As the world’s stock markets braced themselves for more unpleasant surprises in the wake of “Enwrong”, “WorldCon” and “Xeros”, calls were being made for the business community to address a series of key issues in financial reporting.
Ken Lever, pictured right, FD of engineering company Tomkins and a former partner at Arthur Andersen, told the ICAEW annual conference in London, in July, that financial reporting in today’s economy has not responded well to the concept of shareholder value. He urged that the means be found to present a broader, more realistic and balanced picture of an entity’s financial condition in order to gain access to capital markets.
Lever noted that management has played its part in these problems. All too often, he said, boards concentrate on the wrong things and send the wrong signals. For example, in the 1990s, many senior executives waxed lyrical about aligning their incentives with those of their shareholders, only for those same executives to grant themselves huge share option entitlements.
“Few executives actually understand what the term ‘shareholder value’ means,” he said. “(They should ask) what creates value, and crucially, how do you present that to the outside world?”
Lever quoted economist Alfred Rappaport, professor of Management at Northwestern University in Illinois, who regards shareholder value as the “economic value of the enterprise, less any residual debt left in the business, (where) economic value is today’s value of the future free cash-flow that is deemed realistically sustainable by the markets over a defined time-horizon”.
But he argued that few people have understood this, and that many have made the mistake of confusing shareholder value with economic value, or have even conflated economic value and share price. “Take Tomkins’ share price, for example,” he said. “It has fluctuated between 130p and 270p in recent times – but this sort of movement does not reflect the economic value of our company.”
Lever said it is vital that companies publish the right information.
Modern annual reports look like marketing brochures, with financial data, including the balance sheet and p&l, relegated to the back and printed on inferior quality paper.
“A key point is to get as much of the information that management uses (when making its decisions) out, so investors can understand it,” he said. Even some commercially-sensitive information, particularly business development plans, should be published, he added.
However, Lever admitted that Tomkins would be unlikely to release detailed projections and information relating to cash creation, although the company would “if the mood warranted it”.
But Tomkins would provide clear statements about its business activities, because openness with investors pays dividends over time, he said. The more transparent and realistic a company’s messages, the more likely the long-term prospects will be appreciated by investors.
Lever said that the major problem with current investor relations is that too much emphasis is placed on a historic view of a company’s fortunes, with too great a faith placed in an objective assessment of its condition.
“I prefer the economic model, which looks at cash and the future, which customises information for variable needs, and which pays greater heed to non-financial data,” said Lever.
He argued that traditional financial reporting data does not, and was not intended to, provide guidance for economic investment decisions, although this was not to suggest that such information did not provide help to investors.
Lever offered a number of solutions to the problem of the information gap, none of which, he said, were intended to be a “silver bullet”. “Offer prospective information – data that gives some guide to the future. Identify risk and its impact on the cost of capital. See what the value drivers are and look at performance indicators with a view to progress over time,” he said.
Lever characterised good information as being of high integrity, relevant, reliable, transparent and capable of verification. “Effective investor relations is easy,” said Lever. “There is no mystery if the message is clear. It should include external reporting, such as the annual report and OFR, and briefings to analysts, investors and press alike.”
The golden rule, Lever added, “is that the information should be available to one and all – and the more often the better”.
The way forward was clear, he suggested. “Recognise the limitations of accounting information, reduce the complexity and presentation of financial information, focus on prospective information, present a balanced picture of risk and potential reward, and report relevant qualitative and quantitative information,” he said.
Lever also hinted that a new regulatory regime may be necessary to provide a better framework for communicating with investors.
Looking to the future, Lever said there would be a key and principal benefit if his advice was heeded. “The risks run by investors and lenders will be decreased, a lower return on capital will be accepted, so all members of society will benefit and capital will be directed into those areas where value can be created,” he said.
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