Improving the Corporate Disclosure Process

During the past several years, the business community has been fascinated by a debate over the functioning of capital markets and the need for market reform. Contributing to the debate are a variety of academics, investors, financial commentators, and government policymakers who, through published reports and research, are challenging the conventional wisdom of market efficiency and laissez-faire economics. Some have focused on the functioning of the capital markets and its effectiveness in resource allocation.1 Others have investigated the related topics of financial reporting regulation and corporate governance.2 Still others are challenging the financial accounting tradition by arguing for new accounting models that use more nonfinancial performance measures to capture the returns to strategic investments in technology infrastructure and core competence.3 The intent of all these reports has been to offer insight into the complex interrelationships among patterns of information flow, capital market efficiency, and the competitive performance of U.S. industrial enterprise.4

It is perhaps not surprising that the studies, reports, and articles have generally created more confusion than clarity. Rather than contributing to a single, shared perspective of market functioning, the studies offer a multitude of theories and definitions of market activity that have served only to aggravate the debate, drawing more distinct political and rhetorical boundaries between supporters and critics.

On one side of the rhetorical divide are the economists who argue that unfettered markets offer the most economically rational means for capital allocation. They support the basic economic notion that the markets are efficient and, if left to function freely, will allocate capital to maximize risk-adjusted returns. They also tend to believe that a company’s stock price is an effective summary statistic of its performance. In general, they see no need to reform market functioning or modify substantively the information flow driving market activity. To buttress their view, these economists point to the liquidity, flexibility, and size of the U.S. markets as evidence of their effective functioning.5 They also rightly note that U.S. reporting standards are some of the most developed and sophisticated in the world.

On the other side of the debate are the critics. Generally, they argue that the institutional and regulatory structures supporting market activity are flawed and have failed to provide adequate safeguards against wasteful management and inappropriate corporate investment. They also decry the “short termism” of the markets. These critics suggest that by fixating on quarterly earnings estimates, shareholders and investment analysts have created a market in which managers have little incentive to invest in vital research and development projects to ensure the future prosperity of the U.S. economy.6

The research on which both camps draw is preliminary; nonetheless, there have been policy recommendations and calls for reform. The type of reform is itself a subject of debate, but those who would institute improvements are increasingly arguing for structural change in company law and financial reporting regulation. In a recent report, the American Institute of Certified Public Accountants (AICPA), for example, suggested quite sweeping reform of corporate disclosure policy and the creation of a new corporate reporting model.7 One of its policy suggestions would mandate the disclosure of nonfinancial performance measures. In brief, the AICPA argues that the effective functioning of the markets critically depends on effective information sharing among companies, securities analysts, and shareholders. The aggregate financial information on which the markets now depend, the report suggests, has skewed perceptions of company values and inhibited investment in long-term corporate capabilities. The report concludes that only if the intent and form of corporate reporting is redefined and distribution of more detailed financial and nonfinancial information is ensured, will the U.S. economy be ensured a successful long-term outlook.

Despite the AICPA’s efforts to base its policy recommendations on data from shareholders, lenders, and analysts, and despite academics’ attempts to document users’ information requirements, very little is known about those requirements and how they vary with investment type, users’ sophistication, or investment intent.8 There is also surprisingly little insight into how market participants rate market functioning. Do participants think the markets are efficient or inefficient? Would they reform them? Do they think that market functioning and capital allocation could be improved by changing the nature and scope of financial reporting regulation? Would structural change in reporting regulations and company laws improve information flow in the capital markets, or could improvements in market functioning be made some other way?

We conducted a study to provide insight, if not direct answers to these questions. We wanted to understand how participants view the market and the quality of its functioning, whether improvements in functioning are warranted, and how they might be realized. In contrast to other studies based on analyses of share price movement or aggregate national and industrial output statistics, we based our study on data collected directly from people in the markets, i.e., the analysts, corporate managers, and portfolio managers who buy, sell, and manage most of the stock held by shareholders.

After conducting this study, we now believe that the information links connecting managers, investors, and analysts are indeed flawed and that there is a communications gap among market participants. We also believe that the gap is largest between the managers and shareholders of firms in high-technology industries. However, while analysts and investors recognize the gap’s existence, they apparently do not see it as severe enough to require fundamental change in reporting regulations. Instead, the participants in our study suggest ways to change the process of disclosure and communication.

Our study results suggest that firms can improve shareholders’ and analysts’ understanding of corporate achievements, strategy, and potential by modifying the media they use, reaching out more proactively to users, and studying and responding to their “share” customers’ needs just as they do to their “product” customers’ needs. Our findings also suggest an advantage in developing corporate information disclosure strategies.9 These strategies would explicitly define the intent and purpose of disclosure, the types of information to communicate, and senior managers’ roles in the disclosure process. When well constructed, these strategies would also define measurable goals and objectives against which current disclosure policies’ effectiveness could be appraised. According to our study results, an effective, strategically managed disclosure process should increase management credibility, analysts’ understanding, numbers of long-term relationship investors, and, potentially, share value.10

The Study’s Origins and Research Methodology

We trace the origins of this study back to 1992 when we conducted field interviews with chief financial officers and financial analysts to understand whether and how nonfinancial performance measures should be publicly disclosed to shareholders. The interviews were an extension of previous research we had done on the role of nonfinancial information inside companies.11

Interestingly, the managers and analysts we interviewed were not particularly concerned with nonfinancial disclosures. Certainly none had any vehement arguments for mandating nonfinancial disclosures. What all these individuals were concerned about was the process of disclosure. Many of the financial analysts with whom we spoke considered corporate managers uncooperative and uncommunicative. These analysts were convinced that there was a communications gap separating them from the activities of the firm. At the same time, most of the managers we interviewed thought they were quite conscientious in their communications and worked actively to meet analysts’ needs. However, they too thought there was a communications gap. Many believed that their messages and disclosures were misunderstood and misinterpreted.

