Monday, October 15, 2012

The disclosure dilemma: Why more disclosure has led to less information

The last three decades have been the golden age of disclosure, as both accounting rule writers and regulators have pushed companies to reveal more and more about their prospects to investors, both in the US and internationally. Some of this push can be attributed to more activist investors, demanding more information from companies, but much of it can be traced to accounting fraud/malfeasance, where companies held back key information from investors, who paid a price as a consequence. In response, legislators, the watchdog agencies (SEC and its equivalents) and the accounting rule-writers (GAAP, IFRS) have all responded by increasing the amount of information that has to be disclosed by firms. That should be good news for investors, but here are the contradictions that I see:
  • If the objective of “disclosure” laws is to prevent the next Enron, Parmalat or Worldcom accounting scandal, it clearly has not worked, since we seem just as exposed as we have always been to these problems. If anything, companies seem to have become more creative in hiding “bad” stuff, in response to disclosure laws, making it more difficult to detect problems. 
  •  If the objective is to help investors value companies better, it has not worked either. To me financial disclosures are raw data, when I do valuation, and I must confess that I find financial statements more difficult to work with today than I did thirty years ago, when disclosure laws were less onerous.
So, what gives here? Why have these increased disclosure requirements not worked the magic that they were supposed to? While we can point to lots of reasons, including imperfections in the disclosure requirements, I think that the biggest problem is that the disclosure rules have turned financial disclosures into data dumps. To see my point, take a look at the 10K for a publicly traded company, even a small one, and you will see a document that runs into tens or even hundreds of pages. For instance, Procter & Gamble’s most recent 10K runs 239 pages and it is slim next to Citigroup’s most recent 10K which runs more than 300 pages.  If you are interested in valuing Procter & Gamble or Citigroup, you have to work your way through these pages, separating the wheat from the chaff, or more specifically, information from data. Faced with information overload, it is easy to get distracted by the legal boilerplate (you might as well throw out the entire section that discusses risk) and the trivial details that clutter modern disclosures. In my estimate, less than 10% (and that is being generous) of a modern financial disclosure has any value to an investor and to find this information, here are some things to keep in mind: 
  1. Read with focus: Know what information you are looking for, before you start looking for it.  In other words, reading a 10K, just looking for useful information, is equivalent to digging up your backyard, looking for interesting stuff. Your most likely outcome is that you will end up with a mountain of dirt and little to show for your work.
  2. Don’t sweat the small stuff: If you are valuing a $ 60 billion dollar company, you can afford to skip over that section that describes in excruciating detail a $25 million real estate lease that the company has entered into or the $50 million lawsuit filed against the company. 
  3. Don’t cater to your inner accountant: We know that accounting has its fixations and that financial disclosure often cater to these fixations. Thus, there are large chunks of these documents that are dedicated to how intangible assets have been “fair valued” or goodwill has been “impaired” (a mythical asset that exists only in the accounting world). Since I don’t trust accounting fair value judgments to begin with and goodwill has but a peripheral role (if that) in cash flow based valuation models, I can afford to skip these sections. 
As some of you already know, I do teach a valuation course at Stern and my invite to anyone who is interested in sitting in still holds. Since a key part of doing valuation is learning how to work with financial disclosures, I recently put together a webcast on disclosures, where I used P&G’s most recent 10K to value the company. If you are interested, you can find the webcast with the supporting material (the 10K, my slides and my valuation of P&G). In fact, they are part of set of webcasts I am doing on the nuts and bolts of valuation:

I am afraid that things will only get worse for investors. The push towards more disclosure, well intentioned though it might be, is unstoppable and  will create more bulk in annual reports and company filings, and more distractions for investors.

