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Fudge, but not so sweet

OUTRAGEOUS executive pay, unwarranted executive bonuses, rewards for failure and executive remuneration far outstripping returns to shareholders, are just some of the phrases that capture the headlines and make the running in the “Occupy” realm today. But executive pay, however important, is not often top of shareholders’ engagement agendas. Shareholders are nearly always far more interested in a company’s business objectives, the strategies for achieving them and progress against those strategies.

Of particular concern to shareholders is the variable quality of segmental disclosures in annual and interim profit announcements. In my experience, one of the biggest bugbears investors have with FDs, audit committees and auditors is the extent of “fudge” in so many presentations of segmental results. There are many tricks of the trade in this area and companies and auditors too often lose sight of what their shareholders are looking for here – sometimes it seems, almost to the point of overlooking fiduciary duties.

Segmental disclosures

The sort of things that can obfuscate segmental disclosures include the allocation to central or head office costs of items that properly belong to a business segment, fudging the segment definitions to hide the extent of over or under performance of the best and worst businesses, questionable bases of allocation of shared costs across the business segments and inadequate disclosure of the capital employed in each business. When challenged by investors on this, auditors will often point out that they are reporting on the accounts of the group as a whole and not on individual segments – a view almost universally derided by investors, who want to analyse the trends of performance of each main business segment. Shareholders often struggle to assess their boards’ capital allocation policies and actions when the segmental disclosures have been over-massaged.

Even well-intentioned FDs and audit committees can find it hard to break out of previous years’ poor segmental disclosure and can become trapped into continuing to hide poor performance within the results of their better performing businesses. What starts out one year as a slight shading of the segmental analysis without distorting the overall results story can all too easily lead over a few years to severe distortions of the relative performance of different businesses. Even worse, boards can start to believe their own disclosures and allow them to lead to distinctly sub-optimal capital allocation decisions.

An unfortunate unintended consequence of this can be the under-rating by investors of the best-performing businesses, either because they believe the reported figures and, therefore, do not appreciate how good a particular business is, or because they are confused and discount for that. While the hiding of a poorly performing business within a bigger, better performing segment might help avoid too much shareholder scrutiny of the poor performer, that is not so smart if it is outweighed by a resultant under-valuation of the good segment by the market. Better to disclose the results as they are, explain what actions are being taken to deal with any poor performers and enjoy the fruits of the enhanced results of the more successful businesses

The best segmental disclosures make clear the results of each segment in a way that enables investors to assess whether the company is achieving its goals for each business segment and to form valuation views on them. I am aware of a number of situations in the last two years, where as a result of shareholder encouragement on the issue, companies have improved their segmental reporting to this end and soon enjoyed an enhancement in the rating of the shares. The better reporting allowed the market to upgrade the best businesses by more than the downgrades of the worst.

Modest obfuscation of segmental results can initially appear attractive to directors and even seem harmless to shareholders, but such a benign outcome may not remain so for long. ?

Eric Tracey is a former FD and is consulting partner at Governance for Owners


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