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Below the Iceberg of Better Reporting

Louis M. Thompson | February 20, 2008

The Securities and Exchange Commission launched a much-needed initiative last year in creating the Advisory Committee on Improvements to Financial Reporting. The SEC staff will now review the Committee’s draft decision memo (you can see coverage of the memo in the “Rules and Proposals” section of the magazine this month) and make recommendations to the SEC for implementation.

In introducing its draft report in January, the Committee stated its belief that financial reporting should provide information that helps users to make investment, credit, and similar resource allocation decisions. But the report also lamented, “Over time, financial reporting has become a burdensome compliance exercise with decreasing relevance to users.” In response, the Committee has made some bold recommendations to make financial reporting more relevant and less complex.

Throughout the history of corporate reporting, financial disclosure has dominated the scene, because financial information is largely measurable and tangible. And while this information can be subject to interpretation, users of financial information rely on it significantly in making investment decisions.

But, there is something ironic about the process investors use to assess the total value of a company and its prospects. Experts such as Baruch Lev, accounting and finance professor at New York University, contend that more than half of the market value of the average S&P 500 company is due to non-financial factors. These factors are often called “intangible assets.” Imagine the valuation proposition as an iceberg: The financial factors are visible above the water line, but the greater part of the iceberg is floating out of sight.

In his book, “Intangibles: Management, Measurement, and Reporting,” Lev makes the case that value (that which gives a return on investment) is created by investing in R&D, employee training, brand creation and maintenance, patents, and business alliances, among other factors.

In a landmark 1995 study called “Measures That Matter,” conducted by Ernst & Young’s Center for Business Innovation, a sample of more than 200 buy-side investors were presented with specific companies in four industry groups. The investors then were asked to allocate their investment capital among those companies and specify the factors that were most important in making their decisions. Except for pharmaceutical companies, where innovation and new product development were ranked first, “quality of management” was the top-rated factor in making investment decisions. That study also found that more than a third of the factors considered in their decisions were non-financial.

In follow-on studies conducted by David Larcker and Christopher Ittner, co-directors of the Wharton Research Program on Value Creation in Organizations, they found that while companies have a sense of the strategically important factors that drive value, the companies also do a poor job of measuring performance in these areas. And I would contend that they are probably doing a poor job of communicating these factors to the investment community.

I assisted Sarah Mavrinac, a former Harvard Business School professor, with her Ernst & Young “Measures That Matter” study, and over the years I’ve spoken at numerous forums about the importance of communicating non-financial factors to investors. I’m often asked how you measure “quality of management.” My answer is that while it may be difficult to quantify, investors know quality of management when they see it. That is why it is so important to feature the senior management team at investor days, in presentations before investor and broker-sponsored conferences, and during individual meetings with institutional investors.

During these presentations, it is vital to communicate a clear corporate strategy that the investors can understand and accept, along with demonstrating that the company has the financial and human resources to implement the strategy.

For example, at a recent investor day presentation by a major aerospace and defense corporation, an investor asked the CEO how the declining number of engineering graduates in the United States might affect the company’s effort to recruit top-notch engineers for its R&D program. Clearly, this investor was focused on an issue that might affect the company’s ongoing strategy of maintaining a strong R&D program—not a factor contained in his financial spreadsheet.

Professor Lev has concentrated his research in the R&D area, given that R&D is often a separate line item in the financial statements and that investment can be related to, or perhaps even measured against, the development of new products.

Another area that can be measured is customer satisfaction, as determined by surveys and ongoing customer relationships. The value of brand identification can also be measured in the context of brand recognition and in relation to competing brands. In my November 2007 Compliance Week column, “Perfecting the Art of Reputation Management,” I gave examples of how reputation issues affect the bottom line of the cited companies.

We are likely to see companies increasing communications about the various sustainability issues under the umbrella of “corporate social responsibility.” We are already seeing in European disclosure documents statements about how companies handle their environmental practices.

I have found over the years that it is difficult to get companies to recognize the importance of communicating how they are enhancing value by investing in various non-financial areas. A decade ago, while conducing a session at a Fortune CEO Forum in Boston on the “Measures That Matter” study, a CEO said that he had just visited with portfolio managers at Fidelity Investments the day before, and nobody asked him about any of these factors. I told him that companies must take the initiative because this information isn’t contained in portfolio managers’ spreadsheets, and they tend to be focused on your financial performance. At that same forum, Cisco Systems CEO John Chambers said that the most important factor in Cisco’s acquisition strategy was capturing intellectual capital through non-hostile acquisitions. (In hostile acquisitions, he said, you are most likely to lose at least a portion of this most important asset.)

I believe that we should stop calling these factors intangible assets and refer to them as integral market values. The word “intangible” suggests that they are non-specific and cannot be measured. This discourages senior managers from discussing them when communicating with investors orally or in written reports. The term “integral” refers to a component as essential, fundamental, indispensable, intrinsic, or requisite. And these components are an “integral” part of a company’s “market value.”

I would also suggest that once the SEC acts on the Advisory Committee’s recommendations on improving financial reporting, it also consider creating a new advisory committee to study improvements in reporting “Integral Market Values” to assist users in their valuation of companies. In a December 2003 guidance release, the SEC attempted to get companies to improve their disclosures in the Management’s Discussion and Analysis. One suggestion was that companies comment on non-financial factors that drive value. Yet, not much has changed in the content of MD&As to make them more useful. And with the Commission’s current focus on the use of XBRL (eXtensible Business Reporting Language), it is possible to develop taxonomies for tagging Integral Market Values that can be used in making comparisons among companies.

It’s time to take an extensive look below the surface at that portion of the iceberg where long-term value can be created and how companies can best communicate this information to let investors make more comprehensive investment decisions.