Financial Reporting: The Importance of Corporate Transparency

Ask investors what kind of financial information they want companies to publish, and you'll probably hear two words: more and better. Quality financial reports allow for effective, informative fundamental analysis.

But let's face it, the financial statements of some firms are designed to hide rather than reveal information. Investors should steer clear of companies that lack transparency in their business operations, financial statements or strategies. Companies with impossible to understand financials and complex business structures are riskier and less valuable investments.

The word "transparent" can be used to describe high-quality financial statements. The term has quickly become a part of mainstream business vocabulary. Dictionaries offer many definitions for the word, but those synonyms relevant to financial reporting are: "easily understood," "very clear," "frank" and "candid."

Consider two companies with the same market capitalization, overall market-risk exposure and financial leverage. Assume that both also have the same earnings, earnings growth rate and similar returns on capital. The difference is that Company X is a single-business company with easy-to-understand financial statements. Company Y, by contrast, has numerous businesses and subsidiaries with complex financials.

Which one will have more value? Odds are good the market will value Company X more highly. Due to its complex and opaque financial statements, Company Y's value will likely be discounted.

The reason is simple: less information means less certainty for investors. When financial statements are not transparent, investors can never be sure about a company's real fundamentals and true risk. For instance, a firm's growth prospects are related to how it invests. It's difficult, if not impossible, to evaluate a company's investment performance if its investments are funneled through holding companies and are hidden from view. A lack of transparency may also obscure the company's debt level. If a company hides its debt, investors can't estimate their exposure to bankruptcy risk.

High-profile cases of financial shenanigans, such as those at Enron and Tyco, showed everyone that managers may employ fuzzy financials and complex business structures to hide unpleasant news. An overall lack of transparency can mean nasty surprises to come.

The reasons for inaccurate financial reporting are varied. A small but dangerous minority of companies actively intends to defraud investors. Other companies may release information that is misleading but technically conforms to legal standards.

The rise of stock-option compensation has increased the incentives for key employees of companies to misreport vital information. Companies have also increased their reliance on pro forma earnings and similar techniques, which can include hypothetical transactions. Then again, many companies just find it difficult to present financial information that complies with fuzzy and evolving accounting standards.

Beyond that, some firms are just simply more complex than others. Many operate in multiple businesses that often have little in common. For example, analyzing General Electric (GE) — an enormous conglomerate with numerous lines of business, is more challenging than examining the financials of a firm like Netflix (NFLX), a pure play online entertainment service.

When firms enter new markets or businesses, the way they structure these new businesses can result in greater complexity and less transparency. For instance, a firm that keeps each business separate will be easier to value than one that squeezes all the businesses into a single entity. Meanwhile, the increasing use of derivatives, forward sales, off-balance-sheet financing, complex contractual arrangements and new tax vehicles can befuddle investors.

The cause of poor transparency, however, is less important than its effect on a company's ability to give investors the critical information they need to value their investments. If investors neither believe nor understand financial statements, the performance and fundamental value of that company remains either irrelevant or distorted.

Mounting evidence suggests that the market gives a higher value to firms that are upfront with investors and analysts. Transparency pays, according to Robert Eccles, author of "The Value Reporting Revolution" (2001). Eccles shows that companies with fuller disclosure win more trust from investors. Relevant and reliable information means less risk to investors and thus a lower cost of capital, which naturally translates into higher valuations. The key finding is that companies that share the key metrics and performance indicators that investors consider important are more valuable than those companies that keep information to themselves.

Of course, there are two ways to interpret this evidence. One is that the market rewards more transparent companies with higher valuations because the risk of unpleasant surprises is believed to be lower. The other interpretation is that companies with good results usually release their earnings earlier. Companies that are doing well have nothing to hide and are eager to publicize their good performance as widely as possible. It is in their interest to be transparent and forthcoming with information so that the market can upgrade their fair value.

Further evidence suggests that the tendency among investors to mark down complexity explains the conglomerate discount. Relative to single-market or pure-play firms, conglomerates could be discounted. The positive reaction associated with spin-offs and divestment can be viewed as evidence that the market rewards transparency.

Naturally, there could be other reasons for the conglomerate discount. It could be the lack of focus of these companies and the inefficiencies that follow. Or it could be that the absence of market prices for the separate businesses makes it harder for investors to assess value.

Investors should seek disclosure and simplicity. The more companies say about where they are making money and how they are spending their resources, the more confident investors can be about their fundamentals.

It's even better when financial reports provide a line-of-sight view into the company's growth drivers. Transparency makes analysis easier and thus lowers risk when investing in stocks. In that way, the investor is less likely to face unpleasant surprises.