Commentary: Annual Reports: Still Not Enough Candor

By Mike McNamee

Think back a year ago. Accounting scandals were breaking out all over, Congress was gearing up to write reform legislation, and the Securities & Exchange Commission was out stumping for better disclosure by companies. Did Corporate America get the message?

Nope. The SEC spent a year reviewing the annual reports of America's 500 biggest companies -- and had to go back to 350 of them for more information, clearer explanations, or deeper insights. Although it didn't name companies or penalize them, the agency says too many simply rehashed the numbers or "presented boilerplate."

Now it's crunch time. Annual reports for 2002 are heading to the printers, and companies are on notice to tell their owners more about opportunities and risks they face. The SEC and investors alike need to be on high alert for obfuscation, gobbledygook, and what Alan L. Beller, director of the SEC's Corporation Finance Div., calls "elevator music" -- soothing sound signifying nothing.

The "management discussion and analysis" (MD&A) section of reports needs the biggest improvement. Even before the Enron Corp. scandal, the SEC wanted executives to use MD&A to paint a clear picture of how a company made its money, what drove the year's sales and earnings up or down, and what significant goals and risks the company saw ahead. Warren E. Buffett -- whose chairman's letters for Berkshire Hathaway's annual report are a model -- has a simple standard: Chief executives should write the MD&A as if they were explaining what's happening to a business partner who has been out of touch for the past year. "I would expect them to tell me what the hell is going on, and I would expect them to tell me that directly," Buffett told an SEC forum.

Companies do offer some of that -- to big investors and analysts who participate in earnings-season conference calls. But the annual report is the main way companies communicate with individual investors, and they're entitled to the same insights. What they're not getting, the SEC says, is analysis of "material year-to-year changes and trends" and of important indicators such as liquidity, cash flow, and capital resources.

The SEC also wants companies to explain their key accounting policies better. Decisions on when to keep debt off a balance sheet, how to recognize revenue from a long-term contract, or how taxes are calculated can swing the bottom line by millions of dollars. The SEC wants companies to add new analysis of why they made key decisions and explain how different approaches would have changed their results.

Hidden assumptions are especially crucial in pension accounting. With the sick stock market, traditional pension plans that bolstered bottom lines in the late '90s are now producing "significant unrecognized losses," which are often unclear to investors, the SEC says. Companies need to spell out the economic and actuarial numbers they plug into their pension calculations so investors can tell whether they're being hoodwinked.

All this extra analysis and detail could turn annual reports into phone books. To avoid that, companies must make clear disclosure a top priority. That means more attention from the CEO -- who should be, in Buffett's term, the "chief disclosure officer" -- and less influence for lawyers, who often turn straightforward reports into mush. "Disclosure is too important to be left solely to lawyers," says Beller.

The SEC, too, must stay on the case. Even with the new lawyers and accountants it's hiring, the agency says it can't review every annual report every year. But it should strive to beat the standard of reviewing each company once every three years set by the Sarbanes-Oxley Act of 2002, especially for big companies. And rather than twisting corporate arms in private -- as it did last year -- the agency should force more CEOs to take the embarrassing step of publicly amending their annual reports. Investors deserve to know what's going on in the companies they own.

McNamee covers the SEC.

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