8.4 THE ROLE OF ACCOUNTING INFORMATION IN TRANSNATIONAL ANALYSIS
8.4.3 The usefulness of components of annual reports
Although it was viewed as a useful benchmark document, the annual report also attracted a degree of criticism, relating primarily to the lack of timeliness and the lack of forward-looking information, both of which have been identified in domestic based research. Overall, however, it was clear from the interviews that the annual report is of critical importance in transnational analysis. It represents a useful information source in itself; and for fund managers, it supplements and helps verify information acquired from the two other main information sources, company management and investment analysts.
Table 8.7 Usefulness of components of annual reports
Domestic analysis Transnational analysis
Mean Std. dev. Mean Std. dev.
Group balance sheet 4.20 0.77 4.50 0.66
Cash flow statement or equivalent
4.44 0.77 4.47 0.72
Group income statement/equivalent
4.04 0.88 4.39 0.75
Segmental information 4.20 0.68 4.24 0.76
Notes regarding accounting policies
3.85 0.93 4.02 0.95
Operating and financial review or equivalent
3.81 0.84 4.02 0.79
Review of operations 3.69 0.86 3.75 0.88
Financial review 3.65 0.87 3.73 0.87
Report of management board or equivalent
3.36 1.03 3.56 0.94
Chairman’s/president’s statement/equivalent
3.40 1.00 3.48 1.01
Summary statistics or figures
3.10 0.95 3.48 0.97
Statement of total recognised gains and losses
3.03 0.97 3.44 1.15
Historical summary 3.16 0.91 3.36 0.95
Principal subsidiary and associated undertakings
2.90 0.92 3.21 1.02
Shareholder information 2.89 0.96 3.16 1.09
Graphs and charts 2.81 0.90 3.04 1.05
Corporate governance information
2.38 1.04 2.44 1.14
Auditors’ report 2.32 0.98 2.30 1.12
growth, which is typically captured by information reported in the income statement and/or the cash flow statement.
The interviewees attributed the primary ranking of the balance sheet to various factors. First, and common to both domestic and transnational analysis, the balance sheet is important in performance measurement for determining the levels of capital invested in ratios such as return on capital employed (ROCE) and return on equity (ROE). Second, the balance sheet acts as an indicator of corporate financing. Thus, information on capital structure, minority interests, changes in shareholders’ funds and reserves
is contained in the balance sheet. While these details are also important in domestic company analyses, respondents commented that in transnational analysis, information on corporate financing patterns is particularly useful in assessing the protection of equity investments, particularly in countries where equity is not the primary source of finance. For example, Fund Man- ager 9 stated that levels of external ownership (i.e. minority interests) relative to internal funds can act as a barometer for the company’s attitude to outside investors:
[The balance sheet] gives you a picture of the nature of the company, of the culture of the company – whether it is very conservative, whether it is run for the benefits of shareholders, or whether there is a family ownership structure where they don’t care what earnings are.
The third function of the balance sheet in transnational analysis is as a means to deriving cash flow. In UK company analysis, such information is provided explicitly in the cash flow statement, as required by FRS1.
It was clear from respondents that the reporting of such information by overseas companies was not always sufficient or presented satisfactorily.
For example, Analyst 9 (a European steel companies analyst) commented:
The balance sheet is useful for foreign companies as they do not always give you the cash flow information in the way you would like, so you can derive cash flow from the balance sheet.
Fund Manager 1 also noted that ‘cash flow statements (if there is one) are often unreliable or in an unusual format, especially in Asia and Europe’.
Similarly, Fund Manager 18 stated that he is not always able to obtain cash flow data, so the balance sheet may be used.
The fourth reason for the importance of transnational balance sheet relates to the perception of fund managers and analysts of the deficiencies of the income statement. Two analysts and six fund managers commented that the income statement is less reliable than the balance sheet, and in some cases, this related to specific countries or regions. Analyst 1 stated:
There is a view in some markets in particular, because of high tax rates and large tax allowances and different treatments of goodwill and amortisation, that the P&L is more prone to manipulation and the balance sheet is therefore more important.
The final function of the balance sheet has implications beyond the im- mediate issue of the use of a particular component of the annual report as it appeared to be symptomatic of a defensive attitude peculiar to transna- tional investment; here, the integrity of investment in terms of security is apparently of greater importance than company growth, as measured by the income statement. This is in line with the extra dimension of risk in
transnational investment, comprising differences in financial accounting, reporting, legal and business environments.
The use of the balance sheet was dominated by concerns about viability and liquidity as opposed to performance measures. Thus, fund managers raised concerns over company debt and tangible assets, especially cash.
Analysis of debt levels are likely to be of particular importance in transna- tional analysis due to the additional foreign exchange risk. Investors are therefore particularly concerned with the underpinnings of the investment, sometimes at the expense of profitability. Fund Manager 3, for example, stated that in certain countries, companies with a healthy cash balance trade at a significant premium due to the perception of risk by local and foreign investors. However, rather than focus entirely on company value, the de- fensive approach is characterised by the establishment of higher hurdles in terms of security of the investment, as exemplified by the following quote:
Firstly, you take a look at survivability in the balance sheet, and then you take a view of earnings, prospects and cash flow prospects. It’s not that the profit and loss account is less valuable, the balance sheet is more. (Fund manager 1).
Inter alia, therefore, the balance sheet is seen as a ‘safety net’ in transnational investment. The following quotes sum up its role and significance:
The balance sheet is the best guide to financial strength and should be the basis on which any investment is made. You can tell from the balance sheet almost immediately if there is something wrong. (Analyst 2)
The balance sheet is a defence check that the firm is not going bust or if it is a highly grown company, that it can finance its growth. It is one of the first things we look at as a check that the foundations are good. (Fund Manager 9).
Two further results from Table 8.7 worthy of specific attention are the relative usefulness of the notes to the accounts, and shareholder informa- tion. That details of accounting policies in the notes to the accounts are more useful in analysing foreign companies is unsurprising, given that, on average, fund managers and analysts analyse companies from a number of different countries. Therefore, reference to the bases on which the financial statements are prepared will be more important, as there will be more vari- ation in accounting treatments than in purely domestic analysis. Information on foreign company shareholders is the 15th most useful source in transna- tional analysis and is more useful (at the 0.05 level) in analysing foreign companies than UK companies. This information is relevant for ascertaining the levels of a) institutional ownership, and b) foreign investor ownership.
Both of these may be useful guides to the priorities given to institutional investors and analysts in terms of disclosure and access to management. In
countries which, in general, do not give equity shareholders and institutional investors priority and/or access to financial information, details of prior in- stitutional investment may be useful for gauging individual companies’
attitudes towards shareholders.