooks promulgated by the accounting standards bodies and the Financial Reporting Council.

The proliferation of technical and disclosure requirements has increased the workload of auditors, but has it actually made accounts more transparent, or easier to grasp?

According to the accountancy firm Deloitte, the average annual report has grown in length by more than 50% over the past 10 years. They are now typically 135 pages long. The reports of the big companies are even longer — BT’s is almost 300 pages. The justification is that there is more regulation. As ever with bureaucrats, form has triumphed over substance.

The purpose of financial reports is to provide understanding. Any fool knows that clear, concise information will be better read and more easily comprehended than cryptic and lengthy material. Ultimately, any type of communication is pointless if it is abstruse and ignored. But it seems quantity over quality is the preference among regulators and auditors.

I have been using corporate annual and interim reports for more than 30 years, since I first studied them as a stockbroking analyst. They have become steadily more opaque and less relevant during that period and, as a result, I believe that their effectiveness has materially deteriorated.

The regulators and the accounting profession are deluding themselves if they believe that quality and usefulness have improved. I suspect only a small minority of institutional investors — let alone private investors — actually read the detail of the annual reports produced by the companies they back.

The authorities might argue that modern big business is a complex affair, and so sophisticated documentation is inevitable — as well as required by experts, who are qualified to interpret it. Supposedly, this justifies the extensive use of jargon and the many inscrutable methodologies devised by the accountants to present the numbers. Yet lots of crucial information is absent from statutory reports — order books, loan covenants, contract terms, technology updates and so forth. This might be supplied in non-statutory presentations, but the system does not seem to be functioning well if such vital stuff can’t be furnished in 300 pages of an annual report.

Last year, a book called The End of Accounting, by Baruch Lev and Feng Gu, proposed an overhaul of financial reporting. Among other things, the authors were heavily critical of how intangible assets are treated in financial statements under generally accepted American accounting principles (GAAP).

Over recent decades, investment in patents, software, brands, know-how and the like, has outstripped corporate investment in tangibles — yet the accountants struggle to treat these assets in a sensible way.

The book called for the recognition of “strategic resources” that are valuable, rare and difficult to imitate. These would be itemised in a “strategic resources and consequences” report.

In industries such as oil and gas, media, pharmaceuticals and insurance, such an analysis would be far more useful than much of the usual financial data in an annual report. The disclosures would be more relevant when determining value than focusing so much on corporate earnings, which are much diminished as an investment tool.

So often, annual reports and company presentations can end up confusing rather than illuminating an audience. Larger companies such as General Electric offer at least half a dozen measures of earnings.

Adjustments for earnings at many companies are legion — the elimination of one-off items that supposedly distort the true, underlying picture. HSBC had 14 “significant items” last year, which led to adjustments in its reported profits.

I speak to finance directors and chief executives who despair at how over-long and impractical their annual reports have become. But no one really protests; it somehow feels as though this inexorable enlargement is a natural phenomenon, like the rising of the sun in the east every morning.

As ever, there are no quick and easy answers to this mess. However, with financial reporting, it seems to me that more has meant worse — and investors are the losers.