PracticeConsultingAccounting column – Research reveals how institutional investors make their decisions

Accounting column - Research reveals how institutional investors make their decisions

City investors look at the p&l and cash flow rather than the balance sheet. So are they getting a true picture?

Contrary to the assumption of cynical FDs, recent research (Institutional Investors, Accounting Information and the ASB* by Dr Richard Barker) suggests that accounting information is much used by institutional investors.

However, it also suggests that various issues of recognition and measurement are not well understood – which is worrying because these investors should be the most sophisticated users of accounts.

Institutional investors make judgements on companies in terms of the quality of their financial information. Their main concern is the level of disclosure. The City does not think that creative accounting is a major problem, although you could argue that if issues of recognition and measurement are not understood then institutional investors don’t stand much chance of spotting it.

The investor has four main statements on which to judge a company: profit and loss account, cash-flow statement, balance sheet and operating and financial review (OFR). The research shows that, while p&l reform has succeeded in stopping users simply looking at the bottom line, there is little use of recognised gains and losses that are not included in normalised earnings. This means there are questions over the usefulness of the statement of total recognised gains and losses. The ASB and users of accounts agree that the cashflow statement is of secondary importance to the p&l. The cashflow is useful in assessing a company’s financial position and quality of earnings but is less important as an input to cashflow-based valuation models.

The balance sheet is firmly in third place, mostly because analysts and fund managers regard information as useful only if it causes share prices to change. As data in the balance sheet is relatively stable it has little effect in that context. However, the City appears unconcerned about the interaction between earnings and balance sheet values and therefore does not appreciate the clever FD’s ability to use the balance sheet as a medium for managing earnings.

Like the balance sheet, the OFR does not excite professional users. As institutional investors maintain regular contact with the company they believe they would be unlikely to read anything in the OFR which they did not already know. Disappointingly for the ASB, which introduced and promoted the OFR, it is viewed in the City as little more than a PR exercise, because it contains subjective and selective disclosures.

Given the City’s view on the main components of accounts, perhaps it is not surprising that the research found the most commonly used financial ratios were those related to the p&l and cash flow (ratios such as interest cover and operating margin), rather than those based on balance sheet data (such as working capital efficiency).

What is striking about the research is how unsophisticated institutional investors can be when valuing companies they look at. Analysts and fund managers are highly consistent in their preferences. The most popular valuation models are still the price-earning ratio and the dividend yield.

For all the approbation they have received in recent years, discounting models, such as the discounted cashflow (DCF) and the dividend discount model (DDM), are thought to be of little importance for the simple purpose of making reliable forecasts beyond the near future.

Barker says that presentation standards such as FRS1 (cashflow) and FRS3 (financial performance) have been effective. But recognition and measurement standards such as FRS10 (goodwill), FRS12 (provisions) and FRS15 (fixed assets) are more difficult to judge. The ASB is unlikely to back this conclusion. It holds, for instance, that FRS10 brings tangible benefits to any accounts user.

Beneath all this lies the old argument between the “balance sheets approach” (which is broadly the ASB’s position) and a “transaction approach” which, generally, is seen as relating to existing accounting practices. Barker argues that where there is a conflict between the p&l recording a company’s financial position and the balance sheet stating correctly a company’s position then accounting standards should favour the former document.

On that basis, Barker has two recommendations: first the ASB should extend its improvements in the disclosure and presentation of financial statement data. This would mean more highly segmented and mandatory disclosure in the OFR, which should be audited, and greater segmental disclosure of earnings and cash flow. And second, the ASB should focus on earnings, as they play a primarily role in equity valuation. In essence the research is suggesting that the way the ASB can help users who are not experts at reading accounts or understanding FRSs is to maximise the economic relevance of the aggregate data reported in the profit and loss account.

* Cambridge University’s Judge Institute of Management, published by the Scots ICA. It can be ordered from research@icas.org.uk, price #15.

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