14 November 2006

Reporting: keep it simple, stupid

A rather lengthy response to a post over at Dennis Howlett's place.

I, too, find it strange that we're having the debate on IFRS now - when the damage has already been done. I can understand why fair value accounting was seen as a viable way of taking company reporting forward, but the tools just ain't there. (And although I sympathise with Dennis's finance/HR alliance ideas, the fact is that in the vast majority of companies, HR is a substandard function that just isn't up to managing its people well, let alone coming up with viable ways of communicating their value.)

My view - based on nine years of watching what FDs actually do and hearing how they feel - is that we need to ditch the whole idea of comparability. So I guess I'm actually siding with the Big Four - although I agree with Dennis that they've been a bit disingenuous in how they've gone about this. Here's my thinking.

Most good managers don't run their companies to engineer reported results anyway. We've seen what happens when they do (Enron, WorldCom, iSoft etc etc) and those of you with an accountancy qualification know how much leeway there is in the standards even when (in theory) we can all agree on what they mean. Instead, they use a set of targets and metrics – many of which are shared, like ROCE – to monitor their performance and produce better results. Knowing what those targets are and how management is performing against them is surely more use to investors that how they’ve been filtered into a set of accounting standards. It also means companies can focus on the real drivers of their particular businesses, not some arcane way of segmenting their accounts that fits a theoretical notion of how you uncover value.

I was talking to an M&A adviser at KPMG the other day about the market research industry. He pointed out that it was almost impossible to compare any two businesses in the sector. "Evaluating MR companies is tricky because it’s hard to find true like-for-like comparisons," he told me. "Even with an Ipsos or a TNS, where you have a big group mostly involved with MR, they present their results differently and the only way to really compare them is net margins. But even then, with so many M&A deals going on, it’s hard to make real comparisons between them on like-for-like basis."

In fact, many professional investors already take a case-by-case approach. They get close to companies to understand them beyond the accounts – that’s what gives them an edge as professionals. Some like to focus on a couple of key metrics – Terry Smith once told me that all he was interested in was cash, and talking to management was just a distraction! I suspect many analysts and institutions already operate more like private equity managers now – they’re looking way beyond IFRS and into their own set of either unambiguous or tailored value drivers.

A majority of private investors don’t read the annual report and accounts anyway – or if they do, they’re more likely to be steered by the marketing bumpf at the front than the crowd of figures at the back. And a really smart investor looks at things they can see – joking aside, if you want to know which retail shares to buy, spend an afternoon in Bluewater or your High Street. If M&S is packed… well, you’re in possession of intelligence that won’t be in the accounts for another six months. Buy.

Bottom line: whatever happened to caveat emptor? By scaling back the accounting standards to a bare minimum that allows the banks, investors and the tax man to see a couple of key metrics presented objectively (cash! net margin!), you force companies to compete for finance on their own terms. And you force finance providers to take a much harder look at the companies they invest in. If that means some people get burned because they choose to believe outrageously optimistic statements or shonky metrics from management – well, that’s their look-out. Even my old mum knows that if something looks too good to be true, it probably is.

But the companies that do engage in transparency, the managements that have a track record of good risk management and delivering results – they’ll get the lower cost of capital that, it has been suggested, is the big benefit of these increasingly complex and prescriptive accounting standards. (Of course if FDs, analysts, investors and regulators all think accounts are more confusing under IFRS - and they are - then cost of capital will rise...) And if investors think management isn’t transparent? Big flashing warning signs should go off and that obfuscatory management should be removed.

The one glimmer of hope might be that the ASB and the IASB pursue the international FRSSE for all non-“public interest entities”. But they’d have to take some bold steps to simplify it still further. FDs and investors, I believe, would breath a sigh of relief.

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