Financial Reporting Numbers Game

Posted on November 9, 2009 by David Laidlaw

One of the subjective criteria that we assess when analyzing a company is the quality of the corporate management.  As with many aspects of our research process, this process is subjective.  It is impossible to read the Curriculum Vitae for each corporate officer and then determine in aggregate whether or not the management is hard working and ethical.  One thing that we do focus on as a reflection of management quality is the accuracy and depth of their financial reporting.

The SEC requires public companies to report financial results at least quarterly and whenever any major event occurs that would have a material impact on the company’s stock price.  All results are reported accorded to Generally Accepted Accounting Principles(GAAP) as promulgated by the Fair Accounting Standards Board (FASB).  The regulations and standards are extremely exacting covering the vast majority of iterations that could arise regarding what to report and how to report it.  Given the specificity of the rules, one would expect that there would be little differences regarding the quality of financial reporting between companies, especially those in the same industries.  However, this expectation does not come to pass.

The qualitative differences between corporate disclosures in financial reports are wide.  Too many companies report the bare minimum as required and withhold vital data claiming they do not want to release the information for competitive reasons.  For example, Palm, the smartphone maker and pioneer in the handheld device space, introduced a new phone, the Palm Pre, in June.  In its recent earnings release, the company stated that it had sold 823,000 smartphones during the prior quarter.  However, when pressed on a conference call, management clarified that those sales were not all Pres, but included earlier generation phones.  An argument could be made the company did not want Apple (iPhone) or Research in Motion (Blackberry) to know the exact sales of its new phone, but industry and Wall Street know that the Pre is a very distant competitor to the dominant phone manufacturers given all the releases from competitors and the wireless companies themselves.  Vague reporting also plagues areas such as proprietary pharmaceutical companies where companies are guaranteed monopoly production according to FDAregulation and patent protection.  For instance, Alexion pharmaceutical makes a drug to treat an extremely rare blood disease called PNH.  While it releases total revenue figures, the company refuses to disclose how many patients are taking the drug in its major markets in North America and Europe. 

As usual, conflicted incentives cause these holes in reporting.  Managements often obscure useful information as they fear the release will not reflect well on that company’s underlying strength and future prospects.  Information is withheld to prop-up the company’s stock price long enough for management to sell its options and personally enrich themselves at the expense of their shareholders.  We have found through experience that the accuracy and degree of disclosure speaks volumes about the quality of corporate management and is a vital component of our decision-making process.