While I am sure that I will be ignored, here are my suggestions to the regulatory and accounting disclosure czars if they truly want to help investors:
  1. Focus on principles, not rules: The principles that govern valuation are simple and robust, but they seem to take a back seat to rules when it comes to disclosure requirements. To provide a simple example, capital expenditures should measure what a company invests in its long term assets, whether those assets are tangible (land, building, equipment) or intangible (human capital, brand name, intellectual property). Not only are the accounting rules governing capital expenditures unnecessarily complex but they are internally inconsistent, with different rules governing tangible and intangible investments. (Prime exhibit: the treatment of R&D expenditures). 
  2. Less is more: My wife, who is the "organizer' in our house, has a very simple rule for everyone in the family. For every new item that any of us buys, one item has to be removed (given away or abandoned) from our closets. It is an excellent rule, since in its absence, we would undoubtedly hoard what we already have, on the off chance that we might need it in the future. I would propose a similar rule in disclosure. When companies are required to disclose something new, an old disclosure requirement of equal length has to be eliminated, thus preventing disclosure bloat.
  3. Target investors, not lawyers: As I browse through financial disclosures, I am struck by how much of the content is written by lawyers, and for lawyers, with the specific intent of shielding companies from lawsuits and/or regulatory backlash. While I understand that companies are gun shy about being sued, and that this protection is necessary,  it may be time to allow companies to file two disclosures, one for lawyers and one for investors. Using P&G as my example, I could construct an investors' 10K, about 20 pages in length, stripped off all the legalese that the full 10K includes.
  4. Let accountants do accounting (and not valuation): I know that "fair value" accounting is here to stay, but  I believe that the push is misguided. By requiring accountants to play the role of appraisers, it asks them to play conflicting roles: provide a faithful recording of what has happened in the past (traditional accounting) while also forecasting the future (a key component of making valuation judgments). In the process, I think that we will end up with financial statements that do neither accounting nor valuation well and that investors will pay the price.
Looking forward, investors will increasingly be tested on their capacity to separate the data that matters (information) from the data that does not (noise or distraction). There is an interesting twist (and I thank Bill, who commented on this post for this insight). The increasing complexity of financial disclosure does open up the possibility that investors who can navigate their way through these disclosures and separate information from data will have a competitive advantage over other investors, who give up in frustration.


Jason DaCruz said...

Thanks for the post, Professor -

I still get intimidated when asked to tear apart a full 10k. I'd love a book that deals with the admittedly paradoxical common anomalies in financial reporting; ways that management can fiddle with numbers when reporting.

Unfortunately, I don't see a practical way of getting around legalese. Just look to the disclosures offered to the world of finance. Despite the rigorous reporting requirements of registered investment companies (e.g. mutual funds), a recent SEC study showed that investors are still completely lost!

Bill said...

You conclude: Looking forward, investors will increasingly be tested on their capacity to separate the data that matters (information) from the data that does not (noise or distraction).

How does that differ from the way things were, looking backward?

I for one appreciate the disclosures, and appreciate the edge given to me by those who do not want to dig through 10Ks.

Shailesh Saraf said...

The best solution is to decentralize regulation from the SECs to, for example, the stock exchanges.

Centralized regulation, apart from being slow, has a one-size-fits-all approach.

Let stock exchanges compete for corporates and investors on the basis of the simplicity and effectiveness of the rules they offer.

Ofcourse, one needs to remove any entry barriers for new stock exchanges to come up.

Anonymous said...

Accounting has become a 'mess' in the real sense. Both USGAAP and IFRS are making it more complex and confusing by the day.

We see changes made to IFRS almost every year; they make some new principle/rule in a year and the next year or so they change it again and this goes on.

Fair value accounting has become a joke - neither management nor auditors nor the investing public understand the complexities involved in the valuation and accounting parameters.

Accountants should strictly stick to historical information, meaning they should provide data relating to the past on a cost basis. It is not a valuation tool (not sure how this perverse attitude has come around). Market value could always be given in what we say in brackets - it has nothing to do with the balance sheet, income statement and cash flow numbers. That would be just for the information.

Now, if someone wants to value the company that person should pick up the annual report and work on it based on valuation approaches (not on accounting rules).

Coming to skipping some info from the annual report like a small $25 million lease item, it could be dangerous if the pages somewhere mention a large commitment or contingencies involving say billions. Given the risk it is best to read in full if you really want to value the company and then take out wheat from the chaff.

All in all fully agree with what you have mentiioned.

Anonymous said...

Interesting and quite hilarious article for the Apple fans - -

But question for Crosby is: why are you using it when you are ashamed of it?

Personally, I don't care which phone I use since most of my use is restricted to call, message and news. I am not a big fan of those apps - there are far better things to do in life. However, I chose iphone because the rest are either crap or sort of. Blackberry is ugly looking, Samsung is too big in size, Nokia and the other... well..I negated them. So what is left is iphone..and I am using it. Also it gels with my ipad (see how Apple is manipulating us).

Will this iphone craze last long? Only time will tell. Technology can kill one....ask RIM and Nokia.

Now with the dominance of Samsung internationally (they have even come out with a smaller size)the war is getting highly aggressive.

