Meeting the Street: A Discussion of Earnings and Other Guidance Provided to Investors

Meeting the Street A Discussion of Earnings and Other Guidance Provided to Investors

Robert Kueppers and Gregory Weaver Deloitte

A publication of Financial Executives Research Foundation, Inc.

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Financial Executives Research Foundation, Inc., gratefully acknowledges its donors, especially Cummins, Inc., for their generosity and support.

ADVISORY COMMITTEE

Cheryl de Mesa Graziano Director of Research Financial Executives Research Foundation, Inc. Connie Mc Daniel Vice President and Controller The Coca-Cola Company William M. Sinnett Manager of Research Financial Executives Research Foundation, Inc.

the source for financial solutions 200 Campus Drive P.O. Box 674 Florham Park, New Jersey 07932-0674 www.ferf.org an affiliate of

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financial executives international

Meeting the Street A Discussion of Earnings and Other Guidance Provided to Investors Table of Contents Purpose and Executive Summary

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Introduction

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Survey Results

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Views and Perspectives

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What Does the Guidance Say?

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Conclusion

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About the Authors, Deloitte, and the Financial Executives Research Foundation

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Executive Report

November 2003

Meeting the Street A Discussion of Earnings and Other Guidance Provided to Investors Purpose -- As corporate leaders, regulators, investors and accountants work to restore public trust in the capital markets, each examines the possible causes of high-profile corporate failures. Concern over the role that earnings estimates may have had in some cases has led many to measure the benefits of publishing earnings projections against the risks associated with doing so. This executive report will present some viewpoints from several experienced corporate leaders on this important topic. Results of an informal survey and an overview of related guidance are also included.

Executive Summary Significant events of the recent past have caused many executives and directors to openly debate the merits of practices that were once second nature to U.S. companies. The topics of these discussions have ranged from board practices, such as interlocking board relationships, to executive compensation practices, such as the granting of stock options. What is strategically sound for one company may not be appropriate for another. This period of re-examination may help restore public trust in the capital markets. One area that has come under increasing scrutiny is the common practice of providing forwardlooking earnings guidance to analysts. Citing concerns that a focus on meeting this guidance distracts management from the company’s long-term goals, several large organizations have announced that they intend to reconsider the earnings guidance they have provided. In a recent Deloitte survey, 22 percent of partners responding stated that their clients had reduced the amount, or changed the type, of information provided to the public. An additional 20 percent indicated that their clients continue to debate this issue.1 What factors led to this decision at many companies? What, if any, information will these companies continue to provide to the public? How have investors and other stakeholders reacted to the company’s revised policy? Are there unintended consequences, such as a reduction in analyst coverage, that should be considered? These and other questions are examined in the accompanying executive report. Included in this report are some of the results of the previously mentioned survey of Deloitte partners and interviews with a group of corporate and business leaders on this topic. Finally, this report provides a high-level overview of regulatory guidance that currently defines the acceptable parameters of forward-looking information to be shared with investors. Like so many other governance issues under debate, there is no one-size-fits-all answer, thus the information presented here is merely intended to foster a dialogue.

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The partners surveyed were not selected using a statistical sampling method. The results may not be indicative of those that would have been obtained had a statistical methodology been used to conduct the survey.

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Introduction Progressive Coca-Cola McDonald’s AT&T Safeco World Savings & Loan Mattel Gillette What do these companies have in common? Clearly it isn’t industry, structure or size. And while they are all publicly traded companies, that isn’t their only similarity. None of these organizations provide earnings estimates to analysts or other outsiders. Some have followed this policy for years, and others made the decision recently. Each had its own reasons for discontinuing the long-standing practice among publicly traded companies of providing earnings guidance to outsiders. Some have cited concerns over the regulatory environment; others have raised questions about how such guidance influences senior management’s commitment to financial reporting. Still others believe that they are attempting to refocus management on the achievement of long-term goals rather than short-term results and stock prices. Table 1. The following is a listing of several companies that have announced they will no longer provide quarterly or annual earnings estimates: Company

Date Announced

Reason Cited for the Change

Gillette

January 2001

Focus on earnings estimates distracted management from longterm goals.2

Coca-Cola

December 2002

Establishing short-term guidance prevents a more meaningful focus on the strategic initiatives that the company is taking to build its business and succeed over the long term.3

McDonald’s

January 2003

AT&T

January 2003

Safeco

January 2003

As part of a revised reporting strategy by the company’s new management, McDonald’s announced that it would no longer give specific quarterly or annual per-share earnings guidance. Instead, it will provide a series of financial expectations that it contends will allow analysts to complete their earnings 4 projection models and make fairly accurate forecasts. Financial management is reinforcing its commitment to accurate financial reporting in accordance with generally accepted accounting principles. AT&T will stop making earnings projections, but it will provide more detail about its operating performance. Analysts and investors can use this information to 5 fashion their own forecasts. Given the current regulatory environment, management 6 believes it is no longer a wise practice to provide guidance.

