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Disclosure Makes Dollars and Sense

By Dr. Richard Petty

14 April, 2008

In the case of many companies determining the intrinsic value of a business is difficult for experienced professionals, let along the average investor. This is largely the result of what are termed information asymmetries - when one party in a transaction knows more than the other. These endure in spite of the progress that has been made in revisiting old accounting orthodoxies or the efforts made to control more vigorously certain types of interaction between actors in the capital markets.

The financial reporting environment has evolved to ensure that the content of publicly available company accounts is prepared more consistently to make it easier to compare and help with decisions. The introduction of the International Financial Reporting Standards and legislative changes that have sharpened and tightened mandatory reporting requirements in many parts of the world have done much to revitalise company reporting.

However, if maximising company value is the aim, there is still much to do. Most valuations focus on market indicators, and on attaching clearer dollar signs to the “hard” tangible assets of an entity and the cash flows likely to be derived from them. One challenge confronting all types of valuation is that assessing “true” value entails making implicit assumptions, and relying on often skewed market metrics, that tend to compound biases. Placing faith in the end result is akin to trusting a horoscope for life's choices.

One explanation for this is that insufficient information is available to investors to adequately resolve the uncertainty that confronts them when wrestling with how much risk there is and how much it should be compensated. The darker the box, the higher the risk premium, and the costlier the capital. But there are practical steps that companies can take to make their condition better known to investors, thereby inflating value estimates and compressing discount factors in a way that delivers an immediate increase in shareholder value.

Perhaps the most effective action many companies can take is to extend their existing reporting framework to provide detailed supplementary information on the value of their intangibles. This value is in the form of both human capital and structural capital, such as brands, patents, trademarks and systems.

There is considerable empirical evidence that voluntarily communicating information on intangibles, when done properly, leads to an increase in share price. The information does not necessarily have to be expressed in dollar terms. Non-financial performance metrics also work to inform. In this case, all interested parties are sensibly motivated to lobby for a light to be cast into the invisible corners of business that are often hiding places for soft assets.

Flashing this searchlight with the goal of revealing under-emphasised value points is exactly what an increasing number of companies, many of them located in Europe, have done. In 1994, Swedish consulting firm Celemi pioneered a new approach to annual reporting by including in its annual report an Intangible Assets Monitor. About the same time, another Nordic firm in the financial services sector, Skandia, began reporting more extensively than was required by accounting standards, or by law, on its intangibles. Both firms achieved sustained value increases as a result. Skandia and Celemi's efforts to develop an extended reporting model show how changes to conventional financial accounting practices can be engineered successfully by innovative managers without the need to be led by regulatory impost.

The fact that conventional financial accounting practice does not require many non-financial performance indicators to be given adversely affects knowledge-based organisations that are looking to raise capital in the debt and/or equity markets. Intangibles such as staff competencies and customer relationships receive no formal recognition in the traditional financial reporting model. Other intangibles such as brand equity, patents and goodwill are reported in the financial statements only when they meet stringent criteria.

The understanding that the bulk of many firms' value is in their intangible assets, and the acknowledged invisibility of intangible value on balance sheets, has led to calls from regulators, practitioners and academics for information on intangible assets to be more fully disclosed in company annual reports.

Greater disclosure would be good for shareholders. There is a positive correlation between voluntary disclosure and increased market capitalisation. Not reporting fully and fairly increases a company's cost of capital, which leads to lower investment and growth. Upward market pricing adjustments have been observed in cases where firms report in greater detail on specific intangibles, such as patents, and in instances where more general information about human capital is given. Analysts reward firms that report voluntarily on their intangibles by giving more extensive coverage to them.

Voluntary disclosure pays for itself in multiple ways. Extended reporting frameworks that encompass voluntary reporting have been shown to return the investment made in them many times over. They also evince corporate social responsibility, and are aligned with good corporate governance. This suggests that an efficient response by companies seeking optimal market results would be to increase disclosure and transparency in their reporting. So, are companies reporting optimally? If not, why not?

