can better disclosure reduce stock market volatility?

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Can Better Disclosure Reduce Stock Market Volatility? Mohamed E. Hussein © 2001 John Wiley & Sons, Inc. BOOKS REVIEWED: Eccles, R.G., R.H. Herz, E.M. Keegan, and D.M.H. Phillips. 2000. The Value Reporting Revolution (New York: John Wiley & Sons, Inc.). Boulton, R. E. S., B. D. Lib- ert, and S. M. Samek. 2000. Cracking the Value Code: How Successful Businesses Are Cre- ating Wealth in the New Econo- my (New York: HarperCollins). T he unprecedented rise in stock prices, especially prices of dot-com compa- nies, was seen as evidence of the higher productivity generat- ed by technologies of the new economy. Even Alan Greenspan, chairman of the Federal Reserve Bank, tem- pered his “irrational exuber- ance” statement and embraced the new productivity definition. However, the roller coaster ride of the stock prices of many companies—including some of the most solid of technology and old economy names—and the meltdown during the year 2000 (the NASDAQ lost 55 percent and the Dow Jones lost 20 percent) have experts and novices grasping for explana- tions. Many feel that the funda- mental characteristics of the New Economy are still valid but that market participants are having a tough time separating the wheat from the chaff. This is attributed to the quality of information disclosed by com- panies. Nonfinancial informa- tion of critical success factors such as R&D pipeline, cus- tomer relations, and supplier networks are usually not dis- closed. Financial information is usually historical and probably managed by management to portray a picture of orderly growth. The FASB issued a report stating that companies can improve their disclosure by vol- untarily disclosing information about their strategies and their critical success factors. It encourages companies to share the metrics they use to assess those critical success factors. The SEC under the recently retired Chairman Arthur Levitt attributed some of the problem to the privileged relationship between management and ana- lysts, in which management favors analysts with informa- tion before disclosing it to the rest of the market’s partici- pants. The SEC chairman felt this relationship might influ- ence the analysts’ assessment of the companies they follow. The SEC issued the “Fair Dis- closure” (FD) regulation, which prohibits management from disclosing information to ana- lysts without simultaneously publicly disclosing it. Chair- man Levitt was also worried that close consulting relations between companies and their auditing firms may influence the auditing process. The two books reviewed here address these issues from two different angles. The Value Reporting Revolution calls for the reform of corporate report- ing both in terms of the specif- ic information disclosed and the institutional relations, espe- cially the relationship between corporate management, ana- lysts, and investment bankers. Cracking the Value Code dis- cusses the intangible assets, especially new assets such as customer relations and supplier networks, and uses case studies to show how these new assets can be managed to create value. THE VALUE REPORTING REVOLUTION The book is sponsored by PricewaterhouseCoopers and most of the authors are partners in the firm. Pricewaterhouse Coopers holds the copyright. The book is motivated by the volatility of the stock market and the disconnect between financial information disclosed and the prices of stocks, espe- cially those of New Economy companies. The authors argue that corporate reporting ignores b o o k r e v i e w 73

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Page 1: Can Better Disclosure Reduce Stock Market Volatility?

Can Better Disclosure Reduce StockMarket Volatility?Mohamed E. Hussein

© 2001 John Wiley & Sons, Inc.

BOOKS REVIEWED:

Eccles, R.G., R.H. Herz, E.M.Keegan, and D.M.H. Phillips.2000.The Value Reporting Revolution(New York: John Wiley &Sons, Inc.).

Boulton, R. E. S., B. D. Lib-ert, and S. M. Samek. 2000.Cracking the Value Code: HowSuccessful Businesses Are Cre-ating Wealth in the New Econo-my (New York: HarperCollins).

The unprecedented rise instock prices, especiallyprices of dot-com compa-

nies, was seen as evidence ofthe higher productivity generat-ed by technologies of the neweconomy. Even AlanGreenspan, chairman of theFederal Reserve Bank, tem-pered his “irrational exuber-ance” statement and embracedthe new productivity definition.However, the roller coaster rideof the stock prices of manycompanies—including some ofthe most solid of technologyand old economy names—andthe meltdown during the year2000 (the NASDAQ lost 55percent and the Dow Jones lost20 percent) have experts andnovices grasping for explana-tions.

Many feel that the funda-mental characteristics of theNew Economy are still valid

but that market participants arehaving a tough time separatingthe wheat from the chaff. Thisis attributed to the quality ofinformation disclosed by com-panies. Nonfinancial informa-tion of critical success factorssuch as R&D pipeline, cus-tomer relations, and suppliernetworks are usually not dis-closed. Financial information isusually historical and probablymanaged by management toportray a picture of orderlygrowth.