Mattel

February 2003

Management is refocusing on creating long-term shareholder value rather than meeting short-term expectations.7

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“Gillette Beats 4Q Views, Eliminates Providing Guidance,” Dow Jones News Service, January 26, 2001. “Coke to Stop Estimating Earnings; Company Will Stop Providing Quarterly, Annual Forecasts,” The Washington Post, December 14, 2002. 4 “Ending Forecasts Provokes Criticism,” The Wall Street Journal, February 12, 2003. 5 Ibid. 6 Ibid. 7 “Companies: Mattel CEO Expects Challenges to Persist,” The Wall Street Journal Europe, February 4, 2003. 3

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Providing earnings estimates is an important area for discussion as investors may punish companies that fail to meet such estimates. In addition, investigators charged with understanding the corporate failures of the past two years have raised concerns about the preoccupation with meeting Wall Street's expectations among senior management at many companies. For example, investigations of several former WorldCom executives have alleged the existence of two sets of financial records. One may have included actual operating results, while the other may have contained various accounting irregularities aimed at meeting announced earnings estimates.8 On the other side of the debate, some doubt that stock volatility will be reduced by a trend to eliminate earnings estimates. Investors may continue to react sharply to earnings that reflect significant fluctuations. Some analysts and investors have also questioned the motives of certain companies that recently decided to eliminate or significantly scale back forward-looking information.9 Global economic uncertainty has hurt the operating results of many public companies, making it difficult to meet earnings estimates provided even six to eight months prior to the release of the actual results. Smaller companies may be concerned about how analyst coverage could be diminished if they choose not to provide earnings estimates. Institutional and other investors may continue to demand information to guide their investments in large, established companies. It is unclear, however, whether investors will demand analyst coverage for emerging companies. It may be too costly for analysts to take the time to develop comprehensive earnings projections for small companies. The analyst community itself is facing uncertainty and challenge. In early 2003, several large investment banks agreed to settle claims related to alleged improper investment practices, which resulted in a highly publicized agreement with securities regulators. Some market observers have speculated that this settlement will cause these firms to cut their research operations, which could reduce coverage of small- to mid-cap companies.10 This debate raises a number of issues that may require careful consideration. Many companies may find themselves in the gray area between providing no forward-looking information and providing detailed, bottom-line earnings estimates. Survey Results Deloitte recently conducted an informal survey of its client service partners, requesting information related to the types of forward-looking guidance their clients typically provide to analysts and the public.11 The 70 survey participants provide services to clients in the consumer business, financial services, healthcare, manufacturing, real estate, transportation, utilities, technology, media and telecommunications industries. A full 84 percent of the respondents indicated that the clients they serve release forward-looking information to the public. Thirteen percent said that the client has never provided forward-looking information, while 3 percent indicated the client recently decided to discontinue the practice. Of those companies that release guidance information, many provide earnings per share (EPS), revenue and/or net income information (refer to Charts I and II).

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“Leading the News: WorldCom Report Suggests Ebbers Knew of Accounting Irregularities,” The Wall Street Journal, March 12, 2003.

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“Ending Forecasts Provokes Criticisim,” The Wall Street Journal, February 2, 2003. “(Still) Pity the Poor Little Guy,” Business Week, May 19, 2003. 11 The partners surveyed were not selected using a statistical sampling method. The results may not be indicative of those that would have been obtained had a statistical methodology been used to conduct the survey. 10

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Chart I.

Does the company provide forward-looking information to analysts and other outsiders? 3%

13% Yes No, the company has never provided forward-looking information

No, the company recently decided to stop providing forward-looking information

84%

Chart II. What types of forward-looking information are provided?* *Respondents could select more than one option. 39

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15 13

Operating cash flow

Executive narrative i.e., CEO/CFO statement

Capital expenditures

Net income

Revenue

EPS

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Many of the respondents noted that their clients release forward-looking information for the upcoming year or quarter, usually in the form of press releases or conference calls (see Chart III). Fifty-six percent of the respondents said they anticipate no change in the type or amount of forward-looking information provided by their clients, while only 22 percent said their clients reduced the amount and/or changed the type of information released. About one-fifth continue to debate the issue. (see Chart IV).

