COLUMN-Debate over Trump-backed financial reporting change misses key point: Fridson

By Marty Fridson

NEW YORK, September 30 (Reuters) - How often should companies report their financial performance? This debate is back in the headlines after President Donald Trump supported a proposal to reduce the frequency of financial reporting.

What the current discussion has failed to highlight, however, are the underlying problems with existing reporting that could be magnified by the proposed plan.

Trump on September 15 endorsed a proposal by the Long-Term Stock Exchange (LTSE) to cut back required financial reporting by public companies from quarterly to semiannually.

Pundits have weighed in on both sides of the issue. While the two camps differ on the optimal frequency of interim reporting, they share the implicit assumption that the information contained in corporate financial statements has value because it accurately reflects the issuers’ short-term performance.

However, decades of case studies, which I reviewed in five editions of "Financial Statement Analysis: A Practitioner's Guide" along with my co-author Fernando Alvarez, show this is far from a safe assumption to make for every public company.

This raises an issue that has not yet been a major part of the current debate on reducing the frequency of reporting: the risk of amplifying distortions in financial statements.

SMOOTHING EARNINGS

Many companies routinely engage in a variety of legal but misleading accounting tricks to create the illusion of steadier quarterly earnings-per-share (EPS) increases than their inherently volatile businesses would naturally produce.

For example, if a company sees that the current quarter’s EPS will come in below trend, a favorite gambit is to pull revenues forward from the next quarter. That may be achieved by offering customers a limited-time discount that makes no sense in terms of maximizing full-year profits, but beefs up current-quarter reported income.

Another popular tactic is to defer maintenance spending that really ought to be done sooner rather than later, as a way of booking less expense in the current 90-day period.

This sort of economically unjustified time-shifting of profits for the sake of steady EPS progression also occurs when projected income is above trend.

Companies often fear that reported earnings that are "too high" in the current quarter will make it difficult to produce the desired year-over-year percentage increase 12 months from now.

Note that all of these actions merely involve bookkeeping, with no bearing on the actual economic value of the company in question.

Ironically, corporate managers do not appear justified in their belief that a smoother quarterly EPS progression will lead to a higher stock valuation.

McKinsey & Company has published several studies debunking that thesis, beginning with “The Myth of Smooth Earnings” in 2011. The research found no evidence that the equity market awards superior valuations to companies with comparatively low volatility in their reported earnings.

Nevertheless, many corporate managers continue to use accounting practices that can mislead investors.

Now suppose the Securities and Exchange Commission eventually approves the proposal to elongate the interim reporting period from three to six months.

Imagine, too, a company that expects its EPS to run below trend not just in the current quarter but also in the next. Management would have to make a larger "tweak" to its reported numbers than it would have under the current rules.

The result: a grosser distortion of the information provided to investors, not the sort of outcome market regulators are tasked with producing.

PROS AND CONS

There certainly could be benefits to switching to a semiannual rule. For one, it would reduce the time that corporate managers need to devote to satisfying financial reporting requirements.

It might also enable them to adopt a healthier, longer-term focus on their businesses. Supporters of the proposal also claim that quarterly reporting imposes excessive costs on smaller public companies.

Advocates further argue that reducing the corporate cost burden from four reports to two would stimulate long-term capital investment. However, a 2017 study by the CFA Institute Research Foundation found that no increase in capital investments resulted from the UK’s 2014 switch to a semiannual reporting requirement.

Moreover, opponents of the proposed change maintain that having lengthier delays between important events and their disclosure would be negative for investors.

In a survey of Chartered Financial Analysts, an overwhelming majority feared that reduced reporting frequency would create more uneven information disclosures, disadvantaging some investors relative to others.

A similarly large majority predicted that the switch would make it more difficult to compare companies. That belief reflects the reality in Europe, where only semiannual reporting is required, but some companies voluntarily issue quarterly financial statements.

Some U.S. public companies may similarly be expected to go beyond the requirements if the U.S. were to reduce the frequency of earnings reports.

There are, therefore, plenty of reasonable arguments for and against migrating from quarterly to semiannual reporting. But the risk of encouraging greater distortions in financial statements should be a serious consideration.

(The views expressed here are those of Marty Fridson, the publisher of Income Securities Advisor. He is a past governor of the CFA Institute, consultant to the Federal Reserve Board of Governors and Special Assistant to the Director for Deferred Compensation, Office of Management and the Budget, The City of New York.)

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