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Reuters reported that the stock price decline re¬‚ected investors™ concern about the
quality of the ¬rm™s earnings. However, in response FPIC spokeswoman Amy D. Ryan
stated, “As far as we™re concerned, we had a great quarter.” The company™s chief oper-
ating of¬cer, John Byers, argued that the company™s decision to release the unit™s re-
serves was normal business practice and based on its expectations of future claims. In
response to the higher than expected dental claims, the company announced that it had
increased its rates for this insurance.
The sharp decline in its price raises questions about the valuation of the company™s
stock. On September 9, 1999, the price-to-book ratio was less than one, and the price-
to-earnings multiple was 6.0. The market therefore expected that the company would
generate a return on equity somewhat lower than its cost of capital. FPIC™s management
appeared to be puzzled by the sharp drop in price and argued that the market was under-
valuing the ¬rm. However, before this can be concluded, a number of questions need to
answered:
• Was the firm previously overvalued? If so, what forces were behind the market™s
high valuation of the company? If the market expected the company to continue to
grow at 2.8 percent, to generate a 13.8 percent return on equity, and the firm™s cost
of capital is 11.3 percent (consistent with a market risk premium of 4 percent and a
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risk free rate of 5 percent), FPIC would be worth around $20.50. Why then was the
stock valued at $45 early in August? Had management been painting too rosy a pic-
ture for the company™s future in its meetings with analysts?
• What events explain the company™s sudden drop in stock value? As noted above,
the primary question for analysts was the quality of the firm™s earnings. However,
management needs to have a deeper understanding of these issues.
• If management believes that the firm is actually undervalued, what options are
available to correct the market™s view of the company?


COMMUNICATION THROUGH FINANCIAL REPORTING
Financial reports are the least costly and the most popular format for management com-
munication. Below we discuss the role of ¬nancial reporting as a means of investor com-
munication, the institutions that make accounting information credible, and when it is
likely to be ineffective.


Accounting as a Means of Management Communication
As we discussed in Chapters 3 to 8, ¬nancial reports are an important medium for man-
agement communication with external investors. Reports provide investors with an ex-
planation of how their money has been invested, a summary of the performance of those
investments, and a discussion of how current performance ¬ts within the ¬rm™s overall
philosophy and strategy.
Accounting reports not only provide a record of past transactions, they also re¬‚ect
management estimates and forecasts of the future. For example, they include estimates
of bad debts, forecasts of the lives of tangible assets, and implicit forecasts that outlays
will generate future cash ¬‚ow bene¬ts that exceed their cost. Since management is likely
to be in a position to make forecasts of these future events that are more accurate than
those of external investors, ¬nancial reports are a potentially useful form of communi-
cating with investors. However, investors are also likely to be skeptical of reports pre-
pared by management, since managers have con¬‚icts of interest in providing
information that will be used to assess their own performance.


Investors™ Concerns about the Credibility
of Accounting Communication
It is dif¬cult for managers to be truly impartial in providing external investors with infor-
mation about their ¬rm™s performance. Management has a natural incentive to want to
“sell” the company, in part because that is its job and in part because it is reluctant to pro-
vide information that jeopardizes its own job security. Reporting consistently poor earn-
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ings increases the likelihood that top management will be replaced, either by the board of
directors or by an acquirer who takes over the ¬rm to improve its management.2 Conse-
quently, investors sometimes believe that accounting communications lack credibility.


Factors that Increase the Credibility of Accounting Communication
A number of mechanisms mitigate con¬‚icts of interest in ¬nancial reporting and in-
crease the credibility of accounting information that is communicated to stockholders.
These include accounting standards, auditing, monitoring of management by ¬nancial
analysts, and management reputation.

Accounting standards, such as
ACCOUNTING STANDARDS AND AUDITING.
those promulgated by the Financial Accounting Standards Board (FASB) and the Secu-
rities Exchange Commission (SEC) in the U.S., provide guidelines for managers on how
to make accounting decisions and provide outside investors with a way of interpreting
these decisions. Uniform accounting standards attempt to reduce managers™ ability to
record similar economic transactions in different ways, either over time or across ¬rms.
Compliance with these standards is enforced by external auditors who attempt to ensure
that managers™ estimates are reasonable. Auditors therefore reduce the likelihood of
earnings management.