Chart III. Where is forward-looking information provided?* *Respondents could select more than one option. 47 Quarterly earnings press release or conference call 41 Annual earnings press release or conference call Press release or conference call not related to financial statement earnings releases Company’s Web site Other

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Chart IV.

Does the company intend to continue providing forward-looking information? 2% Yes, no change in the type or amount of information provided Yes, but a reduction in the type or amount of information provided

20%

Unknown, company is still considering this issue Yes, but an increase in the type or amount of information provided

22% 56%

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Views and Perspectives12 The following interviews with thought-leaders on this topic offer views on providing forwardlooking earnings guidance. Each individual was asked to provide his or her real-world perspective on this issue. James Cantalupo, Chairman and Chief Executive Officer, McDonald’s Corporation James Cantalupo is chairman and CEO of McDonald’s Corporation. A 28-year veteran of the company, Mr. Cantalupo has served as president and vice-chairman of McDonald’s Corporation and CEO of McDonald’s International. He currently serves on the boards of directors of Sears, Roebuck, and Co., Illinois Tool Works, World Business Chicago and the Chicago Council on Foreign Relations. He is an honorary member of the board of trustees of the Chicago chapter of the National Multiple Sclerosis Society and a past president of the International Federation of the Multiple Sclerosis Societies. Mr. Cantalupo serves on the board of trustees of Ronald McDonald House Charities, and he previously served as a director of the Northern Trust Bank/DuPage. Can you tell us about the events and circumstances that caused McDonald’s to decide to stop providing earnings guidance? Historically, our business lent itself to providing forward-looking earnings targets. We were very formalized and fairly simple, at least on the surface. Analysts loved to cover us because they were rarely wrong. Over time, we began to globalize our The decision [not to provide earnings estimates] business. Today, nearly half our has changed our focus from the short term to earnings are generated outside of the the long term pretty dramatically. We had always United States. We operate in 120 looked at things from a quarter-to-quarter countries worldwide, and the perspective. socioeconomic environment of each James Cantalupo one, to varying degrees, influences our financial results. This has changed the “crystal-ball” landscape considerably. Our ability to predict quarterly earnings with the precision the investment community was looking for was severely impacted. We were also at the beginning of a revitalization plan for the business, and we wanted to emphasize our targets for the next 18 months to three years, not the next few quarters, both internally and externally. In that situation, there was no point in putting ourselves on the line with quarterly earnings targets. The decision has changed our focus from the short term to the long term pretty dramatically. We had always looked at things from a quarter-to-quarter perspective. Of course, that can never go completely away as long as there are analysts out there making projections. How did the market react when McDonald’s announced it would no longer provide earnings estimates? Also, what types of information are you providing? We announced in January just after I came back from retirement. The market knew the situation, and we approached it from the standpoint that we had a big job in front of us that required a total refocus. The analysts didn’t think it was unusual and were actually quite supportive of the position. We really didn’t have a lot of push-back, and I was very pleased with how the market reacted. I think the positive reaction was partly related to the fact that we did provide some guidance to analysts on specific drivers of earnings—we simply didn’t give them specific EPS targets. The information we provided for 2003-04 can be easily worked into the analysts’ models. We repeated 12

Several of the companies whose representatives are quoted in this article are clients of Deloitte. These individuals were not compensated or otherwise induced in any manner, nor was Deloitte compensated by the companies for inclusion in this executive report.

