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Clear Thoughts
The New World of Reporting Earnings
Originally Published Friday, 04/22/2005
| Public companies are now forced to comply with new regulations increasing the amount, quality and timing of their financial reporting. How does it impact the firms, our investing strategies and stock price performance? |
Are the new laws bad and costing corporate America too much time, money and headaches, or does corporate America just need to get used to them?
Russell Reynolds Associates, a global executive recruiting and assessment firm, states in a recent press release that "many CFOs and controllers rise to the occasion; but some decide to opt out of public company top roles, too. Being a financial officer of a publicly traded company has become more challenging and less attractive with compliance demands, so companies must keep scouting new talent."
Financial data has been reported since the great depression, and the SEC has tried to set standards of what, how, when and to who the data is reported. The most recent major legislation is Sarbanes-Oxley. The law, which President Bush signed in 2002, has companies assets, and beginning this year, report on the state of their internal controls, a system of checks and balances over financial accounting that are designed to prevent corporate fraud. It requires senior managers to certify the adequacy of their internal financial controls. Outside auditors are also required to sign off on those controls.
Another mandated change happened back in 2000, called Regulation FD (Fair Disclosure) which requires companies to disclose newly public information to everyone at the same time. This prevents a selected group, including Wall Street analysts, from having private conferences with company management that may disclose non-public information. This is why all earnings calls and investor days are now publicly broadcasted. Time has passed and the complaints of compliance have disappeared.
Even as the trials of Worldcom and Enron keep the accounting scandals front page news, management of public companies continue to complain about the undue time and cost of complying with Sarbanes-Oxley. This year, many companies are unable to file their annual reports on time.
How has this impacted corporations and their senior executives?
Russell Reynolds Associates recently released a study with the following statistics:
- CFOs of Fortune 500 companies experienced a 23% increase in turnover in 2004 and a corresponding 21% increase in the number of resignations.
- With regard to controllers at Fortune 500 companies, the turnover rate increased by 25% in 2004 and increased 400% in the number of resignations.
- There was no increase in the turnover rate of treasurers in Fortune 500 companies in 2004.
Quoting a recent press release, Russell Reynolds attributes these changes to multiple factors. "The increased and relentless pressures of Sarbanes-Oxley compliance and the competitive drive to beat the numbers every quarter are two factors driving rising turnover among financial officers."
The Securities and Exchange Commission now requires that public companies with market capitalizations of $75 million or greater to include their internal controls reports on annual reports filed beginning last month. The SEC gave smaller companies an extra 45 days to file their reports.
Of the more than 2,600 companies that had filed their annual reports by March 16, 11% (289) warned of material weaknesses.
In recent weeks, hundreds of public companies have warned investors either that they have significant problems with their controls or that they won't be able to finish their reports in time to meet a mandated deadline.
Another 291 companies with market caps over $75 million have warned investors this year that they will be late in filing their annual reports, up from 65 companies last year, with almost 50% due to issues with internal controls.
Analysts have blamed compliance problems on a number of factors. Worried about their new financial liability, accountants have taken a hard line on internal controls, naming even minor problems as a "material weakness." At the same time, analysts think that companies have few excuses for not complying. The requirement that they have controls has been out there since the late 1970s. Sarbanes-Oxley simply supplemented the existing laws.
A survey of companies that reported material weaknesses in their internal controls indicated that in the five days following their reports, their stocks underperformed the market by 2.9%.
Despite the complaints of companies and their backers, many analysts feel the exercise has been worth it. That so many companies have had to report problems with their internal controls illustrates that Sarbanes-Oxley is doing its job by helping uncover weaknesses that were either unknown or being ignored.
We at Clear Asset Management agree.
Our question isā?¦ "What would the long-term influence on companies and their shareholders if left unresolved?"
Clear Asset Management's investment process is built to take advantage of advances in computer science, and has been greatly enhanced by the quality and timing of fundamental data disclosure due to these two laws.
The fact that corporations and their accountants have to take the next step in "having a clean act," after the scandals we have seen and the billions of dollars lost by investors, we believe far outweighs the cost of compliance.
Public bellyaching and threats of corporations going private to avoid the cost of compliance is far out weighed by the benefits of protecting investors and the public markets.
We hope the government and regulatory bodies will continue to evolve the laws to balance the needs of investors and corporations. For now, the scale is tilting towards investors, and until corporate misdeeds are in check, rightfully so.
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