MONITORING BY FINANCIAL ANALYSTS. Financial intermediaries, such as ana-
lysts, also limit management™s ability to manage earnings. Financial analysts specialize
in developing ¬rm- and industry-speci¬c knowledge, enabling them to assess the quality
of a ¬rm™s reported numbers and to make any necessary adjustments. Analysts evaluate
the appropriateness of management™s forecasts implicit in accounting method choices
and reported accruals. This requires a thorough understanding of the ¬rm™s business and
the relevant accounting rules used in the preparation of its ¬nancial reports. Superior an-
alysts adjust reported accrual numbers, if necessary, to re¬‚ect economic reality, perhaps
by using the cash ¬‚ow statement and the footnote disclosures.
Analysts™ business and technical expertise as well as their legal liability and incen-
tives differ from those of auditors. Consequently, analyst reports can provide informa-
tion to investors on whether the ¬rm™s accounting decisions are appropriate, or whether
managers are overstating the ¬rm™s economic performance to protect their jobs.3

MANAGEMENT REPUTATION. A third factor that can counteract external investors™
natural skepticism about ¬nancial reporting is management reputation. Managers that
expect to have an ongoing relation with external investors and ¬nancial intermediaries
may be able to build a track record for unbiased ¬nancial reporting. By making account-
ing estimates and judgments that are supported by subsequent performance, managers
can demonstrate their competence and reliability to investors and analysts. As a result,
managers™ future judgments and accounting estimates are more likely to be viewed as
credible sources of information.
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Limitations of Financial Reporting for Investor Communication
While accounting standards, auditing, monitoring of management by ¬nancial analysts,
and management concerns about its reputation increase the credibility and informative-
ness of ¬nancial reports, these mechanisms are far from perfect. Consequently, there are
times when ¬nancial reporting breaks down as a means for management to communicate
with external investors. These breakdowns can arise when: (1) there are no accounting
rules to guide practice or the existing rules do not distinguish between poor and success-
ful performers, (2) auditors and analysts do not have the expertise to judge new products
or business opportunities, or (3) management faces credibility problems.

ACCOUNTING RULES. Despite the rapid increase in new accounting standards,
accounting rules frequently do not distinguish between good and poor performers. For
example, current accounting rules do not permit managers to show on their balance
sheets in a timely fashion the bene¬ts of investments in quality improvements, human
resource development programs, research and development (with the exception of soft-
ware development costs), and customer service.
Some of the problems with accounting standards arise because it takes time for stan-
dard setters to develop appropriate standards for many new types of economic transac-
tions. Other dif¬culties arise because standards are the result of compromises between
different interest groups (e.g., auditors, investors, corporate managers, and regulators).

AUDITOR AND ANALYST EXPERTISE. While auditors and analysts have access to
proprietary information, they do not have the same understanding of the ¬rm™s business
as managers. The divergence between managers™ and auditors™/analysts™ business
assessments is likely to be most severe for ¬rms with distinctive business strategies, or
¬rms that operate in emerging industries. In addition, auditors™ decisions in these cir-
cumstances are likely to be dominated by concerns about legal liability, hampering man-
agement™s ability to use ¬nancial reports to communicate effectively with investors.

MANAGEMENT CREDIBILITY. When is management likely to face credibility prob-
lems with investors? There is very little evidence on this question. However, we expect
that managers of new ¬rms, ¬rms with volatile earnings, ¬rms in ¬nancial distress, and
¬rms with poor track records in communicating with investors will ¬nd it dif¬cult to be
seen as credible reporters.
If management has a credibility problem, ¬nancial reports are likely to be viewed with
much skepticism. Investors will see ¬nancial reporting estimates that increase income as
evidence that management is padding earnings. This makes it very dif¬cult for manage-
ment to use ¬nancial reports to communicate positive news about future performance.