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the same process in April with updated information on forecasted capital expenditures. Also, we’re now releasing actual monthly sales information. If there’s something important that investors need to know, we’ll mention it. In our business, same-store sales are really critical, so we give that in all our releases. We’ll reassess this decision in the future. When we get back on track and our business model is more developed, there’s really no reason why we couldn’t have the same predictability we had before. Then we might be in a position to provide even more projected information. For now, we have provided a picture of targeted, sustainable top-line and operating income growth that can be expected beginning in 2005. We recognize the next couple of years will be rebuilding years. How did the board of directors react to the decision? Our board was positive because the company had missed several prior projections. It was not a decision made by the board; it was made by management. The board also agreed that monthly sales releases made sense. I happened to be on four other boards at that time, all of which were providing earnings estimates. I feel the same way regardless of which role I’m in. Providing precise quarterly earnings projections just doesn’t seem to have a lot of upside potential. Companies have plans, and events unfold much differently, so providing an annual plan up front and continuously providing actual results seems to be a more sensible model to follow. Charles L. Hill, Director of Research and Chief Financial Analyst, Thomson First Call Charles L. Hill, CFA, is director of research and chief financial analyst for Thomson First Call, which conducts real-time broker research and provides quantitative data to the global financial community. Prior to joining First Call, he was vice president at Scudder, Stevens & Clark, performing securities analysis of technology companies. Mr. Hill has also worked in several capacities at Kidder, Peabody & Co., Bache (now Prudential), Quantum Associates and IBM. He holds an M.B.A. from Harvard University, as well as a B.S. in chemical engineering and a B.A. in history from the University of Delaware. How does a company’s decision to provide forward-looking earnings estimates affect the ability of research analysts to accurately cover the company? In order to provide reasonable estimates, analysts need appropriate tools. The bottom line for a company is driven by many factors, and analysts need guidance on how the company’s performance would compare under different scenarios. With so many variables at play, companies really don’t That is the type of information know what earnings are going to be. Why, therefore, that can only be obtained from would you give any specific earnings targets, whether the company. For example, it’s a specific number or even a range? My advice is not management may know that a to provide earnings targets, rather, to inform the public price drop below a certain more broadly on what management does know. level would lead to the closing Charles Hill of a certain facility. If the analyst doesn’t know that information, earnings estimates wouldn’t reflect this possibility. An outsider can only go so far without some level of information from the company. What can happen if a company stops providing all forward-looking information? I think the trend will result in more volatility. Unexpected fluctuations in the company’s priceearnings ratio may be punished even more severely if investors are taken completely by surprise. Companies often believe that discontinuing forward-looking information will focus investors on the long term, which also may not be the result. Investors may be forced to focus more time and

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attention on understanding the short-term performance of the company rather than looking across the valley to the long term. It is in the company’s best interests to keep the public informed as best it can. Absent forwardlooking guidance from the company, the investment community's reaction to financial surprises is going to be, “Wow, what kind of internal controls does the company have if something like this can occur without warning?” That’s not to say that I believe bottom-line guidance is either necessary or wise. With so many variables at play, companies really don’t know what earnings are going to be. Why, therefore, would you give any specific earnings targets, whether it’s a specific number or even a range? My advice is not to provide earnings targets, rather, to inform the public more broadly on what management does know. Let’s say a company has made the decision not to provide bottom-line earnings estimates. What types of information should it make publicly available? Forgetting for a moment about the question of exactly what types of forward-looking information should be provided; I think companies must be very proactive in providing information on the current quarter. Reporting within the current quarter has changed as a result of Regulation FD. It used to be that analysts would try to differentiate themselves by being the first to report financial information provided by the company. Now, all information has to be released to investors at the same time, and analysts are at the mercy of whatever the investor relations department is willing to tell them. In other words, everyone is on equal footing. So, I believe companies should be very proactive in providing information on the current quarter results during the quarter. Underline what you know rather than giving guidance on what you hope or think the results are going to be. As a quarter goes on and events unfold, let the public know. With respect to forward-looking information, again I think the company should talk about future events and results when they are known. Companies that clam up completely will see a much wider range of estimates out there; estimates then become “guesstimates,” providing little value to the investor community. As a CEO, I can narrow that range by providing more explicit guidance without hanging myself out to dry by providing a specific earnings target. Good analysts who are doing their job can take the information provided by a company and turn it in to a reasonable estimate. Does the advice change depending on the industry? Modifications by industry are probably warranted. Commodity industries like metals or papers probably don’t want to give a revenue range, whereas consumer-driven industries that are sensitive to economic events can probably give a pretty tight revenue range. Again, focus on what you know—and that will change depending on the industry. Robert J. Mylod Jr., Chief Financial Officer, priceline.com Robert J. Mylod Jr. has been chief financial officer of priceline.com since November 2000. From May 2000 to October 2000, he was acting chief financial officer for WebHouse Club, a privately held e-commerce company and a licensee of priceline.com. From January 1999 to May 2000, Mr. Mylod held several different positions within priceline.com’s finance department, including senior vice president. Prior to joining the company, he was a principal at Stonington Partners, a private equity investment firm that manages more than $1 billion of institutional capital dedicated to venture capital investments and leveraged buyouts. Mr. Mylod is on the board of directors of Alliance Capital Partners and Findwhat.com, an Internet search engine. He holds a B.A. in English from the University of Michigan and an M.B.A. in accounting and finance from the University of Chicago.

