C LOSI N G V I E WS

137

Closing Views

Numbers investors can trust

Timothy M. Koller
KEVIN KELLY

What counts isnt the bottom line but rather how it is calculated.

ccountants, regulators, and corporate executives are again

embroiled in debate, this time over how to account for stock options issued in one year but sold in another, when their value may have changed dramatically. This is just the latest act in a recurring drama: the conflict between the investors desire for more accurate corporate valuations and the desire of companies to control perceptions of the way particular items will affect their net income. A few years ago, for instance, the debate focused on the techniques companies use to account for goodwill in their acquisitions and whether changing these techniques would damage their earningsand thus their appeal to investors. As baby boomers grow ever grayer, the stated value of pension reserves will be next. Unfortunately, this kind of financial reductionism is a poor substitute for the information that investors really need. Their trust has been battered by stunning corporate greed, ethical lapses of accounting firms, and the malfeasance of high-profile executives and financial analysts. Faced with a political backlash, regulators are right to take steps to restore investor confidence. But unless companies become more transparent and boards of directors provide more information on the underlying performance of their businesses, investors cant be blamed for withholding that trust. Executives regularly sweat meetings with analysts in which the focus is on whether or not a single numberquarterly net incomehas been met. Some believe that good earnings numbers can boost the shares of their companies even if these numbers dont reflect any change in the performance of the underlying businesses. In reality, with the right level of disclosure, markets would see through manipulation of this kind. Despite long arguments over the potential

138

T H E M c K I N S E Y Q U A R T E R LY 2 0 0 3 N U M B E R 3

effect on share prices of eliminating the pooling of goodwill from acquisitions, for example, the impact of the new rules was negligible: the reported net income of some companies increased by 50 percent or more, yet their share prices barely moved as compared with those of their peers. Why? Because the change in accounting didnt alter the underlying cash flows, and the market already knew the amount of amortization in those companies income statements even if it wasnt displayed prominently. The same thing is likely to happen if new accounting rules for stock options are adopted. At a recent meeting with venture capitalists and academics, one topranked sell-side technology analyst confessed to caring little whether stock options were counted as an expense on income statements, much less the value assigned to those options. As long as the income statement or its footnotes gave him sufficient information on their number, exercise prices, and duration, he could judge their impact on a companys value.

Toward genuine disclosure

When investors try to predict future cash flows and profits, past performance becomes the foundation of credible forecasts. A company could provide investors with most of the information they need to assess its underlying performance by more clearly delineating operating and nonoperating items, by providing more information about the performance of individual business units, and by being more candid in the management discussions published with financial statements. If companies moved away from the simplistic focus on single numbers toward a more transparent model, investors would truly benefit.

Details, details
Currently, most companies minimize the amount of detail in their financial statements, relegating much useful information to the footnotes. They also mix together operating (recurring) items with nonoperating (nonrecurring) ones. Financial statements should include more detail, but the present accounting rules dont distinguish between operating and nonoperating items in a sensible way. As a start, income statements should separately identify these figures: Nonrecurring adjustments in pension expenses. These numbers often reflect the pension funds performance more than the companys operating performance, but they can affect financial results significantly. Investors would benefit if they could separately assess a companys skill at managing its pension assets and its operational performance as compared with that of its peers. Gains and losses from nonrecurring sales of assets. Large companies like to improve the appearance of their bottom lines by burying gains from asset sales in their operating results. They claim that the impact of this practice is imma-

C LOSI N G V I E WS

139

terial, but investors should be the ones to decide that. Furthermore, companies should separate the gains and the losses from nonrecurring sales of assets. Executive stock option expenses. The cost of stock options should also be fully disclosed in a separate item of the income statement, not because they fall outside operating expenses but because the amounts are often large and difficult to estimate. Just as each of these items should be listed separately in income statements, balance sheets should distinguishas they now typically dontbetween assets and liabilities used in the operations of a business and those that are not, such as excess cash or investments in unrelated activities. Moreover, cash flow statements should be reconciled with balance sheets more transparently.

Focus on business units

Todays large, complex corporations include many business units, which rarely share the same potential for growth or profitability. Sophisticated investors often try either to value each business unit separately or to build up consolidated forecasts from the sum of individual units. However, their underlying health is hard for investors to discern, since many companies report only the minimum amount of information required, more often than not relegating it to the footnotes at the back of the annual report. Going forward, information about business units ought to be more prominent and detailed. A good case can be made that corporate reporting should even focus on the business units performance, which can be more valuable to investors than consolidated results. At a minimum, companies should produce a clear statement of each business units operating income, in a format similar to the consolidatedincome statement, though without nonoperating and financial items such as interest expenses. Similarly, they should disclose their operating units balance sheets, including details of working capital, property, plants and equipment, goodwill, and all other operating assets. (Cash, debt, pension liabilities, and other nonoperating items need not be shown.) In addition, the financial statements of business units should be reconciled clearly with the consolidated reports.

Analysis that counts

Under US accounting rules, companies must publish with their financial statements a document called Managements Discussion and Analysis of Results of Operations and Financial Position. Many of these reports provide little more than boilerplate disclosures. Investors deserve better: in addition to raising the standard of reporting for business units, companies should explain the effect on revenues of acquisitions and foreign-currency exchange rates as opposed to organic growth. To have a better baseline for forecasting, investors also need

140

T H E M c K I N S E Y Q U A R T E R LY 2 0 0 3 N U M B E R 3

to understand whether a companys reported overall revenue growth was entirely organic (which can reflect operating improvements, for example) or whether much of it came from acquisitions (which can also carry new risks).

Objections overruled
Such supplemental disclosures are already the norm in some industries. Many retailers, for example, break down the effect on their revenues of same-store sales growth and of changes in the number of stores. Pharmaceutical companies even routinely disclose the sales of their major products. But such disclosures arent as widespread as they should be. Moreover, any move toward more detailed accounting will likely generate criticism that it will not only prove too expensive and complex but also lead to the disclosure of competitive information. I disagree. There shouldnt be any significant increase in costs merely to produce information that isor should beprepared for a companys management and board of directors already. Indeed, if companies dont have this information, its absence raises questions about the integrity of their financial systems and the ability of their senior executives to manage. True, more detailed accounts would add to a financial statements complexity. Some investors will neither understand nor appreciate a greater degree of disclosure, but financial statements should be aimed at the sophisticated investors who ultimately drive share prices. Others will gain from the greater level of transparency that should follow. Of course, companies should be allowed to protect sensitive, vital information. In a limited number of cases, some of them should be allowed to opt out of certain disclosures that could damage their competitive position. But more complete financial reporting is unlikely to produce widespread leakage of competitive information.

CEOs and senior executives like to be able to smooth the performance of their companies in order to have the option of offsetting poor performance in one part with good performance elsewhere or to hide low organic growth by making acquisitions. Yet investors will be better servedand learn to trust corporate results once againwhen the people who run companies discard their predilection for accounting devices that artificially boost the bottom line and decide instead to show investors the true complexity of big business.

Tim Koller is a principal in McKinseys New York office. Copyright 2003 McKinsey & Company. All rights reserved. This article first appeared as Accounting: Now for something completely different, in McKinsey on Finance, Summer 2003, pp. 1620.