To learn more about the nature and severity of this communications gap and to extend our study into related areas of market efficiency, reporting regulations, and corporate disclosure, we conducted a pilot survey of chief financial officers and financial analysts in summer 1993. Using respondent feedback, we then modified the survey and added portfolio managers and investors as a separate response group.12

We constructed many of our survey questions to capture respondents’ impressions of market functioning and the structures of reporting. However, we also devoted a substantial number of questions to issues of corporate action and process. Our process questions and survey methodology in general reveal our interest in understanding human agency as well as “structure.” Despite the traditional academic tendency to analyze the market in aggregate structural terms, we believe that market functioning is not determined by structure alone. It is not simply the result of regulation or laws. Market functioning is also an expression of human action and process. And, because the structures of the market are constructed from and reinforced by underlying processes and sets of human actions, we believe that we cannot understand the market without understanding both structure and process.

We do not criticize the structural approach of the many academics who have already contributed substantially to the disclosure debate. On the contrary, we consider our work complementary to theirs. However, because our work is grounded in the realities of daily “market” life and based on analyses of visible processes, we believe it offers a relevancy that more traditional econometric studies are not usually able to provide.

We also believe that our work can contribute to future academic research and to the construction of new “models” of market functioning. Most information models in previous disclosure analyses are limited; they address interactions between managers and analysts, or managers and investors, or analysts and investors, etc. No structured model has captured the complexity of the markets’ information environment as a whole. However, we do attempt to deal simultaneously with the concerns, incentives, perceptions, and aspirations of multiple parties. We present the capital markets as a social system with all its complexity intact. Although our work is exploratory, its domain is rich, and we believe that the results could be very useful in future analyses that accommodate multiple stakeholders with all their conflicting interests.

Our intent in this paper is to present the aggregate results of our survey and compare and contrast the three survey groups’ response averages. However, we know that respondents’ attitudes do vary significantly with such variables as company size or growth rates, industry age, or investment strategy. To capture some of this variance, we have segmented the data to analyze the unique situations of four industry groups: consolidating, mature, service growth, and high-technology growth (see Table 1 for the industries in each group and data on sales growth rates).

In the sections that follow, we look first at the respondents’ attitudes toward disclosure and communication and explore the nature and size of the communications gap. We then examine attitudes toward market efficiency and functioning to understand how seriously the gap affects the quality of capital allocation. We then consider potential solutions to the gap, looking first at users’ attitudes about structural changes in reporting regulations and then at potential improvements through process changes. Finally, we evaluate the potential benefits of disclosure improvements.

Quality of Communications

One of our central research concerns was the quality of information flow between a company and the capital markets. Like the AICPA’s special committee, we believe that the effectiveness of the markets’ capital allocation process is critically dependent on the availability of precise, accurate information about a firm’s performance and potential.

Our survey data support the critics’ contentions that the capital markets’ communications systems are flawed and that improvements in information disclosure and dissemination processes are needed. We analyzed and compared the three survey groups’ responses on the types of disclosure strategies firms used most frequently. We asked all three groups to identify the disclosure strategy and style their firm or the firms they followed adopted most often. We ranked the options respondents could choose to reflect the extent to which information needs are anticipated and information is made available. For example, we asked managers, “Which of the following statements best describes your company’s approach to corporate information disclosure?” They could select one of five descriptions of strategy:

1. We comply with all legal disclosure requirements but do not offer additional information.
2. We comply with disclosure requirements and offer additional information that we consider relevant or useful to analysts.
3. We answer all questions put to us by analysts and investors short of divulging proprietary or sensitive information.
4. We answer all questions, as in the third strategy, and initiate contact with analysts and investors whenever new information becomes available.
5. We work actively to anticipate concerns and questions and attempt to maintain a continuous dialogue with analysts and investors.

Our data suggest that managers see themselves as quite proactive in communicating with analysts and investors (see Table 2). One-third of the managers report that they work actively to anticipate concerns and questions and attempt to maintain a continuous dialogue with external constituencies. The distribution of analysts’ and portfolio managers’ responses is remarkably different from managers’. Only 6 percent of the analysts and 4 percent of portfolio managers believe that the typical company has adopted the most proactive disclosure strategy, i.e., strategy five. Most analysts and investors identify the second strategy as the one that the companies they follow use most frequently. In fact, while only 25 percent of the managers report using strategies one and two, i.e., the two least proactive strategies, nearly 40 percent of the analysts and nearly 65 percent of portfolio managers believe managers have these strategies.

Differences in the perceived quality of communications and disclosure are even more apparent when we analyze responses by industry group (see Table 3). Nearly 75 percent of the analysts following firms in the high-technology and service growth industries think managers use the two “least open” disclosure strategies, compared to 25 to 30 percent of the managers in these industries. And while 40 to 60 percent of managers think they have the two “most open” disclosure strategies, only 17 percent of the service growth analysts and a mere 4 percent of the high-technology growth analysts share this view. In contrast, analysts and managers in the consolidating industries generally tend to agree on the form and quality of disclosure. No analyst or manager in the consolidating industry segment thinks that firms use the “most open” strategy, and 40 percent of analysts and managers agree that most firms have adopted strategy three or four.

Other survey data substantiate the communications gap’s existence and give insight into its consequences. For example, we asked analysts whether they fully understood the typical company’s strategy. We found that, on average, most analysts agree only slightly that they do.