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What is your company’s policy for providing earnings estimates to analysts and other outsiders? It is crucial to have a clear understanding of the corporate context of earnings guidance as it relates to growth companies versus more mature companies. As compared to the Cokes and Gillettes of the world, our revenues are comparatively small, and our financial results are relatively volatile. In the absence of information provided by the company, there will be a higher risk of significant deviation from analysts’ estimates for high-growth companies than for more established companies with predictable results. As a result, companies like priceline.com have little choice but to provide detailed, current operating guidance to avoid the unacceptable stock volatility that comes from these deviations. I think the practice of analyzing a company’s performance against analyst estimates is here to stay. You hear it all the time on CNBC and in a company’s own press releases where companies compare their actual results against First Call, which is essentially the average of several analyst estimates. If a company like priceline.com doesn’t provide its own estimate, actual results can deviate on both the positive side and the negative side. If there were to be a prohibition on providing guidance, there is a potential that our operating results would deviate more significantly from what analysts predicted than would be the case for a more established company. Financial markets are apt to negatively react to these deviations—all of which could have serious consequences for our stock price. As a result, I would never stop providing guidance unless it was a requirement. How do you feel about the trend of many companies, including several we have interviewed, to stop providing earnings guidance? The practice of measuring a company Volatility in the stock price may make it more against earnings estimates is not difficult for companies to complete acquisitions without flaws. The reality is that a that rely on their stock as the currency for the company might miss its earnings estimate, but be performing very well. transaction. Companies owe it to their Investor mindset has been to punish shareholders to manage this volatility using companies that miss analyst appropriate means, such as providing earnings estimates regardless of the underlying guidance, to improve the likelihood of meeting operational results of a company. If the long-term growth strategy. earnings estimates were abolished Robert Mylod completely, then that’s another thing entirely. Investors would have to begin measuring the value of a company based on true performance, instead of measuring the value based on its ability to meet the analyst estimates. Frankly, I don’t see this happening any time soon, and until it does, many companies just will not be in a position to stop providing guidance. If you believe, as I do, that analysts will continue projecting earnings whether or not the company gives them the information to do so, I believe this decision could have broad implications. Companies whose results are more volatile and less predictable may be particularly concerned if their long-term strategy includes growth through acquisitions. Volatility in the stock price may make it more difficult for these companies to complete acquisitions that rely on their stock as the currency for the transaction. These companies owe it to their shareholders to manage this volatility using appropriate means, such as providing earnings guidance, to improve the likelihood of meeting the long-term growth strategy. What other options do you recommend exploring? Before I answer that question, I do want to commend the SEC on the implementation of Regulation FD, which I submit has had a positive impact on CFOs everywhere. Prior to

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Regulation FD, when an analyst would significantly deviate from the guidance provided by the company, a CFO would be confronted with difficulties and challenges related to correcting such predictions. Under FD, I publicly present line-by-line analysis that conveys the best information that I have, and that’s it. Analysts who stray from this guidance basically do so at their own peril, as CFOs are generally precluded from providing any additional information. I firmly believe that Regulation FD may be one of the best regulations that the SEC has established. As a practical matter, I’m not sure we have seen a viable alternative to the current practice of measuring companies against First Call estimates. Until that time, I would submit that efforts might be better focused on perfecting the model under which we currently operate. For example, there are some serious issues with the numbers game as it is currently being played. Many companies provide an earnings estimate that is low compared to their own internal budgets and projections in order to leave a lot of cushion. Then, midway through the quarter, they may put out a press release that indicates their performance is beating estimates—the market reacts favorably and the stock rises. This creates an incentive to be overly conservative with the numbers. There are no rules out there that say the earnings estimates should be the company’s best estimate, and perhaps there should be. Herbert M. and Marion Sandler, World Savings Bank Herbert M. Sandler is co-chairman and co-CEO of World Savings Bank, the second-largest thrift in the country. World Savings Bank has been the subject of numerous feature articles in The New York Times, The Wall Street Journal and other major business periodicals. Mr. Sandler has been called upon to testify numerous times before the Banking Committees of both the Senate and House of Representatives. He is currently a member of the boards of directors of the Success for All Foundation and The Fisher Center for Real Estate at the University of California at Berkeley. His most recent industry service has been on the board of the Federal Home Loan Bank of San Francisco and the Thrift Institutions Advisory Council to the Federal Reserve Board. Mr. Sandler is an attorney and a graduate of the College of the City of New York. He received his J.D. from Columbia University. Marion Sandler is co-chairman and co-CEO of World Savings Bank. She began her financial career at the investment banking firm of Dominick & Dominick, and she holds the distinction of being the first woman selected for its executive training program. Later she moved to Oppenheimer & Co. as a senior analyst and advisor to major institutional investors. She is currently a member of the boards of directors of the Success for All Foundation, an organization that develops and disseminates a literacy program directed to public schools in impoverished areas, and MDRC, a research corporation dedicated to learning what works to improve the wellbeing of low-income people. She has served as president of the Thrift Institutions’ Advisory Council to the Federal Reserve Board, The Glass Ceiling Commission and the advisory boards of the Schools of Business Administration of the University of California at Berkeley and of the New York University School of Business. Mrs. Sandler holds a degree in economics from Wellesley College and an M.B.A. in banking and finance from New York University. What is your company’s policy on providing earnings estimates? HS: Our company does not provide forward-looking earnings estimates to the public. Period. That has always been our policy. We do report actual results more frequently than many companies. For example, we publicly release rolling 13-month financial highlights using actual results every month. You may find it interesting to know that Regulation FD had no impact for our organization. We have always practiced full disclosure by providing information to everyone at the same time. MS: It’s a matter of maintaining our credibility. CEOs who consistently miss earnings estimates lose credibility with the market. And the bottom line is that you are predicting the future. We just don’t always know how every factor will play out. I think many CEOs are naïve in this respect— they believe they are expected to provide earnings estimates, so they do.

