Quality Financial Reporting for Investor Relations Officers

PART FOUR IN A SERIES

In the preceding three columns, we described the Quality Financial Reporting paradigm. It is an attitude, not a set of procedures. By adopting a QFR strategy, management tries to build positive and lasting partnership relationships with capital markets that lead to lower capital costs and higher stock prices.

QFR is practiced to produce financial statements and disclosures that reduce uncertainty by providing complete, timely, and otherwise useful information. In two prior columns, we speculated that applying QFR would change the work of chief financial officers and legal advisers. This week, we look at what QFR does for the job of the investor relations officer.

A Critical Role Beyond Compliance

The field of investor relations is focused on communication and disclosure. One definition, which we will revisit in a moment, was penned by the National Investor Relations Institute: "Investor relations is a strategic management responsibility using the disciplines of finance, communication and marketing to manage the content and flow of company information to financial and other constituencies to maximize relative valuation."

With the most recent legislative and regulatory developments that have ensued post-Enron, this IR function is more important than ever before. Investors have ostensibly lost faith and trust in all companies and the capital markets in general, not just those who have been proven guilty.

We think the IR responsibility aligns almost perfectly with QFR. As a result, IROs can apply QFR to assist management in selecting financial and other kinds of reporting policies to build relationships with investors and potential investors that reduce uncertainty, promote trustworthiness, mitigate risk, and reduce capital costs. The idea is to upgrade the reported information's quality by going beyond mere compliance with minimum standards.

A Definition Revisited

We want to briefly examine the phrase in the NIRI definition: "to maximize relative valuation."

Specifically, we shudder over the word "maximize."

Conventional wisdom holds that a higher stock price is always better, but the real situation is more complex. We think every security has an inherent "intrinsic" value that is shaped both by prospective cash flows to its holders and by the risk of actually realizing those cash flows.

The objective of financial analysis is to first estimate the security's intrinsic value and then compare it to the market value. If the markets have underpriced the security, profits can be made by buying it and waiting while the markets bid the price up to the intrinsic value. If the security is overpriced, it is time to sell the stock (if you own it) or sell it short (if you don't). The markets are said to be efficient if they process information and implement these decisions very quickly. In efficient markets, a stock's trading value rapidly converges on its intrinsic value.

The Objection

So, here is our objection to efforts by management to "maximize" a stock's value: if these efforts overprice the stock, those who buy it (new stockholders that management works for) face a loss. And, if the stock is undervalued because the markets don't believe management, then the sellers (stockholders that management was working for) face a loss as the stock rises to its intrinsic value.

Thus, as we see it, the role of the IRO is to keep the markets informed so that the market value stays near the intrinsic value. This is a strategy championed by many investment gurus, including billionaire Warren Buffett.

A New Strategy

With that point clarified, what can IROs do to promote the stock?

The first area of focus should be to reduce the risk that the markets will be underinformed by encouraging management to adopt QFR and capture its advantages.

While it's great to have toll-free response lines, websites, newsletters, stockholder magazines, and glossy annual reports, market values are really driven by these two factors: prospective cash flows and risk.

QFR most directly attacks the latter; it's up to management to increase the stock value by improving the prospects for future cash flows.

To encourage QFR, IROs need to curb managements' tendency to manage the financial statements instead of the business. Although earnings management is ubiquitous, plenty of evidence shows it doesn't work. Indeed, it may cross the ethical line into deception, which is a sure way to clobber share value.

Compliance Isn't Enough

Next, the managers need to understand the inadequacy of merely complying with GAAP. It is not enough to meet minimum standards and it is shortsighted to apply cheap accounting practices. Managers are also misguided if they focus on legal defensibility to the detriment of quality disclosures (see last week's column).

The IRO's task is to get managers to report information that actually reduces uncertainty and investors' risk. They must not increase them by adopting inferior reporting policies.

The mention of "marketing" in NIRI's definition of IR also interests us because the most basic tenet of QFR calls on management to shift to a market-driven focus. In other words, reporting decisions should meet the investment community's demands for information, and should not be driven solely by the company's point of view.

So much of what is in GAAP reflects what accountants want to provide, which explains — for example — the focus on historical costs instead of assets' fair values. It also explains why auditors don't think their independence is compromised by consulting. Those are "supply-driven" perspectives, not demand-driven; it's possible — even likely — that the market feels quite the opposite.

Examples

To illustrate our point, try answering the following questions as if you are a top manager of a public company:

Do you prefer options expense to be on the income statement or in a footnote?

Do you want all liabilities on the balance sheet or some off the balance sheet?

Do you want a tough and thorough auditor or a complacent friendly auditor?

We suspect your answers are as follows:

In a footnote;

Off the balance sheet; and

Complacent and friendly.

Now, answer them as if you are a sophisticated financial analyst trying to decipher the company's intrinsic value. We think your answers will be:

On the income statement;

On the balance sheet; and

Tough and thorough.

This complete disparity has existed for literally decades — accountants and managers have dominated the standards setting process and resolved issues for their own benefit while neglecting the market-driven needs of "users."

QFR turns that relationship around. IROs are uniquely positioned to get that point across.

If you're interested in reading further and getting more examples of how to implement QFR, see our book, Quality Financial Reporting, published in 2002 by McGraw-Hill.

In Part Five, the authors summarize their five-part series on QFR.