Published August 2002

Full disclosure by companies, analysts needed

By John Bachmann
Guest Editorial

As the (Enron) situation unfolds, it is increasingly clear that unacceptable financial reporting practices were condoned by individuals who should have known better. The health of the economy depends on our ability to encourage investment in the capital markets — any activity that erodes investors’ confidence in the reliability of information about the performance of public companies can have a broad-reaching negative impact. The question now is, what should we do?

If changes are to be made, I suggest starting with the notion that individual investors, if provided with facts, will generally make wise investment choices. Some feel we need more complex laws, but I believe that would contribute to the problem, not the solution. What is needed more than anything else is complete, honest disclosure, both by companies and by analysts reporting on companies.

Full disclosure should include a brief, simply stated summary of the financial facts, in order of importance and accompanied by timeliness, plus detail about all accounting decisions that meaningfully impact current earnings and their economic impact on the central participants, including officers, employees, shareholders, etc. Following is a list of areas where I believe full disclosure is the best approach:

• Clarity. A summary of financial performance should be provided in plain English.
• Brevity. A one-page summary in a readable type size should disclose what is important. If a company’s management can’t identify what’s important, I question why they are managing.
• Compensation. Few factors reveal more than compensation. It encourages and discourages specific behavior. If an investor knows what the incentives are and who receives them, the actions of those individuals are easy to interpret. For senior executives, disclose all components of compensation, including salary, bonus, retirement benefits, perquisites and stock options. An executive whose incentives are based exclusively on stock price, for example, may make decisions intended to drive the short-term stock price, without regard for long-term shareholder value. For analysts, reveal all components of compensation for the previous year, as well as the percentage each contributes to total compensation — (and) detail their holdings in the companies or industries they follow and any additional revenue the firm could receive from investment banking activities performed on behalf of those companies.
• Earnings. Focus on actual earnings vs. earnings for expenses that companies choose not to include. For example it has been fashionable to study Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Like it or not, these are real expenses, and companies have to account for them.
• Employee stock options. Expense the value of options and disclose the effect they could have on future earnings if exercised.
• Liabilities. Not all debt may appear on a company’s balance sheet. Clearly disclose the company’s liabilities.
• Acquisitions. Show the cumulative total of acquisitions quarterly and annually. If a large number of small acquisitions is made and not properly disclosed, the impact on earnings may be misinterpreted as the result of organic growth.
• Retirement funding. Setting aside funds for workers’ retirement is a significant cost for business — influenced by the projected growth of the total retirement fund. If projections of investment performance are unrealistically optimistic, the amount of the expense will be understated.
• Nonrecurring items. Clearly differentiate normal revenues and expenses from those that are nonrecurring. Require consistency. If an item is a nonrecurring expense, any corresponding income should also be treated as nonrecurring.
• Intercompany reporting. Report revenues and earnings by business or product line. Prominently identify intercompany transactions and their effect on overall results.
• Insider sales. Sales of shares by those considered company insiders should be reported and made public immediately.
• Full disclosure. As required by SEC Rule FD, which governs companies’ behavior, distribute material information to all constituents in the market simultaneously. Enforcement is essential to maintaining investors’ confidence in the markets.

Note that I have not said current practices are bad. Far from it. We want executives to be owners in the companies they manage. However, those of us in management and in the securities industry are the stewards of the capital markets. As such, we must reaffirm our commitment to ensuring fairness for all.

In my view, that requires consistent and prominent disclosure of the facts necessary for an investor to understand a company and its performance.

Ultimately, investor confidence will serve as the solid base on which we grow our economy and our markets.

While President Lincoln did say, “You can fool some of the people all of the time and all of the people some of the time,” remember that he also said, “But you can not fool all of the people all of the time.”

These thoughts by John Bachmann, managing partner for St. Louis-based Edward Jones, a national investment company with 8,357 offices, were passed on to the firm’s clients recently, thoughts worth passing on to our readers.

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