3 The Shortcomings of Financial Disclosure

Question 1

What are the four financial statements that financial accountants have traditionally used to communicate how a company creates value and answer investor questions?

Answer 1

1) balance sheet
2) income statement
3) statement of cash flows
4) statement of stockholders’ equity

Question 2

Since the standardization of accounting several decades ago, what has become increasingly clear?

Answer 2

While financial statements are a critical component to well-functioning markets, they alone do not tell a company’s full value creation story

Question 3

What are examples of missing value creation information from the financial statements?

Answer 3

declining ratio of net assets to enterprise value, managerial myopia and short-term focus, changing regulatory and societal expectations

Question 4

Outside of standardized financial statements, companies often choose to report non-GAAP measures. What is one of the most common non-GAAP measures?

Answer 4

Earnings before interest, taxes, depreciation and amortization (EBITDA) which provides an alternative measure of a company’s profitability or cash flow not subject to standardized financial accounting practices

Question 5

The use of non-GAAP measures has grown dramatically in the past three decades. What are examples?

Answer 5

-changes in operating structure
-impacts of a merger or acquisition
-adjusted earnings

Question 6

Are non-GAAP measures financial metrics?

Answer 6

Yes, because they are derived from financial statements

Question 7

What is a key aspect of companies that has changed since 1973 when FASB and IASC were founded?

Answer 7

Market capitalization of large companies being primarily tied to tangible assets. In 1975 tangible assets were 83% of the market value. In 2020, tangible assets account for only 10% of the S&P 500 and intangible assets are 90 percent (in Europe, intangible is 74%)

Question 8

What are examples of intangible assets?

Answer 8

Intellectual capital, customer relationships, brand value. “Soft assets”

Question 9

In the absence of applicable accounting metrics to aid efficient pricing, what is true about the market value of intangible assets?

Answer 9

They are particularly sensitive to impairment.

Question 10

What did FASB acknowledge about non-financial resources like human, social and natural capital?

Answer 10

companies and investors embrace information beyond financial statements because even though conventional accounting does not treat them as assets, they undeniably represent sources of future value.

Question 11

What was explicitly endorsed by several key organizations in the financial reporting community in the 1990s and 2000s?

Answer 11

The value of non-financial information

Question 12

In the early 1992, the AICPA formed the Jenkins Committee. What was it also called?

Answer 12

Special Committee on Financial Reporting

Question 13

What did the Jenkins committee conclude and recommend?

Answer 13

There is value in the material trends, demands, commitments, concentrations and events known to management that would cause reported information not to be indicative of future financial performance. This includes forward-looking information such as management plans, and company opportunities and risks, and long term drivers of value creation.

Question 14

What did the Association for Investment Management and Research / CFA Institute conclude in their report “Financial Reporting in the 1990s and Beyond”?

Answer 14

That financial statements are one component of a comprehensive business reporting model that serves users, and encourages management to disclose and discuss their strategies, proposed tactics and plans, and expected outcomes.

Question 15

Following these reports, FASB formed a research project and issued Improving Business Reporting: Insights into Enhancing Voluntary Disclosures and found what?

Answer 15

Leading companies in select industries voluntarily included some non-financial information that was useful to investors, the importance of that information is likely to increase, and the most useful and relevant disclosures related to strategy and metrics that influence or relate to a company’s success.

Question 16

What are the earliest efforts to promote the disclosure of non-financial information represented by in regulatory filings? (2)

Answer 16

The existence of the narrative from management to discuss their financial position and provide necessary context for future performance, called the Management Commentary portion of financial disclosure in the IFRS; and the Management’s Discussion and Analysis (MD&A) in the U.S.

Question 17

What are the two key principles of the IFRS Management Commentary?

Answer 17

1) provide management’s view of the entity’s performance, position, and progress (including forward-looking information)
2) supplement and complement information presented in the financial statements (and possess the qualitative characteristics described in the IFRS Conceptual Framework for Financial Reporting)

Question 18

What are the three fundamental characteristics of qualitative information in the IFRS Conceptual Framework?

Answer 18

1) relevance
2) materiality
3) faithful representation

Question 19

What are the four enhancing characteristics of qualitative information defined by the IFRS Conceptual Framework?

Answer 19

1) comparability
2) verifiability
3) timeliness
4) understandability

Question 20

What are the five reporting elements of the IFRS Standards for Management Commentary?

Answer 20

1) historical financials
2) other subject matter disclosures (including climate)
3) business description
4) management information and market data
5) management perspectives

Question 21

What are the four points of the U.S. SEC’s requirements of the disclosure of Management’s Discussion & Analysis (MD&A) regarding focus and content?

