ACCOUNTING COLUMN - Investors want better information - and eventually they will receive it

Use of the concept of shareholder value as a mainstay of company strategy can be seen as an attempt to turn financial reporting from a backward-looking activity into a forward-looking one. From the management perspective, the focus on value is a reminder that the use of equity capital is not free. Equity is invested in the expectation of earning a return, and management only creates value if the company’s return on capital is greater than its cost. To achieve this, management has to sustain a company’s source of competitive advantage and identify and exploit future sources of competitive advantage. Of course, as management becomes more focused on creating shareholder value, investors naturally become keen to understand management’s thinking and strategy. As a result, investors increasingly look for long-term future-orientated information – they want evidence that management has indeed set its sights on creating shareholder value. This need for evidence is the prompt for Inside Out: Reporting on Shareholder Value, a discussion paper from the ICAEW’s increasingly impressive Financial Reporting Committee. It argues what many financial directors already know: namely that despite investors’ keen interest in the development and implementation of company strategy, the annual report includes too little strategic and other future-orientated information. The committee recommends that management should report more transparently to investors on “the foundation of their business model” and in particular on their strategy, and the key indicators of successful implementation of that strategy. The committee is suggesting that the disclosures should relate to strategy, marketing and competitive positioning, key performance and value based measure of performance. This translates into seven areas of disclosure for the company as a whole and for each significant business activity: – describing the strategic ambitions; – indicating the strategic direction together with target or milestones; – describing the strategic decision-making process; – describing the performance management process; – providing some calculation of the preferred measures that are used internally to monitor economic performance; – describing the key drivers of value in the various business activities; and – measuring performance – financial and non-financial – by marking out the key drivers of value that are used internally to monitor potential in the business. While the authors of Inside Out have managed to find some real life examples of the sort of measures they propose – focusing mostly on description of strategy – there is ample evidence that this sort of reporting is in its infancy. This finding is backed up by the recently published Well Rounded Annual Report, which is the Foundation for Performance Measurement’s second survey of the annual reports of FTSE-100 companies. It found that annual reports do not provide readers with the information they need to make informed judgements about investment in those companies. For instance, the Foundation found that not a single FTSE-100 company published a target for innovation, management performance, brand development, supply chain, staff performance and learning, or customer service. Perhaps even more surprising, only 13 of these top companies published a target for financial returns – not one retail bank, retailer or telecoms company did so. Of the honourable exceptions, EMAP states in its annual report “Normalised operating margins increased to 19.5% (1998: 18.4%) and we are now within a whisker of the 20% we set ourselves for the year 2000.” The argument against publishing is that information about a particular aspect of performance may be of more use to competitors than to current or potential investors. However, the Foundation dismisses the confidentiality argument as a red-herring. It says: “Given the virtual absence of information about some aspects of performance in current annual reports … companies could disclose far more data on the kinds of measures they use internally before the issues arises at all.” However, the pressure to open up may become irresistible. As David Phillips argues in a recent PricewaterhouseCoopers publication, ValueReporting: Forecast 2000, there will be fewer and even more powerful institutional investors in the 21st century – and they will dwarf the companies that they invest in. Their importance, and the increasing importance of shareholder value, will mean that those finance directors and their colleagues who won’t disclose will surely find themselves punished as the City knows best – it will ensure that their companies’ share prices underperform. Peter Williams is a chartered accountant and freelance journalist.