Does Quarterly Reporting Hike Risk

Written by YRK Reddy | Updated: Dec 29 2003, 05:30am hrs
For a long time, shareholders were happy if the accounts of the publicly traded companies were audited and finalised and reported within the period allowed by the statute. With the advent of accounting software packages, computer support and intranets, it is obviously possible for most companies to finalise their accounts within a short period. For companies which have a set of long-term oriented investors (bringing in patient capital), a half-yearly limi- ted review would be sufficient.

However, quarterly reporting has been accepted as a new norm of reporting in the US markets and eagerly followed by several others. As a result, we now have a situation where companies are having to prepare quarterly accounts and subject them progressively to a limited review by auditors and report them to the public. Interestingly, Cynthia A Glassman, commissioner, SEC, USA, has expressed concern over the pressures brought in by the quarterly reporting, while addressing the addressing professionals in September 2003. Life in companies has suddenly become quarterly cycled. They are constantly under pressure to show growths in their topline and bottomline while controlling the costs.

Where there are natural cycles in business due to seasonality or other factors, there is an implicit and artificial move to flatten this as much as possible. Moreover, the practice of giving guidance to research analysts and the market puts further pressure on both counts of being able to predict reasonably well and to ensure that the market expectation in terms of the rates of growth are maintained. If there is too much of variance, the quality of forecasting and planning will be open to question and also invokes if the variations are beyond 20% of the limited review by the auditors the requirement to report to the stock exchanges. (It is another matter that these accounts are merely taken note of by the Board and not approved, which makes one wonder where the responsibility must lie, if there are serious mis-statements).

Thus, companies are indirectly fed on the assumption that the market comprises of short-term oriented investors and that they must cater to their needs. The company may, in fact, support and develop such short-term orientation by pandering to such needs in the market place, even if the motive is not to indulge and profit by insider trading. Caught in this vortex, managements may be subjected to conditions where there are incentives to adopt creative or aggressive accounting, if not fraudulent reporting.

As per one interpretation, aggressive accounting denotes forceful and intentional choice and application of accounting principles done to achieve desired results, typically higher current earnings, whether or not the practices followed are in accordance with GAAP; and creative accounting denotes steps used to manipulate the numbers in financial reports, including the aggressive choice and application of accounting principles, fraudulent financial reporting, and earnings management or income smoothing. Fraudulent financial reporting involves intentional mis-statements or omissions of amounts or disclosures in financial statements, to deceive financial statement users, which are determined to be fraudulent by an administrative, civil, or criminal proceeding.

The consequences of these pressures are obvious. Instead of yearly application of deviant accounting practices, the application now would be in quarterly cycles and probably mounting incrementally. Some believe that the overstatement of health, which was probably around 10%, may now have crept up to 20-25%. In the current environment, the disincentives for not being creative or aggressive are very high indeed as the market may punish the companies for not meeting hyped-up expectations relentlessly. This would be the case even if the overall earnings, seen as a residuary income or return in investment by themselves, may be relatively good.

However, in the new world of capital markets, it is no longer the residual income or return on investment that satisfies investors, especially if they enter at a high price. They apparently look to market value addition. This implies that companies keep working hard like strip-tease artists, to keep the attention and attraction of the investors so that they do not vote with their feet by exiting at low prices and accelerate the race to the bottom. At times, if there have been limits to a companys ability to massage around income recognitions, write backs, etc, the company may resort to sweetening the bitter pills.

Typically, such sweetening has been by way of announcing an impending export order, a major contract, additional clients, an innovative product launch, a prospect for new discovery, etc. But then, the market does not necessarily respond to these trite tactics consistently. The media too is a moody intermediary. In such events, the companys management will have to make extra effort to continue their engagement and attraction. At the same time, this yo-yo regime helps people in control of the company to make huge profits, often in collusion with the intermediaries, through insider information cleverly aligned with market influences.

This kind of an atmosphere of pressures for quarterly reporting, guidance notes, keeping the research analysts, media, and small investors happy promotes the incentives for deviant accounting, reporting, and insider trading. Such companies suffer the syndrome of playing tennis with their eyes on the scoreboard. Managements will be consumed more by the quarterly striptease than performing well. Glaring increasingly at the scorecard will only cramp their style. The result would be poor, even if one had somebody to move the numbers on the scoreboard surreptitiously. Such a game by the companies is not a sustainable one as failed ones abundantly show. The answer is, doubtless, better standards of supervision, honesty, integrity and ethics. A simpler first step could be to withdraw the incentives and pressures by reverting to the half-yearly reporting from the quarterly rain-dance.

The writer is founder trustee of the Academy of Corporate Governance and member, Commonwealth Group on corporate governance for finance sector and Chairman, Yaga Consulting Pvt Ltd