Answer 21

1) Focus on material information, including other / non-financial material information necessary to make the required statements
2) Include key performance indicators that management uses to manage the business and would be material to investors
3) disclose known trends and uncertainties that are reasonably likely to have a material effect on financial condition or operating performance
4) analys the information that is disclosed

Question 22

Given the expectation that companies report forward-looking information with potential impacts to financial performance or operating condition, disclosures that call for the views of management, they are a natural location for what?

Answer 22

material sustainability-related information

Question 23

What are examples of highly publicized failures in corporate governance that have shaken the public trust in capital markets, showed shortcomings of financial statements, and highlighted the rise of corporate governance codes in response?

Answer 23

Siemens bribery scandal in Germany
Steinhoff scandal in South Africa
Toshiba accounting scandal in Japan
Enron and WorldCom scandals in the U.S.

Question 24

What are two examples of mandatory corporate governance codes and guidelines on disclosure?

Answer 24

U.S. Sarbanes-Oxley Act and Japan’s Corporate Governance Code for JPX-listed companies

Question 25

What are four best practices that codes of corporate governance may define?

Answer 25

1) equal treatment of shareholders
2) set standards for oversight of disclosure and transparency
3) set expectations for boards regarding ethical practices
4) fair representation of a company’s position and prospects

Question 26

What are some tools to measure environmental factors as there is increasing concern regarding resource depletion and environmental impact?

Answer 26

product lifecycle analysis (LCA), greenhouse gas accounting, environmental cost accounting, environmental profit and loss statements

But while these tools can help identify operational efficiencies and externalities, not all facilitate investor-focused communication

Question 27

What is the earliest form of investor use of sustainability information?

Answer 27

Negative screening

Question 28

What is negative screening?

Answer 28

Avoidance of investments found to be objectionable by members of society. Early examples included faith-based investors, student divestment due to the Vietnam War or South African Apartheid. This concept has been used more broadly to screen out “sin stocks”

Question 29

When did an increase in investment firms dedicated exclusively to social and environmental impact occur?

Answer 29

1970s

Question 30

What are the names of firms using an investment strategy dubbed Socially Responsible Investing (SRI)?

Answer 30

Calvert Investment Management,
Pax World Funds / Impax Asset Management,
Walden Asset Management / Boston Trust Walden

Question 31

What is another term for Socially Responsible Investing (SRI)?

Answer 31

values-based investing

Question 32

Today, the use of ESG information among all investor types continues to expand beyond negative screening and values-aligned investing through the practice of ___________

Answer 32

ESG integration

Question 33

How many assets under management are signatories of the Principles of Responsible Investment and what does it stand for?

Answer 33

$110 trillion US dollars as of 2020 and it promotes the inclusion of ESG factors in all investment decisions

Question 34

Three studies found that asset owners, portfolio managers and equities integrate ESG into their investment analysis at what percentages / levels?

Answer 34

73-95%

Question 35

What has happened to the market value of equities as they have become less tangible and how does it relate to the level of risk with sustainability issues?

Answer 35

As the market value of equities has become less tangible, sensitivities to sustainability risks, the management of those risks, and regulatory attempts to address them has risn. Investors factor risk into the returns they require to accept such risk which increases the cost of capital. Meaning, as risk (or perception of risk) increases, costs of capital and discount rates increase, leading to higher hurdle rates and decreases in valuation

Question 36

How do some view the increased focus of investors on sustainability?

Answer 36

As a market correction to the deleterious effects of extreme “short-termism”

Question 37

What is “short-termism”?

Answer 37

Growing pressure put on corporate executives to meet near-term earnings projections at the expense of long-term value creation.

Question 38

What do critics argue as the effects of persistent, extreme short-termism?

Answer 38

Diminished public confidence, depressed economic growth, reduced investment returns.
At its worst, the undermining of the efficiency of capital markets by contributing to the mispricing and misallocation of assets because of lack of reliable information about long-term prospects.

Question 39

What are two examples of measures that the majority of CFOs would do to put long-term value at risk to meet short-term earnings targets?

Answer 39

80 percent would decrease discretionary spending (R&D or advertising) and 39 percent would incentivize customers to make early purchases

Question 40

What percent of C-suite executives believe that using a longer time horizon to make business decisions would positively affect corporate performance in a number of ways, including strengthening financial returns and increasing innovation?