Example: Accounting Communication for FPIC Insurance Group
FPIC Insurance Group™s key ¬nancial reporting estimates are for loss reserves for
insurance claims using actuarial analysis of its own and other insurers™ claims histories.
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At the end of ¬scal year 1998, FPIC reported a loss reserve of $242.3 million. In its 10-
K, the management warns that “the uncertainties inherent in estimating ultimate losses
on the basis of past experience have grown signi¬cantly in recent years, principally as a
result of judicial expansion of liability standards and expansive interpretations of insur-
ance contracts. These uncertainties may be further affected by, among other factors,
changes in the rate of in¬‚ation and changes in the propensities of individuals to ¬le
claims. The inherent uncertainty of establishing reserves is relatively greater for compa-
nies writing long-tail casualty insurance.”
To help investors assess its track record in making loss estimates, FPIC is required to
provide a detailed breakdown of changes in loss estimates from prior years given actual
claim losses. These data indicate that FPIC has actually been quite conservative in prior
years™ forecasts, and has historically incurred fewer losses than it had initially predicted.
It is interesting to note that the area that raised questions for investors about FPIC™s
record was precisely its conservative estimation of loss reserves and their subsequent
reversal. By being conservative, management may have raised questions about its ability
to forecast losses reliably in the future.



Key Analysis Questions
For management interested in understanding how effectively the ¬rm™s ¬nancial
reports help it communicate with outside investors, the following questions are
likely to provide a useful starting point:
• What are the key business risks that have to be managed effectively? What
processes and controls are in place to manage these risks?
• How are the firm™s key business risks reflected in the financial statements?
For example, credit risks are reflected in the bad debt allowance, and product
quality risks are reflected in allowances for product returns and the method
of revenue recognition. For these types of risks, what message is the firm
sending on the management of these risks through its estimates or choices of
accounting methods? Has the firm been unable to deliver on the forecasts
underlying these choices, through writeoffs or accounting method changes?
Alternatively, does the market seem to be ignoring the message underlying
the firm™s financial reporting choices, indicating a lack of credibility?
• How does the firm communicate about key risks that cannot be reflected in
accounting estimates or methods? For example, if technological innovation
risk is critical for a company, it is unable to reflect how well it is managing
this risk through research and development in its financial statements. How-
ever, that does not mean that investors will not have questions about this busi-
ness issue.
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OTHER FORMS OF COMMUNICATING WITH INVESTORS
Given the limitations of accounting standards, auditing, and monitoring by ¬nancial an-
alysts, as well as the reporting credibility problems faced by management, ¬rms that
wish to communicate effectively with external investors are often forced to use alterna-
tive media. Below we discuss three alternative ways that managers can communicate
with external investors and analysts: meetings with analysts to publicize the ¬rm, ex-
panded voluntary disclosure, and using ¬nancing policies to signal management expec-
tations. These forms of communication are typically not mutually exclusive. For
example, at meetings with analysts, management usually discloses additional informa-
tion that is helpful in valuing the ¬rm.


Analyst Meetings
One popular way for managers to help mitigate communication problems is to meet reg-
ularly with ¬nancial analysts that follow the ¬rm. At these meetings, management will
¬eld questions about the ¬rm™s current ¬nancial performance as well discuss its future
business plans. As noted above, management typically provides additional disclosures
to analysts at these meetings. In addition to holding analyst meetings, many ¬rms ap-
point a director of public relations, who provides further regular contact with analysts
seeking more information on the ¬rm.
In the last ¬ve years, conference calls have become a popular forum for management
to communicate with ¬nancial analysts. Recent research ¬nds that ¬rms are more likely
to host calls if they are in industries where ¬nancial statement data fail to capture key
business fundamentals on a timely basis.4 In addition, conference calls themselves
appear to provide new information to analysts about a ¬rm™s performance and future
prospects.5


Voluntary Disclosure
One way for managers to improve the credibility of their ¬nancial reporting is through

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