Financial Reporting Theory Week 6 Presentation

Dennis Chow

Ivan Chan

Rita Lam

All new disclosure should appear in the Management Discussion &

Analysis Statement

Mandatory? All?

What is a Management Discussion and Analysis Statement (MD&A)?

Purpose:

• information relevant to an assessment of the financial condition

• results of operations of the company

Scope of Disclosures in MD&A

Relevant

Reliable

Material

• “those matters which there is substantial likelihood that a reasonable investor would attach importance in determining whether to buy or sell the securities registered”

• Certainty -- Determined by MGT or evaluated objectively for the consequences

Material defined by SEC:

Talking with CEOs

• Mr Richard Li• Chief Executive Offic

er of

Pacific Century CyberWorks Limited

(PCCW)

• Mr Steven A. Ballmer • Chief Executive Offic

er of Microsoft Incorporation

Talking with CEOs

Present Application of MD&A

In Hong Kong,

• Reference for Disclosures in Annual Report of Hong Kong Exchange and Clearing Ltd

– may disclose (Not restricted) e.g.:• description of the business done and

intended to be done • general development of last 5 years • Corporate government practice

Voluntary !!!

In United States,• SEC Regulation S-K – Required three aspects for disclosure:

Basic Information Covered:i) Liquidityii) Capital Resourcesiii) Results of Operation

Present Application of MD&A

Our Standpoint

Oppose Voluntary disclosure Oppose Voluntary disclosure besides basic requirements in besides basic requirements in

MD&AMD&A

I) Redundancy

II) Expose the virtues and evade from the bad

III) Cost & Benefit

Basic thinking process:

I. Redundancy in MD&A

Receiving Information

Interpretation Judgment

Digest & Understand

Reading Annual Report

Predict the performance of the company

Quantity of Information

---will affect “decision-making effectiveness”

The reason of mentioning the process of thinking, as we have found:

• Decision-making effectiveness of readers has decreased by redundant disclosed information in MD & A.

Let’s see example: MD & A of Giordano Ltd

I. Redundancy in MD&A (cont’d)

I. Redundancy in MD&A (cont’d)

5. Geographical Classification

6. Divisional Classification

P/L

CF statement

1. Turnover of the company 2. Gross Margin3. Distribution and Administrative Cost

4. Cash Flow

8. Liquidity and Capital Resources

9. Human Resources

7. Outlook

Notes to Account

Meet the required content in MD & A

I. Redundancy in MD&A (cont’d)

5. Geographical Classification

6. Divisional Classification

P/L

CF statement

1. Turnover of the company 2. Gross Margin3. Distribution and Administrative Cost

4. Cash Flow

8. Liquidity and Capital Resources

9. Human Resources

7. Outlook

Notes to Account

Meet the required content in MD & A

Conclude:

If we add too much voluntary disclosure information to MD & A, it will cause information repetitions and redundancy.

decrease understandability of MD & A

decrease decision-making effectiveness

• Chairman of Ernst & Young,US, NJ.Groves conducted a survey in 1994

• Try to quantify the excessive disclosures in annual report.

I. Redundancy in MD&A (cont’d)

I. Redundancy in MD&A (cont’d)

Collect & measure the total no of pages -- annual report, footnotes, MD&A of 25 companies in USA.e.g. AT&T, Coca-Cola, IBM, etc

reflect the increasing redundancy problem

Increasing total no of pages

Basic assumption:

• Not all information disclosed is useful.

I. Redundancy in MD&A (cont’d)

Collect & measure the total no of pages -- annual report, footnotes, MD&A of 25 companies in USA.e.g. AT&T, Coca-Cola, IBM, etc

reflect the increasing redundancy problem

Increasing total no of pages

Basic assumption:

• Not all information disclosed is useful.

Conclusion:

The redundancy problem in MD & A become serious as the new disclosure increase from year to year

II. Expose the virtues and evade from the bad

• Focus of MD&A– focus specifically on MATERIAL events and

uncertainties known to management – would cause reported financial information not

to be necessarily indicative of future operating results or of future financial condition

• Focus : material

• However: “Material” is left to the judgment of company management

1. Agency Theory

2. Need not to be audited

3. Company interest to divert investors’ attention

Expose the virtues and evade from the bad

II. Expose the virtues and evade from the bad

(cont’d)

1. Agency TheoryJohn K. Courtis (1996) “Agency theory posits that management would

be motivated to disclose items of information which have the potential to show the company and its management in a certain light”

E.g. Repeat the profits made

II. Expose the virtues and evade from the bad

(cont’d)

2. Credibility of Un-audited Information

• something about forecast

• judgment by management

• arbitrary disclosure may mislead users

• tend to disclose positive price-sensitive information

II. Expose the virtues and evade from the bad

(cont’d)

3. Diversion of Attention from Important Matters

Product-line Profit(loss) Prospect

Ladies 50M 100M

“…The Company has an outstanding performance in Ladies’ cloth, it is expected that our business have a good prospect…

II. Expose the virtues and evade from the bad

(cont’d)

• Diversion of Attention from Important Matters

Product-line Profit(loss) Prospect

Ladies 50M 100M

Men (30M) -

Child (50M) -

Total (30M) -

II. Expose the virtues and evade from the bad

(cont’d)

• Handsome• Strong Body• Good Temper• U-grade• 2M salary per year• Own 2 flats and 1 car• Tender to you

• Such an all-rounded man

• Excellent qualification

Be my valentine

I DO

I Should have done an

AUDIT on your marital

status

Conclusion: Let’s Back to Basic

Too many unnecessary information are meaningless

“Oppose Voluntary disclosure besides basic requirement”

ProfileName: D. ChowAge: 25Sex: MMarital Status:

MARRIED

III. Cost & Benefit

Every Information is Money!!!!

Company’s burden increase

Information disclose increaseManagement spent

time

Admin cost

increase

Reasons: 1. Time spent on sorting information

--Directors spent a lot of time to discuss which info should be disclosed

2. Administration cost will be increased

III. Cost & Benefit (cont’d)But the benefit generated from the increased disclosed info in MD & A is not so great as you think!!!!

In Boeing’s MD&A

--- technical terms---describe the production process in the Research & Development --- Model of the military(e.g F/A-18 Super Honet, F-22 Raptor, AH-64 Apche, V-22 Osprey)

Example:

Boeing --- military aerospace products (e.g helicopters, tanks) manufacturers in US

III. Cost & Benefit (cont’d)But the benefit generated from the increased disclosed info in MD & A is not so great as you think!!!!

In Boeing’s MD&A

--- technical terms---describe the production process in the Research & Development --- Model of the military(e.g F/A-18 Super Honet, F-22 Raptor, AH-64 Apche, V-22 Osprey)

Example:

Boeing --- military aerospace products (e.g helicopters, tanks) manufacturers in USthe increased disclosed information

cannot help investors to predict the performance of the company!!!!!!!

Conclusion• MD&A is good• But be precise• Avoid redundancy• Avoid expose the virtues and evade from the

bad• Avoid Cost over Benefit

Provide information relevant to the assessment for the financial condition and results of operation, and stick to the basic requirement

don’t disclose all

~ The End ~Thank you ^_^