restricted access Chapter 4. Disclosure Challenges Ahead
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4 Disclosure Challenges Ahead The continuing flow of accurate, relevant, and timely information is central to the functioning of capital markets . The accounting debacles of 2002 harshly reminded investors of this simple truth. When investors cannot trust the earnings figures companies publish, they fear buying stocks. And when buyers do not want to purchase , stock prices fall, as they did pretty much across the board during the summer of 2002, for this and other reasons. The various accounting and auditing reforms that have already been implemented—through legislation, changes in listing requirements by exchanges, and investor pressure—should help restore investors’ faith in financial statements, although, as we discussed in the last chapter, certain reforms may be unnecessary or counterproductive. However, even trustworthy earnings figures may be of limited value to investors interested in projecting the future cash flows of the companies in which they might invest. This is so for four reasons. First, published financial reports inherently are backward-looking, especially so because assets and liabilities are usually recorded at historical costs. 80 04-0890-CH 4 1/30/03 9:35 AM Page 80     They are not recorded at current market values because these numbers either are not available or cannot be determined objectively. To be sure, many analysts and investors use earnings reports, past trends in earnings, key ratios and other relationships, and other financial information to extrapolate into the future. They also use the information presented in financial reports to evaluate managers’ performance. But as the market turmoil of 2002 has demonstrated once more, making projections solely on the basis of reported earnings can be very dangerous, since the future for many firms may not look at all like the past. In recent years, for many investors and journalists “the future” largely has become what the analyst community says it is, with firms under increasing pressure to hit or exceed analysts’ earnings projections. In turn, this pressure has contributed to the widely derided practice of “earnings management,” or the manipulation of reported revenues and expenses in ways that generate reported earnings that do not disappoint market—or more accurately, analysts’—expectations. Second, much of the value the market assigns to many companies is intangible and cannot be found on their balance sheets (or income statements )—largely because intangible assets often cannot be bought and sold in the marketplace independent of the company itself. Intangible assets include not only intellectual property such as patents, copyrights, trademarks , and trade secrets, but also the value of a company’s work force, its customer base, its name brand and recognition, advertising, and all other intangibles that contribute to its ability to generate earnings. Intangibles are important not only for so-called high-tech companies, but also for many “old economy” enterprises that may have unique production processes, valuable brand names, superior reputations for quality and service , highly trained work forces, and stable customer bases.1 How do we know that intangible assets are important, and increasingly so? Because the market values of companies (as shown by the prices of their shares) tell us so. In a study of intangibles, Baruch Lev calculated the ratio of market values to book values for the stocks in the S&P 500 Index and found that it had doubled, from 3:1 to 6:1, between the beginning and the end of the 1990s.2 Although stock prices have fallen substantially since then, they remain well above the levels of even the mid-1990s, and so there is little doubt that market-to-book ratios have increased markedly over the past decade. Some of this difference probably is attributable to understated 04-0890-CH 4 1/30/03 9:35 AM Page 81     assets (such as the effect of inflation on buildings and inventory recorded as last-in, first-out), but much of it likely is the result of the market valuing assets that are not reported on the balance sheet—among them, the value of customers, employees, research and development, and other intangible assets.3 Third, some important nonfinancial information relevant to pricing the future is not reported in financial reports. Other important information may be reported only quarterly or annually (and even then with a substantial delay), although it is generated constantly. A few examples: the gain or loss of new customers, insider sales or purchases of the company’s stock, changes in management, new patents, and changes in demand for the company’s products. To its credit, the SEC in the aftermath of the...


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