If there is not much of a major innovation in the coming series, Apple will have to seriously think of giving away most of its cash - lest they squander it away!

Anonymous said...


after some time in IB and PE, I have come to the conclusion that every valuation circles around a few number of certain key assumptions which fundamentally drive valuation (as you show in your spreadsheets). If you get those key assumptions right, you already have gone most of the way and if you fail on them any detail will not improve your overall case. Same holds true btw. for the financing side. If the business is not viable in itself, financing won't help you getting it right.

I believe you can apply the very same principle to the disclosures politics in the reporting of listed companies. Regardless of the fancy disclosures, over time cash flow and the company's ability to generate this, is all that matters. Via that proxy, Enron was easy to detect and so are all other fraudulent cases.
Nevertheless the "culture of taking companies to court" has led to prohibitive disclosings in order to avoid law suits, therefore I agree with your seperation approach. However, the pure volume of information enables companies to "burry" information in there, that is unpleasant and hurtful from a valuation perspective.

Ry Zamora said...


It's my first time posting in your blog (I've been lurking for a while now), but your entry struck me so deeply that I needed to react here.

I don't know if you may have noticed, but this legalistic approach applies across MULTIPLE geographies. IFRS, GAAP, as well as Philippine and Japanese reporting standards... they all possess the same thing: SEC disclosures are written with lawyers in mind.

As you do, I myself skip plenty of sections in the annual reports alone and home in on those that have been, in my experience, instrumental in ascertaining the underlying value of the business. Of course, changes in disclosure language is as important...

Going forward, there is just no real incentive for a company to make their disclosures "investor friendly".

Company-written annual/quarterly reports -- whose first quartile of pages laud praises and a rosy future for the business -- are no different from sales and marketing material. Same for conference calls. (Having just read G&D's 15th issue the other day, I'm happy to note one of the interviewed managers confirmed this impression of mine.) 10K's, 17-A's, or whatever you call the local SEC annual filings are "shields" (to use your language) that permit obfuscation of facts from competitors and investors alike AND allow earnings manipulation to seep through.

I doubt the SEC will ever make your suggestions requirements. You're right in your certainty you're going to be ignored. The SEC already has a big skill gap (not sure if the Madoff/MF Global/JP Morgan incidences brought sweeping reforms in the American SEC), and it doesn't help that they're just outsiders looking in.

Anonymous said...

i watched the webcast p&G
many thanx!! GREAT


Old School Value said...

thought provoking post and enjoyed the webcast. Great information and lesson.

Just a quick tip on going through 10-k's and other docs from the sec.

Grab the two latest and you can do use a "compare" feature to see what language, numbers and other changes has occurred by simply using a word processor.

I wrote a tutorial and instructions on how to do this easily.

OldSchoolValue said...

thought provoking post and enjoyed the webcast. Great information and lesson.

Just a quick tip on going through 10-k's and other docs from the sec.

Grab the two latest and you can do use a "compare" feature to see what language, numbers and other changes has occurred by simply using a word processor.

I wrote a tutorial and instructions on how to do this easily.

Anonymous said...

Credit Default Swap and other derivative products dont appear clearly in the 10k or in the book.

I think this one of the reason why the 10k is so big in some case (like Citi). They need to hide some information, especially all about their risk.

There is a dark derivative market working in the economy without regulation. Banks do what they want.

There is good regulation (that stimulate) and bad regulation (that inhibit). What American need is a good one which help market to work heathy.



Anonymous said...

after changing R&D shoukdnt we change the effective tax rate?


Unknown said...

An amazing article Professor!

Anonymous said...

when i watched the webcast about valuation of P&G you may said you also had valued the S&P500 is there a link to spreadsheet for this kind of valuation and the sources of inputs of we want to try it now and later?


Anonymous said...

Professor Damadoran,

Thanks again for the powerfull insight of your posts. This one has struck me as one of the best recently... Just curious about your Nuts and Bolts webpage (, are you planning to complete them in the near future? Am I looking at the right webpage ? If not, which one is the right one?

Thanks again for your knowledge sharing in the internet!

Claudio Timber said...

, I chose iphone because the rest are either crap or sort of. Blackberry is ugly looking, Samsung is too big in size, Nokia and the other... well..I negated them. So what is left is iphone. iPhone site

Sunshine Coast Bookkeeping said...

Great article Professor! You had a full knowledge on Finance.

Unknown said...

Fantastic! it is quite informative blog and interesting to read

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