The FASB issued a reportstating that companies canimprove their disclosure by vol-untarily disclosing informationabout their strategies and theircritical success factors. Itencourages companies to sharethe metrics they use to assessthose critical success factors.

The SEC under the recentlyretired Chairman Arthur Levittattributed some of the problemto the privileged relationshipbetween management and ana-lysts, in which managementfavors analysts with informa-tion before disclosing it to therest of the market’s partici-pants. The SEC chairman feltthis relationship might influ-ence the analysts’ assessmentof the companies they follow.The SEC issued the “Fair Dis-closure” (FD) regulation, whichprohibits management fromdisclosing information to ana-lysts without simultaneously

publicly disclosing it. Chair-man Levitt was also worriedthat close consulting relationsbetween companies and theirauditing firms may influencethe auditing process.

The two books reviewedhere address these issues fromtwo different angles. The ValueReporting Revolution calls forthe reform of corporate report-ing both in terms of the specif-ic information disclosed andthe institutional relations, espe-cially the relationship betweencorporate management, ana-lysts, and investment bankers.Cracking the Value Code dis-cusses the intangible assets,especially new assets such ascustomer relations and suppliernetworks, and uses case studiesto show how these new assetscan be managed to createvalue.

THE VALUE REPORTINGREVOLUTION

The book is sponsored byPricewaterhouseCoopers andmost of the authors are partnersin the firm. PricewaterhouseCoopers holds the copyright.The book is motivated by thevolatility of the stock marketand the disconnect betweenfinancial information disclosedand the prices of stocks, espe-cially those of New Economycompanies. The authors arguethat corporate reporting ignores

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Page 2: Can Better Disclosure Reduce Stock Market Volatility?

information about companies’critical success factors. As aresult the market is focused onshort-term earnings. On pagefive, the authors write, “Untilmanagers begin reporting per-formance on all the measuresthey use internally, they willcontinue to be the pawns in TheEarnings Game—forced toslightly beat quarterly earningsexpectations and carefully man-aging them prior to announce-ment.” The book uses severalsurveys conducted by Pricewa-terhouseCoopers to identify thetypes of information desired byinvestors. A survey by Pricewa-terhouseCoopers of the high-tech industry is used to analyzethe sources of the value gap inthe market. It identifies fivesources for the value gap: aninformation gap, a reportinggap, a quality gap, a under-standing gap, and a perceptiongap. The survey clearly showsthat the information investorsand analysts want is either notreported or, when reported, didnot meet investors’ and ana-lysts’ reliability requirement.Information desired byinvestors and analysts but notreported includes nonfinancialmeasures of strategy, intangi-bles, and risk.

The book proposes a value-reporting-disclosure model thatincludes external as well asinternal information. The exter-nal information includes itemssuch as the competitive environ-ment, regulatory environment,and macroeconomic environ-ment. The internal informationis divided into three subcate-gories: value strategy, managingfor value, and value platform.Strategy includes goals, objec-tives, governance, and organiza-tion. Managing for valueincludes financial performance,financial position, risk manage-

ment, and segment reporting.The value platform includesinnovation, brands, supplychain, people, and reputation,both social and environmental.The book devotes separatechapters to the measures of riskand sustainability. The sustain-ability chapter argues that eco-nomic growth is inextricablybound with its social and envi-ronmental consequences—inother words, information abouta company’s impact on the envi-ronment and other stakeholders.Another impetus for the need ofgreater disclosure is the creationof alliances, joint ventures, andpartnering, or what the bookcalls “soft contracting” relation-ships. The book advocates moretimely disclosure and suggestsusing Internet technologies suchas XBRL to allow investors toprepare analysis in many differ-ent ways.

The book also addressesthe relationship between man-agement and the sell-side ana-lysts, which is the subject ofthe SEC Fair Disclosure regula-tion. The book criticizes someof the sell-side analysts forbeing basically cheerleaders forthe companies they follow. Itattributes this behavior to thefact that most of these analystsare members of investmentbanks that manage transactionsfor the same companies that theanalysts are following. Thebook recommends that invest-ment bankers should disclosethe nature of their relationshipwith companies their analystswrite about.

Finally, the book address-es the question of who shouldset disclosure standards. Thebook proposes a market-driv-en self-regulation by eachindustry. A few leading com-panies in each industry shouldform a consortium, in cooper-

ation with information users.Third-party experts shouldidentify information needs ofusers and the gaps in currentdisclosure, and propose stan-dards to fill those gaps. Theconsortium will adopt the newstandards and the users ofinformation will press othercompanies in the industry touse similar standards.

