Financial Reporting Theory Week 6 Presentation

1. Financial Reporting Theory Week 6 Presentation Dennis Chow Ivan Chan Rita Lam

2. All new disclosure should appear in the Management Discussion & Analysis Statement Mandatory? All?

3. 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

4. Scope of Disclosures in MD&A Relevant Reliable Material Redundancy Info Overload Operation results Liquidity Capital resources Immaterial data Cost > Benefit

5. Material defined by SEC: • “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

6. Mr Richard Li Chief Executive Officer of Pacific Century CyberWorks Limited (PCCW) Talking with CEOs

7. Mr Steven A. Ballmer Chief Executive Officer of Microsoft Incorporation Talking with CEOs

8. Present Application of MD&A Voluntary !!! 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

9. Present Application of MD&A In United States, • SEC Regulation S-K – Required three aspects for disclosure: Basic Information Covered:i) Liquidityii) Capital Resourcesiii) Results of Operation

10. Our Standpoint Oppose Voluntary disclosure besides basic requirements in MD&A I) Redundancy II) Expose the virtues and evade from the bad III) Cost & Benefit

11. Receiving Information  Interpretation Judgment Predict the performance of the company Reading Annual Report Digest & Understand   I. Redundancy in MD&A Basic thinking process: Quantity of Information ---will affect “decision-making effectiveness”

12. I. Redundancy in MD&A (cont’d) 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

13. P/L CF statement Notes to Account 7. Outlook Meet the required content in MD & A 8. Liquidity and Capital Resources 9. Human Resources I. Redundancy in MD&A (cont’d) • Turnover of the company • Gross Margin • Distribution and Administrative Cost 5.Geographical Classification 6. Divisional Classification 4. Cash Flow

14. Conclude: If we add too much voluntary disclosure information to MD & A, it will cause information repetitions and redundancy. decrease understandability of MD & A P/L decrease decision-making effectiveness CF statement Notes to Account 7. Outlook Meet the required content in MD & A 8. Liquidity and Capital Resources 9. Human Resources I. Redundancy in MD&A (cont’d) • Turnover of the company • Gross Margin • Distribution and Administrative Cost 5.Geographical Classification 6. Divisional Classification 4. Cash Flow

15. I. Redundancy in MD&A (cont’d) • Chairman of Ernst & Young,US, NJ.Groves conducted a survey in 1994 • Try to quantify the excessive disclosures in annual report.

16. Increasing total no of pages reflect the increasing redundancy problem  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 • Basic assumption: • Not all information disclosed is useful.

17. Increasing total no of pages reflect the increasing redundancy problem  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 Conclusion: The redundancy problem in MD & A become serious as the new disclosure increase from year to year • Basic assumption: • Not all information disclosed is useful.

18. 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

19. II. Expose the virtues and evade from the bad (cont’d) • Focus : material • However: “Material” is left to the judgment of company management • Agency Theory • Need not to be audited • Company interest to divert investors’ attention  Expose the virtues and evade from the bad

20. II. Expose the virtues and evade from the bad (cont’d) 1. Agency Theory John 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 useful to user? Meaningful? telling the whole story?

21. 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 credible?

22. II. Expose the virtues and evade from the bad (cont’d) 3. Diversion of Attention from Important Matters Smart Fashion Co. Ltd. “…The Company has an outstanding performance in Ladies’ cloth, it is expected that our business have a good prospect…

23. II. Expose the virtues and evade from the bad (cont’d) • Diversion of Attention from Important Matters Smart Fashion Co. Ltd. disclosed NOT disclosed

24. 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 I DO Be my valentine

25. Profile Name: D. Chow Age: 25 Sex: M Marital Status: MARRIED 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”

26. III. Cost & Benefit Information disclose increase Every Information is Money!!!! Management spent time • Reasons: • Time spent on sorting information • --Directors spent a lot of time to discuss which info should be disclosed Admin cost increase Company’s burden increase 2. Administration cost will be increased

27. III. Cost & Benefit (cont’d) But the benefit generated from the increased disclosed info in MD & A is not so great as you think!!!! Example: Boeing --- military aerospace products (e.g helicopters, tanks) manufacturers in US 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)

28. III. Cost & Benefit (cont’d) But the benefit generated from the increased disclosed info in MD & A is not so great as you think!!!! Example: Boeing --- military aerospace products (e.g helicopters, tanks) manufacturers in US the increased disclosed information cannot help investors to predict the performance of the company!!!!!!! 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)

29. 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

30. ~ The End ~Thank you ^_^