Views on improving the integrity of global capital markets
13 January 2015

Candor in Corporate Reporting: What It Means for Investments and Share Price

Posted In: Financial Reporting

Companies that consistently promote candor and transparency generally benefit from superior market performance. This was the takeaway from a talk by L.J. Rittenhouse, CEO of Rittenhouse Rankings, at the CFA Institute 17th Annual Equity Research and Valuation Conference. Rittenhouse based her comments on her company’s annual Rittenhouse Candor Rankings Survey, which correlates measures of executive candor with stock price performance.

Rittenhouse’s talk, held in Boston in November, centered on the “bottom line” of financial statements and understanding the link between executive candor and market performance. Investors look to the bottom line (or net income) because this accounting number tells us whether a business made or lost money and whether the company is growing or not. This number, however, as Rittenhouse explains, is the result of innumerable judgments made by individuals across an organization — judgments about when to record earnings and cash, what amount to record, and where to record these numbers on financial statements. These judgments can be conservative or aggressive, and are shaped by the values of the leaders of companies.

Increasingly, Rittenhouse maintains, the valuation of companies is affected by perceptions of the quality of its leadership. Senior executives are viewed as the protector or destroyer of the corporate culture, and candor is essential to building strong, effective cultures. She contends that much can be learned about the integrity of the leadership and the corporate culture from financial linguistic analysis.

Consequently, she combs through corporate financial communications such as shareholder letters for jargon, hyperbole, absurd or illogical statements, and overused words that lead to point deductions in the Rittenhouse Rankings. Her methodology, called “FOG,” for fact-deficient, obfuscating generalities, demonstrates that companies that engage in transparent corporate communications outperform those companies that are less candid.

Similarly the CFA Institute publication Financial Reporting Disclosures: Investor Perspectives on Transparency, Trust, and Volume discusses the lack of transparency in corporate financial reporting and its implications for investor trust and consequently investment. The study examines the recent financial crises — and the six years of economic uneasiness that have followed — that have clearly demonstrated the insufficiency of financial reporting and disclosures. Illustrative of this are the failures and bailouts of high-profile financial institutions for which transparency on exposures, risks, uncertainties, and leverage were clearly lacking. The study maintains that without trust in financial institutions — the handmaiden to the broader economy — investment overall can lag.

Indeed, investors consider the lack of integrity in financial reporting as one of the most serious concerns for global markets, as illustrated by the 2015 CFA Institute Global Market Sentiment Survey, which reflects the views and expectations of CFA Institute members on financial markets, integrity, and performance for the coming year. Likewise a report of the Association of Chartered Certified Accountants (ACCA), Understanding Investors: Directions for Corporate Reporting — based on a survey of 300 investors — finds that 69% of survey respondents are more skeptical about the information companies provide since the financial crisis.

The ACCA report illustrates the critical relationship between transparency in financial reporting and investor trust — and the potential ramifications for investment activity:

“Clarity and transparency matter. More than two out of three investors said they would apply a bigger discount to a company if its corporate reporting lacked clarity. Good reporting can also help to strengthen financial markets and ensure that capital flows to where it can be most usefully invested.”

Accordingly, the CFA Institute study makes several recommendations to improve communication by companies including providing a balanced and candid picture of the business, emphasizing matters of importance during a reporting period using commonly understood and well-defined terms. We encourage you to read the report to access the detailed recommendations, and ask yourself: Is your company engaged in the kind of candid communication that leads to better market performance?

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About the Author(s)
Mohini Singh, ACA

Mohini Singh was director of financial reporting policy at CFA Institute. She represented membership interests regarding financial reporting and disclosure proposals issued by the FASB, the IASB, and others. Singh holds the Associate Chartered Accountant (ACA) designation.

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