Answer 40

86 percent

Question 41

What did a 2017 study find when assessing firms with a long-term mindset?

Answer 41

They consistently outperform industry peers on nearly every financial measure that matters.

Question 42

Why do fiduciary obligations / fiduciary duty exist?

Answer 42

To ensure that trustees who manage other people’s money act in the best interests of their clients or beneficiaries rather than serving their own interests.

Question 43

What did a 2005 UN report find with regard to fiduciary duty?

Answer 43

“In our opinion, it may be a breach of fiduciary duties to fail to take into account of ESG considerations that are relevant and give them appropriate weight, bearing in mind that some important economic analysts and leading financial institutions are satisfied that a strong link between good ESG performance and good financial performance exists.

Question 44

What did the 2015 follow-up UN report on fiduciary duty find?

Answer 44

Failing to consider long-term investment value drives, which include ESG issues, in investment practice is a failure of fiduciary duty.

Question 45

Why is the fiduciary duty of loyalty with regard to future generations increasingly called into question?

Answer 45

Fiduciary’s duty of loyalty calls for impartial treatment of different beneficiaries, including different generations. Given climate-related risks and abatement of environmental degradation can shift wealth between generations (benefiting older generations while leaving an environmental debt to younger generations).

Question 46

How are the audiences different for financial reporting and sustainability information reporting?

Answer 46

Unlike financial reporting which is prepared exclusively for investors and providers of capital, sustainability information may be relied on by stakeholders such as civil society, employees and surrounding communities…there are different users with different, unique needs for sustainability.

Question 47

What are two examples of how businesses face the evolving nature of sustainability issues that may be financially material both quickly and slowly over time?

Answer 47

Beverage manufacturers in water-stressed regions can chronically impose supply constraints and lead to an operational shut down

Exposure of human rights violations in the supply chain can suddenly turn human rights into a high priority issue

Question 48

Where financial accounting relies on the expertise of professionals within a singular, long-established discipline, sustainability information relies on the expertise of __________________________

Answer 48

professionals across different facets of environmental science, human resources, finance, executive functions, and many other areas

Question 49

What is a common misconception / perceived difference between financial statements and sustainability reporting?

Answer 49

That only sustainability reporting relies on the use of estimates and assumptions without undermining the confidence in the information or its usefulness. Financial accounting relies on assumptions for the salvage value of assets in depreciation calculations (for example)

Question 50

CHECK FOR UNDERSTANDING: What does the rise of intangible assets mean for corporate disclosures?

Answer 50

The increasing proportion of intangible assets as a percent of total S&P market value
highlights that a very significant amount of information regarding corporate performance and value drivers is not captured in financial statements. Where investors
previously relied almost exclusively on the valuation of tangible assets, it is now clear
that tangible assets alone do not constitute a complete set of information that can be used to make informed investment
decisions. A “gap” in information exists where intangible assets are not being clearly and consistently identified, measured, or
managed.

Question 51

CHECK FOR UNDERSTANDING: What factors contribute to increasing investor interest in non-financial information?

Answer 51

In addition to increasing awareness of the “intangibles gap,” the value of non-financial
disclosure was endorsed by key organizations in the financial reporting community, who collectively support the notion that business reporting, both financial and non-financial, needs to improve to better
serve the users of company reports. As such, non-financial reporting became an imperative component of business reports, used to
disclose information relevant to evaluating a company’s future financial condition and
long-term value (including sustainability
information) that is not reflected in financial
reports. The growth of responsible investment practices also prompted an increased focus among investors on other sources of
information that lend insight into company
value, including a rejection of extreme short-termism and the recognition that longterm value generation falls within fiduciary duties of care.

Question 52

CHECK FOR UNDERSTANDING: what challenges exist in sustainability disclosure that do not necessarily exist in financial disclosure?

Answer 52

Relative to financial disclosure and accounting, sustainability disclosure is a young
discipline. Due to this limited history and differences in the nature of sustainability
data, several challenges manifest exclusively in sustainability disclosure for reporters and report users. For one, many different audiences are interested in sustainability
information – including investors but also members of civil society and community
members – meaning companies must balance the needs of different audiences.
Where financial accounting relies on the expertise of a singular, long-established
discipline, sustainability accounting relies on the expertise of professionals across disciplines (such as environmental sciences,
human resources, and others). Challenges also exist related to the ESG data itself.
Companies report on a wide range of ESG topics, often using different metrics and methodologies to measure performance. High variability in the scale and scope of ESG
data across corporate disclosures can skew analysis and limit its comparability when analyzing companies.