1 Financial and corporate reporting â about this book
Definitions: financial reporting versus corporate reporting
This book deals with a longer-term view of both financial and corporate reporting. We do acknowledge COVID-19, a truly black swan event, and its effect in general as well as the devastating after-effects of this coronavirus pandemic on the economy, government, and financial community. This black swan event will have a lasting impact on financial reporting in general â as all recessions and downturns in economic activity tend to change the financial and reporting rules. This pandemic will focus on going-concern, viability, material disclosures, and the future more than ever before.
From the recent past, the Enron scandal still stands out for the subsequent changes to financial regulations and reporting in the US and its knock-on effect on the Western world â the UK included. As this pandemic has had a much larger impact on the financial and economic world, so its effects will linger.
Financial reporting and corporate reporting: we believe that the two are inextricably linked. Financial reporting and annual reports (and Form 10-K in the US)1 and bi-annual or quarterly reports, or reports dealing with certain specific events, are often combined into a single naming convention and classified as financial reporting. However, the exact definition of corporate reporting differs depending on who you speak to. The annual report now normally includes the corporate report â the so-called narrative section at the front end of the annual report is about 65% to 70% of the annual report, at least for the top 100 companies. That is not to say the financial element has become smaller; it too has increased in size, and we predict it will continue to do so.
Just as disruptive technologies have played their part in changing the world, through such sites as Amazon, Uber, and Airbnb, disruption is starting to appear in accounting, financial reporting, corporate reporting, and auditing. Disruption can develop in a number of ways. We think neither financial reporting nor the accounting profession is adequately prepared for such disruption. This is not just technology driven but also the combined effect of a number of factors. These include: changing attitudes to openness and transparency, public perceptions, continued failures or what appears to be a misstatement of financial results despite the continuing actions of regulatory authorities. In addition the auditors continue to give what is in effect a clean bill of health with a crude pass or, occasionally, fail â a black or white stamp despite many shades of grey. The focus of businesses during and after the pandemic has been on cash and liquidity with an understandable emphasis on short-term survival. This book focuses on the longer term with thoughts of improved agility, flexibility, technology and usefulness in a period where there is a focus on all stakeholders and not just the investors and shareholders.
Abbreviations
There are many abbreviations, and it is not possible to always provide their definition in each chapter. The full glossary and a shortened version are available on www.fin-rep.org.
Reality
The importance of accounting in financial reporting can be answered by one question: What would a manager or investor do in the absence of good accounting and financial information?2 For example, how would you monitor performance? How would you make resource allocations and pricing decisions? Of course, we can argue what we mean by âgoodâ. âRelevantâ and âreliableâ are just words. Tying these down to numbers is a little more difficult. In our research and interviews, some analysts claim they can do this on the basis of the âbig pictureâ, underlying operating factors, and the management team â giving a vote of confidence to Mike Ashleyâs Sports Direct (now Frasers Group) but not Quindell (rightly so) or AO (unclear as to whether they will generate real profitability yet as at 2020).3
Financial reporting is like distilling the essence of a three-dimensional image to two dimensions. In doing so, there are many differences in possible images. There is no single âtrue and fairâ view. There are many âtrue and fairâ views. Accounting rules are not an exact science. The same company with the same physical characteristics and transactions can follow different accounting policies and standards and valuation criteria and hence have entirely different profit figures, both of which meet the magic criteria of âtrue and fairâ.
Has financial reporting become too complex?
There is a feeling that perhaps, with all the new regulations, financial reporting and corporate reporting have become too complex, too messy, too difficult to manage or understand. The opposing view is that it is not complex enough to trigger all the possible alarms. Letâs take the too-messy viewpoint epitomised by the editorial board of the Financial Times (FT); financial reporting must get back to the basics.4 Their view is that measuring a companyâs performance should be relatively simple. Generally accepted accounting principles (GAAP) remain the original standard guidelines for financial accounting. The FT claims that more and more companies are resorting to non-GAAP metrics to present what can be a flattering picture of their performance.
All too often investors and analysts are forced to sort through metrics from an alternative reality, where earnings or profits are âadjustedâ, ânormalisedâ or âunderlyingâ. The justification is usually that these figures give a better picture of the companyâs real performance than statutory results. Sceptics say they are simply massaged to show them in the best possible light. It is telling that managementâs remuneration is often tied to that âadjustedâ performance.