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Why do you think some analysts resist this trend? What is at stake for them? MS: There was a time when the analyst community would actually do research and analyze. This all changed in the late ’80s and ’90s. Analysts began reporting whatever the CEO and the company gave them. Hyping the stock versus providing research and analysis became the order of the day. Analysts want validation. The job of the analyst is to project earnings. It’s like being an economist—what’s going to happen and why is it going to happen that way? Analysts get respect when earnings consistently meet their projections. Do analysts need to be fed this information to do their job? Absolutely not. HS: What analysts are trying to get from you is the unknown. I believe that a stock’s value should move up when the company performs well, not when the company meets the number it previously provided. What advice would you give to a company that is working through the decision to discontinue earnings estimates? MS: If you’re short-term-oriented, then you’re not It’s a matter of maintaining our ready to do this. A company that stops giving earnings credibility. CEOs who consistently guidance needs to have a perspective and a miss earnings estimates lose conviction that it is the right thing to do. Again, the biggest problem with providing earnings estimates is credibility with the market. And that most companies just don’t know what earnings will the bottom line is that you are be. It’s interesting that the same companies that predicting the future. forecast earnings are unwilling to provide actual Marion Sandler monthly information. There needs to be a change in mindset from focusing on the short term to focusing on the long term; from focusing on Wall Street to focusing on operating strategy and shareholder value. A company that decides not to provide earnings estimates needs to communicate frequently and, in some cases, in more detail than it has in the past. If your company isn’t ready for all of the above, then you’re not ready for a change. HS: I think it’s a non-decision. You’re either honest or dishonest. You either hype the stock or you don’t hype the stock. Companies that provide forward-looking information are faced with ethical decisions as a result of that practice: should we do the right thing or should we meet our estimates? When you stop providing forward-looking information, these ethical decisions go away. CEOs need to get comfortable with saying, “Sorry, we’re just not going to tell you that.” Michael R. Young, Partner, Willkie Farr & Gallagher Michael R. Young is a senior partner of the New York law firm of Willkie Farr & Gallagher. Mr. Young is a litigator specializing in securities and financial reporting. He is also the author of Accounting Irregularities and Financial Fraud, which many consider the definitive resource on this issue. He has testified in hearings before the Senate Banking Committee’s Subcommittee on Securities, the Blue Ribbon Committee on Improving the Effectiveness of Audit Committees of the NYSE and Nasdaq, and the Panel on Audit Effectiveness of the Public Oversight Board. Mr. Young is a graduate of Allegheny College and the Duke University School of Law. What are the particular dangers you have seen in providing forward-looking information to the public? When a company is thinking about providing forward-looking information, management should keep in mind that earnings estimates do carry a significant danger. Once an estimate is publicly