A survey of financial professionals yields some interesting insights. I surveyed 238 professionals - all of whom had extensive experience in the financial services industry - to find out whether sophisticated users of publicly available financial reports found them useful, and to identify ways in which to improve financial reporting. The survey was carried out in Hong Kong, but there is every reason to expect that the results have validity to other markets.

More than half of the respondents indicated they do not find the accounting information provided by companies to be generally useful for decisions. Nearly all respondents think listed companies need to disclose more information and be more transparent, and 92 per cent of respondents do not think companies are required to disclose enough information in their annual report. Most respondents were in favour of the accounting profession and/or the regulatory authorities imposing additional disclosure requirements on listed companies.

The thinking of the survey participants matches the empirical data, with 88 per cent of respondents believing that the voluntary disclosure of intangible assets information by companies should be rewarded by the capital market in the form of a higher share price. And 91 per cent think that having access to reports on intangible value will assist them in making investment decisions.

Curiously in the light of these results, review of the external financial reports prepared by the top 100 listed companies in Hong Kong at the time of the survey revealed that no company was using an extended reporting framework to reveal the hidden value of its intangibles. So, why is it that financial professionals who believe that reporting on intangibles would be decision-useful, do not do it?

There are several possible reasons. First, old habits are hard to break. Most agents who have a role in preparing documents and financial reports that are to be communicated to the general public seem to believe that revealing more information than is mandatory is anti-competitve. This post-modern stance, reminiscent of French thinker Michel Foucault's obsession with power relations, is usually flawed in relation to company value, but it is common. Convincing others that an entity should voluntarily disclose information may be difficult, although it should be simpler to do when armed with evidence that such disclosures tend to have a positive effect on stock prices.

Senior executives often ask me: "Can you tell me by how much [my company's] market capitalisation will increase if the company reports in the way you suggest?" I truthfully answer no, but understanding that voluntary disclosure is likely to increase share price is a beginning. Fashioning a predictive algorithm to explain and quantify the likely effect of such disclosure is a next step. Progress on developing that model has been made and identifying directional trends is possible, but further refinement is needed. Perhaps a fully articulated predictive model will encourage more executives to commit to preparing extended reports.

Second, it may be that poor awareness of how to extend existing reporting models is working against their evolution. There is evidence that points to this - most of the professionals surveyed were not familiar with the tools used by Celemi and Skandia. Only 19 per cent of respondents claimed to be familiar with the Intangible Asset Monitor, and 12 per cent with Skandia's Navigator.

Third, perhaps most market participants are able to fill the information void in the public domain through private channels. A majority of respondents (60 per cent) felt that they were in a poor or very poor position to get hold of information related to the value of the intangible assets of listed companies through public sources. If, however, private information channels are used, a majority of respondents (68 per cent) reported that they could obtain good or very good information related to the value of intangible assets of listed companies. This finding is significant because it suggests that one group of stakeholders is able to gain an upper hand over other stakeholder groups because of the advantage created by special relationships. An equitable balance could be restored if companies were to report publicly the information that they may be communicating privately to certain elite groups.

The positive effect that voluntary disclosure has on share price works fully only if disclosures are public. Making sure all actors in the financial markets, but particularly shareholders, know that voluntary disclosure of intangible asset information has the potential to positively affect stock prices might lead to an increase in public disclosure. Once leading firms take up this challenge and the benefits of transparent reporting are made clearer to all, it seems likely that other firms will mimic their behaviour. Under that scenario, all stakeholders win.

About the Authors

Professor Richard Petty is Deputy President, CPA Australia and Associate Dean, International, at Macquarie
Graduate School of Management. He is also one of the Principals in the Consulting Firm Enright, Scott & Associates, a firm that advises a number of Multinational Corporations, and governments on the economic impact of large investments, regional development within Asia, and issues related to corporate governance.  Professor Petty is Chairman of the HKMA’s annual reporting awards for listed companies in Hong Kong.