The proposal is surprisingbecause it ignores how thebook itself has criticized man-agement’s role in the currentproblem and overlooks the his-tory of standard setting in theU.S. How can we expect thesame management that is criti-cized in the rest of the book forits role in the “Earning Game”to lead the reform? Moreimportantly, the history of stan-dard setting in the U.S., fromthe Committee on AccountingProcedures to the FinancialAccounting Standards, haveshown that the best arrange-ment is to have an independententity that has a due processthat enables all interested par-ties to make their case. In mostof this history, the initiativeand leadership was provided byauditors championing the pub-lic interest rather than clientservice, in collaboration withinvestors’ representatives, regu-lators, and academics. Man-agers were rarely advocates ofreform. A practical concern isthat the boundaries betweenindustries are getting soblurred it will be difficult toidentify who should be inwhich consortium. In the eventof the success of such consor-tiums, what is the assurancethat they will not create stan-dards that are very differentfrom each other, making it dif-ficult for users to compareacross industries—that is, cre-ating the problems that we cur-

74 The Journal of Corporate Accounting & Finance

© 2001 John Wiley & Sons, Inc.

Page 3: Can Better Disclosure Reduce Stock Market Volatility?

rently have in comparingreports from different coun-tries? At a time when we areattempting to create one set ofinternational standards forfinancial reporting, going backto single industry standardsseems to be step backward.

The book is well written. Itcites a wide range of profes-sional and academic literatureand is enriched by the datafrom several global surveys byPricewaterhouseCoopers.

CRACKING THE VALUE CODE

The three authors of thebook are partners of ArthurAndersen and the firm holdsthe book’s copyright. The bookproposes a model of how busi-nesses create value in the NewEconomy. The book is motivat-ed by the authors’ belief thatthe current valuation and infor-mation models do not includemany of the factors that createvalue for the companies of theNew Economy. The authorsbelieve that new intangibleassets, such as relationshipswith suppliers, knowledge,employees, brands, and sys-tems, are more critical to thesuccess in the New Economythan physical assets, yet theyare not included in the balancesheet. This is attributed to thefact that “the 500-year-oldaccounting system” reflectsvalue created through transac-tions with external parties. On

the other hand, value in theNew Economy can be createdor destroyed without transac-tions with third parties. Forexample, the clinical approvalof a new drug or changes inregulations can have more ofan impact on the value of acompany than its current sales.This is premised on theauthors’ distinction betweenvalue created and value real-ized. They see the value createdby a company to be determineddaily as millions of sharehold-ers buy and sell its stock. Inother words, value createdreflects expected future out-comes as well as currentresults. Value created is alsoseen as reflecting new types ofrisks that arise from new typesof transactions, new markets,new technologies, new com-petitors, and new relationships.

The proposed model linksstrategy, risk, processes, andinformation. It defines fiveclasses of assets: physical;financial; customer, such ascustomers lists, channels, andaffiliates; organizational, suchas leadership, knowledge, andinnovation; and employee andsupplier-related. “Assets—including technologies—com-bine, recombine, and interact ininfinite ways to create econom-ic value,” the authors write.Sources of risk are classifiedinto environmental, process,and information risks.

The model requires new

measurement and informationsystems that provide the infor-mation necessary for decisionmaking in the New Economy.Measurement should be basedon fair value. Where it is diffi-cult to measure values of someof the new intangible assets,their key performance indica-tors should be reported. Thebook cites examples from themany companies included inthe study of performance indi-cators of many of the newassets. The book proposes theintegration of internal andexternal data in informationsystems that uses new advancesin technology to provide cus-tomized and on-time reports forboth external and internal users.

The book is well writtenand the authors make excellentuse of the data from the com-panies they have studied tosupport their proposed model.The data for the book is drawnfrom the study of 10,000 com-panies that included most ofthe leaders in the New Econo-my. I only wish that the authorswere able to crack the problemof determining the value ofnew intangible assets. I believea cause of stock market volatil-ity is the inability to measurethe value of many of the newintangible assets. Measuringand reporting the value of thenew assets in the balance sheetwould enable investors to dif-ferentiate between companieswithin an industry.

July/August 2001 75

© 2001 John Wiley & Sons, Inc.

Mohamed E. Hussein, Ph.D., is professor of accounting at the University of Connecticut at Storrs,Connecticut. Dr. Hussein has taught in the university’s undergraduate, MBA, EMBA, and doctoral pro-grams. He was the Andersen Consulting Faculty Fellow at the university, and he has served as resi-dent director of the university’s Program in European Studies, at the University of Maastricht, in TheNetherlands. His research has been published in a variety of professional and business journals.