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available, failure to meet the estimate will often have a disproportionate effect on the company’s share price. Over the past several years, financial misreporting and accounting manipulations have often resulted from overly optimistic Wall Street expectations that cannot be achieved. This creates an unhealthy mindset in which management begins to believe that the estimates must be met at all costs. In this kind of an environment, managers are tempted to explore the hazy areas of accounting as devices to compensate for operational shortfalls. From there, even managers who think of themselves as honest and ethical may end up perpetrating financial fraud. Does that mean a company should not provide any forward-looking information? Not at all. But it must do so with a realistic appreciation of the difficulties raised by issuing overly aggressive estimates. And, when it comes to employees, companies must be careful to avoid sending the message that failure to meet estimates will be viewed as unforgivable. Do you see an alternative? There is an alternative that may meet the needs of investors to receive timely information about a company’s performance without necessarily creating the dangerous environment that can be created by providing forward-looking earnings estimates. That is, companies can provide historical information on a more frequent basis. Some companies, for example, provide certain operational results, such as revenues, on a monthly basis rather than a quarterly basis. Investors are given actual results in a timelier manner, reducing the need for a company to provide forwardlooking information to control expectations. What are the regulatory considerations if a company were to decide to provide more frequent historical information? There aren’t any SEC restrictions in place that would preclude a company from providing monthly operating results. In fact, some could argue that providing investors with more frequent, even real-time, information is an underlying theme of recent SEC rulemaking and the Sarbanes-Oxley Act. This may be one of the underlying reasons for the Inherent in any proposal for improving the financial accelerated filing dates for annual reporting system is the concept that the numbers and quarterly reports; the deadline cannot be released until they are reliable. for filing 10-Ks and 10-Qs will Companies would need to address [this issue] ultimately be cut by about onebefore they will be able to move towards more third. The Sarbanes-Oxley Act frequent communication of historical information also increased the number and with the public. types of disclosures that must be Michael Young made to investors on a real-time basis. We may be seeing a trend that will eventually lead toward a true real-time financial reporting model with critical financial information being updated continuously. If that happens, providing earnings estimates will become an ancient relic of a system that, frankly, has not worked all that well. Is there a downside of the movement toward real-time financial reporting? A number of concerns are often raised. An important one is that virtually all companies will need to improve the reliability of financial reporting systems to improve the reliability of the real-time financial information. Inherent in any proposal for improving financial reporting is the concept that the numbers cannot be released until they are reliable.

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Another concern, expressed by some executives, is that a real-time financial reporting system would provide competitors with too much information too soon. On the other hand, that may be just another way of saying that real-time financial reporting might serve to enhance competition, and many would view enhanced competition as an overall benefit. Still other executives have expressed concern about the increasing transparency that would result from real-time financial reporting, though that might be viewed as the result of a natural human proclivity towards secrecy. What about the audit function? How can an outside auditor, or for that matter an internal auditor, be expected to opine on financial results that are continuously flowing out to the public on a real-time basis? That is an important question. And what we may see is an evolution of the audit function to accommodate the needs of a real-time system. Let me explain. The way the system is designed now, the auditor provides “data assurance”—that is, the auditor provides an opinion on specified numerical results. As we evolve to a real-time system, we may see the audit function evolve as well. The auditor would potentially evolve from one who gives “data assurance” to one who gives “systems assurance.” That is, the auditor would not offer an opinion on the precise numerical data but, rather, on the internal control system by which that data was generated. Here, again, the Sarbanes-Oxley Act could be viewed as heading in this direction. One of the, in my opinion, landmark aspects of Sarbanes-Oxley is its requirement that management and the auditor issue a report not simply on the numerical data but on the company’s internal control system over financial reporting. Once more, we see as an underlying theme of Sarbanes-Oxley the potential evolution to a real-time financial reporting system. Are you saying that the future is bright for the elimination of financial fraud? Let’s be serious—we are never going to eliminate financial fraud. However, it is foreseeable that today’s nonsensical preoccupation with Wall Street's quarterly expectations will become a thing of the past, and that one of the most powerful motivators behind financial fraud—the perceived need to attain quarterly earnings estimates—will thereby become a thing of the past along with it. In that sense, the future may indeed be bright.

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What Does the Guidance Say? Communications with Analysts and Earnings Releases Companies have a great deal of flexibility when providing information in earnings releases. There is no current guidance regulating the types of information companies should include in their earnings releases with the exception of Regulation G. This regulation addresses additional disclosure requirements related to the release of financial information calculated and presented on a basis other than in accordance with generally accepted accounting principles (GAAP). Regulation G requires companies to provide certain disclosures whenever they publicly disclose or release non-GAAP financial measures, and also provides additional guidance to those companies that include non-GAAP financial measures in filings with the Securities and Exchange Commission (SEC). Additionally, the SEC adopted amendments that require companies to furnish to the SEC, on Form 8-K, earnings releases or similar announcements. The new rules and amendments are applicable equally to domestic and foreign private issuers, with a few exceptions. Regulation G applies to any public disclosure or release of material information that includes a non-GAAP financial measure whether that information is furnished to, or filed with, the SEC. Regulation G also requires the disclosure of the most comparable amount and prohibits misstatements or omissions that would make presentation of a nonGAAP measure misleading. The requirement to furnish earnings releases and similar materials to the SEC on Form 8-K applies to earnings releases and similar announcements made after March 28, 2003. Regulation FD (Fair Disclosure) is also a consideration in company communications with both the public and the analyst community. Regulation FD addresses the selective disclosure of material nonpublic information by issuers and clarifies two issues under the law of insider trading. The regulation provides that when an issuer, or person acting on its behalf, discloses material nonpublic information to certain enumerated persons (in general, securities market professionals and holders of the issuer's securities who may well trade on the basis of the information), it must make public disclosure of that information. The timing of the required public disclosure depends on whether the selective disclosure was intentional or non-intentional; for an intentional selective disclosure, the issuer must make public disclosure simultaneously; for a non-intentional disclosure, the issuer must make public disclosure promptly. Under the regulation, the required public disclosure may be made by filing or furnishing a Form 8-K, or by another method or combination of methods that is reasonably designed to effect broad, non-exclusionary distribution of the information to the public.

