It is normally assumed that when it comes to information, investors can never get enough. Transparency is thought a cardinal virtue in financial markets. Yet the idea that companies should be forced to release financial results every three months is coming under attack across the globe.
A recent British government report into equity markets attacks the practice for promoting short-term thinking among investors and executives. Lead author and Oxford University economist John Kay says that when it comes to data ‘less may mean more, and more may mean less’. His counter-intuitive claim is supported by a growing volume of research. Some scholars even argue that quarterly reports are more damaging than high-profile corporate frauds, such as Enron. Such concerns appear to be filtering through to politicians. The European Union, for example, is thinking of scrapping the requirement for three-monthly releases. Even in the US an increasing number of academics believe that quarterly reports do more harm than good.
The US model
Compulsory quarterly reporting originated in the US. Ever since the early 1970s American firms have had to offer investors these regular financial health checks. Where Uncle Sam has led, many other parts of the world have followed. In 2004 the European Commission compelled companies to publish interim management statements. South East Asian nations have also moved in this direction with only less developed emerging markets trailing.
Many still believe the US accounting model is the right one. Annual reports alone make it hard to keep tabs on a company’s performance, advocates argue. Infrequent reporting can also give an unfair advantage to those closest to the company, says Ulla-Martina Bauer ACCA, a senior manager at accounting firm BDO in Germany, and a member of ACCA’s Global Forum for Corporate Reporting. ‘Quarterly reports give the public a better understanding of how the company is performing throughout the year and that might help prevent insider dealing,’ she says, speaking in her personal capacity. If the public suspects that insiders have an unfair advantage, they may eventually withdraw from the market altogether.
Given such compelling arguments, it might seem odd that quarterly reports are falling out of intellectual favour. The most basic charge against them is that they add far less value than is commonly assumed.
‘Companies can employ a variety of accounting tricks to give the impression of smooth earnings, which can sometimes conceal underlying turbulence,’ says Mark Hanson, who follows US energy companies for investment research company Morningstar. The tricks include tweaking allowances for losses or postponing maintenance on buildings or equipment. ‘As a result, the financial aspect of these reports do not always add value,’ says Hanson.
Quarterly reports can also fail to reflect the long time horizons of many businesses. ‘For many companies, investments take years to come to fruition, which makes these short-term updates often irrelevant,’ Kay says. One example is the oil industry, where a deep sea well often takes over five years to bring into production after its initial discovery.
The deluge of information is not just useless but actively damaging, according to Kay. ‘Even investors who know that a piece of information is irrelevant may feel compelled to act on it, especially if they think others will do so,’ he says. ‘As a result there is usually a flurry of activity around the time of quarterly releases.’ And while stock turnover generates commissions for the banks it depletes returns for pension funds and other investment institutions. ‘This is all bad news for investors,’ says Kay.
Perhaps more importantly, the requirement for quarterly reports can hinder corporate performance. This goes far beyond the strain that updates place on a business’s accounting function. Since company stocks can slide sharply if quarterly earnings disappoint the market, executives may sacrifice long-term value so they can meet expectations. A 2006 survey of 400 CFOs found that around 80% said they would decrease discretionary spending on research and development, advertising and maintenance to hit an earnings target. More shocking still, 55% said they would delay starting a new project, even if that meant sacrificing value. ‘Chief financial officers appear to be willing to burn real cashflows for the sake of reporting desired accounting numbers,’ the report concluded. The main motivation was a belief that even one earnings miss could damage a company’s reputation with the market. Executive heads tend to roll after a few such disappointments.
More damaging than fraud
The report’s authors, Professor John Graham and Professor Campbell Harvey of Duke University and Professor Shiva Rajgopal of the University of Washington, said this practice destroyed more value for shareholders than headline-grabbing fraud cases such as the implosion of WorldCom. ‘Much media attention is focused on a small number of high-profile firms that have engaged in earnings fraud,’ their paper said. ‘We assess that the amount of value destroyed by firms striving to hit earnings targets exceeds the value lost in these high-profile fraud cases.’ The report put the lost value at around $150bn a year in the US, equivalent to two Enrons.
These striking conclusions were backed up by a June 2011 paper by Professor Jurgen Ernstberger of Ruhr University Bochum. He also demonstrated that companies will forgo long-term rewards to avoid losing face with investors in the short term. His study found examples of companies offering bigger discounts to consumers to lift short-term sales, despite being aware that doing so would damage long-term profitability.
A strong case can also be made that investors would not be giving up information of any great value if quarterly releases were abandoned. In October 2011 the European Commission declared that ‘investor protection is already sufficiently guaranteed’ by businesses having to reveal any market-moving information immediately to the market. In the UK alone, for example, there were 133 profit warnings in the first half of 2012, according to Ernst & Young data.
Most experts agree that there are some companies and sectors in which frequent updates are essential. The fortunes of a fashion retailer, for example, can shift quickly depending on the appeal of each season’s line. But there is plenty of evidence to suggest that quarterly reporting is counterproductive. ‘If we want an investment culture that really focuses on long-term value, we need to give up the idea that all companies should be forced to update their figures every three months,’ says Kay.
This article first appeared in Accountancy Futures, Edition 6, 2013