Beyond the earnings game

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Events in the US over the past six months will have a lasting effect on corporate behaviour and the accounting industry. The rebuilding of public trust has already started but will the changes in train eliminate ‘the earnings game’ which has been at the root of the problems?

Today’s reporting model and the dynamics of the market are largely driven by short-term earnings and the calculation of a company’s earnings is not a precise science.

It relies upon the application and interpretation of accounting standards and a significant amount of judgement. A relatively small adjustment at the margin can make a significant difference to share price.

The current crisis has highlighted that a rules-based system, despite its apparent appeal, is not the answer because it focuses clever minds on finding ways around the rules.

Some would argue we have seen it all before, but I believe we are witnessing a defining moment in the development of corporate reporting.

From the perspective of the auditing profession, this has led to the debate on audit rotation and the provision of non-audit services.

While these are important issues that need resolving, the concern has to be that we are overlooking the core issue – the root of the problem.

So what is this omission? It is keeping the corporate reporting model focused primarily on financial information, and in so doing providing a chance for the earnings game to resurface during the next bull market.

The debate therefore needs to focus on the adequacy of today’s reporting model. We should be questioning how investors, customers and employees can make an objective assessment of how a company is being run and what its future prospects are.

How can they find out the health of the customer base, whether employees are motivated and generating the innovation needed to sustain and grow the business, and whether social and environmental issues are being addressed?

What’s needed is a new corporate reporting model that focuses on the longer term – not just the next three months. A blueprint for action has recently been set out in a new book, Building Public Trust, co-authored by Sam DiPiazza, Pricewaterhouse-Coopers CEO, and professor Bob Eccles.

It proposes the development of a three-tier reporting model.

Tier one is a set of global, generally accepted accounting principles (global GAAP). Market regulators worldwide should agree to allow any company using global GAAP to list on the exchanges within their jurisdiction.

IASs are already moving in this direction.

Tier two relates to industry-specific standards for measuring and reporting performance consistently applied and developed by the industries themselves.

This should reflect what management believes is the information necessary to understand value creation. These standards should in particular cover performance measures relating to intangibles and other areas such as brands, customers and innovation.

Tier three is company-specific information, to be driven by the underlying management strategy. This would include information such as strategic plans, risk management, compensation policies, corporate governance and company-specific performance measures.

All this information needs to be presented in a coherent and structured way and the PwC value reporting framework provides such a structure. It gives an overview of the company’ s market, its strategy and the way it manages to create value, particularly focusing on the key activities and relationships which drive value creation, and their link to financial performance.

So how can we make this picture a reality? I believe the answer is in the hands of those who comprise the corporate reporting supply chain, in reality not a big group.

It includes the CEOs from, say, the top 500 companies in the world, the Big Four accountancy firms and the top ten brokers and fund management groups together with key regulators and standard-setters.

If this group can be engaged and a small amount of energy channelled towards this cause, much will be achieved. After all, strengthening the integrity of the reporting system on which the whole capitalist model relies is significant and one with long-lasting value.

Let us hope some of the key building blocks to create a forward-looking reporting model can be put in place before our memories fade.

Furthermore, let’s ensure the real financial fundamentals around cash generation, gearing and interest cover are not ignored next time. If not we will be sucked back into playing the short-term earnings game and the perils it creates.

  • David Phillips is European value reporting leader at PwC.

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