The truth in accounting is rarely black and white. Companies have the right to present their earnings in the most attractive form, and accounting standards, the rules under which the game is played, give them the freedom to do so. There is also often valuable information to be gleaned from which measures executives choose. It is time for a return to a more objective measure. In 1996, around 60 per cent of S&P 500 companies reported at least one non-GAAP earnings-per-share figure. According to Audit Analytics, a US data analyst, by 2017 more than 97 per cent of S&P 500 companies used at least one non-GAAP metric in their financial statements.
The need for greater transparency comes amid a rush by technology start-ups to tap the financial markets with a corresponding rise in more exotic metrics. The FT cites WeWork as an example: a company forced to pull its listing in September 2019, WeWork (auditor EY) introduced prospective investors to a new version of the most common metric for cash earnings, or EBITDA (earnings before interest, tax, depreciation, and amortisation). An early prospectus for a bond offered âcommunity-adjustedâ EBITDA before taking into account âextraâ costs including marketing costs. Community teams manage the buildings, but the number of new measures introduced is amazing in the WeWork prospectus.5
However, it gets much worse.
- 1 WeWork used measures such as enterprise membership percentage, run-rate revenue, committed revenue backlog, contribution margin, and many others.
- 2 The contribution margin is interesting in that it does not include: other operating expenses, pre-opening location expenses, sales and marketing expenses, growth and new development expenses, general and administrative expenses, depreciation and amortisation, and stock-based compensation expenses.
- 3 To get to their version of EBITDA, they add back non-cash GAAP straight-line lease costs, and then that reveals their version of EBITDA, called contribution margin excluding non-cash GAAP straight-line lease cost.
So these expenses added back to make this newly created artificial contribution margin were more than $3 billion in 2019, revealing a small positive figure of more than $0.5 billion. To a casual observer, it looks very much as if these manipulations were made just to reveal a positive figure. That said, the prospectus does attempt some detailed justification for these figures â at best, these are arbitrary arguments. One can think of a whole set of counter arguments. In retrospect, WeWork totally overplayed the underlying reality, and the management team were caught by an incredulous market.
WeWork, with its stylish workspaces, started out with an IPO valuation of more than $47 billion and ended up being nearly bankrupt before being rescued by SoftBank (the Japanese multinational conglomerate holding company) with an equity injection of $10.65 billion for a 28% stake. That investment is now causing some recriminations and regrets in SoftBank6 â subsequently SoftBank divested itself of all shares in WeWork. The trouble is that companies such as Uber and WeWork are newer companies, all with high market valuation but which are making increasing year-on-year losses. Uber had a market capitalisation of $78 billion at peak close to its IPO (summer 2019) and had fallen to below $50 billion by November/December 2019. Uber made an operating loss of between $3 billion and $4 billion in 2018 and 2017 respectively; its loss for 2019 was $8.6 billion, and in 2020 may again be of the same order of magnitude greater. Similarly, WeWorkâs net loss in 2018 was close to $2 billion and was $8.5 billion loss in 2019.
As well as WeWork and Uber, Lyft, Slack (bought by Salesforce), Doordash, Snowflake and Pinterest all made losses. Also, conventional non-tech firms such as CVS, GE, and Qualcomm and older US companies valued at more than $50 billion reported losses in 2018. The Daily Telegraph counted 134 companies that were listed in the US in 2018:7
81pc were loss-making businesses and almost a third were tech stocks, according to the Warrington College of Business at the University of Florida.
The only time the percentage of publicly-launching companies that made no profits at all was equally as high was in 2000, when 380 initial public offerings (IPOs) were recorded â the height of the dotcom bubble.
The FT editorial goes on to postulate8 that one of the challenges has been that there is no standard definition of operating profit under GAAP or the IFRS (International Financial Reporting Standards). Often, companies report an operating profit measure, but it is up to them to decide how to define it, making comparisons tricky. The FT conducted an analysis of a hundred companies in different countries by the IASB (International Accounting Standards Board), which is the industry rule maker for much of the world outside of the US, and found that it revealed nine different variations of operating profit.
The FT reported that in the US, the SEC has escalated its scrutiny of non-GAAP measures and that the IASB is already working on this issue. The SEC (US Securities and Exchange Commission) has decided that it wants to bring more structure to a companyâs profit-and-loss statement and standardise operating profits through a consistent measure. This will still allow companies to make adjustments, but the end result will be greater transparency. Draft proposal...