Conclusion At this time, there is no one-size-fits-all answer to the question of what, if any, forward-looking information can or should be provided to the public. In the end, the needs and objectives of each company’s stakeholders will play the most important role in management’s decision-making process.

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About the Authors Robert Kueppers is a senior technical partner at Deloitte and is the firm’s National Managing Partner—Risk, Professional, and Regulatory Matters. In this capacity Mr. Kueppers leads the firm’s professional practice group in its National Office, and has overall responsibility for the firm’s risk management programs, as well as domestic regulatory matters and legislative affairs. Mr. Kueppers is active in issues affecting the profession on behalf of the firm. He is presently the Chairman of the AICPA’s SEC Practice Section Executive Committee. He is a past member of the AICPA’s Professional Ethics Executive Committee and the SEC Regulations Committee. Mr. Kueppers is also a Vice President, Treasurer, and a Trustee of the SEC Historical Society in Washington, DC. Greg Weaver is the National Managing Partner of Audit & ERS for Deloitte. He is an active member of the U.S. Executive Committee for the firm and is also a member of the Global Assurance Leadership team, a team of individuals charged with overseeing the global audit practices for Deloitte. Prior to his current role, Mr. Weaver was the Deputy Managing Partner of Assurance. He has spent his entire career (more than 30 years) providing professional services to large multi-national companies, with a specialty in mergers and acquisitions. He is active in the AICPA and a member of the Financial Accounting Standards Advisory Council. Greg is also a member of the board of directors of the National Action Council for Minorities in Engineering, Inc. Bob and Greg would like to thank and acknowledge each of the individuals who agreed to be interviewed for this Executive Report, as well as the following Deloitte professionals who were instrumental in its research and production: Nicole Haims, Senior Manager; William Leimbach, Partner; Diana Rabito, Senior Project Specialist; Thomas Restivo, Senior Manager; and Dawn Trapani, Partner. About Deloitte Deloitte, one of the nation's leading professional services firms, provides accounting, assurance and advisory, tax, and management, financial and human capital consulting services through nearly 30,000 people in more than 80 U.S. cities. Deloitte is dedicated to helping our clients and our people excel. Known as an employer of choice for innovative human resources programs, Deloitte has been recognized as one of the "100 Best Companies to Work For in America" by Fortune magazine for six consecutive years. Learn more about Deloitte at www.deloitte.com. About Financial Executives Research Foundation, Inc. Financial Executives Research Foundation, Inc. is the research affiliate of Financial Executives International. The purpose of the Foundation is to sponsor research and publish informative material in the field of business management, with particular emphasis on the practice of financial management and its evolving role in the management of business. The mission of the Research Foundation is to identify and develop timely, topical research to advance the financial management profession. The Foundation is an independent 501(c)(3) educational organization. The Foundation receives no portion of FEI Members dues; rather, it relies on voluntary taxdeductible contributions from corporations and individuals. The views set forth in this publication are those of the authors and do not necessarily represent those of the Financial Executives Research Foundation Board as a whole, individual trustees, or the members of the Advisory Committee. This and more than 50 other Research Foundation publications can be ordered by logging onto www.fei.org/rf

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This article contains general information only and should not be relied upon for accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice of services, nor should it be used as a basis for any decision or action that may affect you or your business. Before making any decision or taking any action that may affect you or your business, you should consult a qualified professional advisor. The information contained in this publication likely will change in material respects; we are under no obligation to update such information. Neither Deloitte & Touche LLP, Deloitte Touche Tohmatsu, nor any of their affiliates or related entities shall have any liability to any person or entity who relies on this publication.

Copyright © 2003 by Financial Executives Research Foundation, Inc. and Deloitte & Touche LLP All rights reserved. No part of this publication may be reproduced in any form or by any means without written permission from the publisher. International Standard Book Number 1-885065-66-3 Printed in the United States of America First Printing

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