Market Value - Professional Investors Views on Financial Reporting in Canada

8/13/2019 Market Value - Professional Investors Views on Financial Reporting in Canada

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Market value

Professional investors viewsabout financial reportingin Canada

A report co-sponsored byCPA Canada, PwC andVeritas Investment Research


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Highlights


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A valuable toolbox

When making investment decisions,

investors value formal financial reportssuch as the financial statements,managements discussion andanalyses (MD&A), annual informationforms (AIF) and management proxycirculars. Generally, investors reportedbeing satisfied with the informationthey receive from companies.Nevertheless, investors also notedareas where improvements shouldbe made to accounting standards orsecurities regulations. While initiallyskeptical about Canadas transition

to International Financial ReportingStandards (IFRSs), investors experience with the first year of IFRS reporting hasresulted in most being comfortable withthe changeover.

Communicating complexity

Financial reporting has becomesignificantly more complex over thelast several years, and in some cases,companies seem to struggle witheffectively and concisely communicatingsuch complexity to stakeholders. Forexample, few investors were awareof the importance of transactionsthat are processed through OtherComprehensive Income, even thoughthese transactions may have significantimplications for the company. Preparersshould carefully consider how best toplainly and succinctly communicate theimpact of such transactions to ensurethat investors are properly informed.Overall, the use of less boilerplatelanguage in financial documents was a

repeat request.

One report

Many investors believe that all of a

companys formal annual financialreporting should be presented ina single omnibus report to avoidduplicate information across documentsand concentrate all data for ease ofsearching. A significant minority,however, prefer the current multi-reportapproach, which in their view providesmore timely information.

Non-GAAP measures

While nearly all investors appreciatenon-GAAP measures to betterunderstand managements insightsabout performance results, stakeholdersalso want more comparability acrossreporting periods and between peers.The desire for comparability extendsto information generated by dataconsolidators who extract non-GAAPmetrics from financial reports andpresent them without adjustment fordiffering definitions.

Keeping current

Several investors were uncomfortable with their level of understanding ofaccounting standards. While partlyaddressed through companiesinformation sessions and disclosuresof material new accounting standards,the increasing complexity in financialreporting may indicate a need forinvestors to place additional emphasison financial reporting in theirprofessional development plans.

Areas for improvement

Investors identified various additionalareas where reporting should beimproved, including segments, pensionsolvency, and debt covenants. Theseare set out in Section 6 of the Detailed findings .

To reach the aforementionedconclusions, a cross-disciplinaryteam from the Canadian Institute ofChartered Accountants (now CPACanada), PwC, and Veritas InvestmentResearch conducted one-on-oneinterviews with over 30 professionalinvestors chief investment officers,portfolio managers, and buy- and sell-side analysts. We asked interviewees:

their experiences with the transitionto IFRSs;

how they use financial reports; the information they use in decision

making; their views on non-GAAP measures;

and areas of reporting that should be

improved.

The following pages set out detailedfindings and excerpts from theinterviews, along with an analysis ofthe trends.

The sponsoring organizations were represented by:

Lucy Durocher, CPA , CA PwC Canada

Chris Hicks, CPA , CA CPA Canada

Anthony Scilipoti, CPA , CA Veritas Investment Research

Key takeaways Approach

Market value | Highlights


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In order to gauge investors experience with the transition from previousCanadian GAAP to InternationalFinancial Reporting Standards (IFRSs), we asked respondents to describetheir feelings about IFRSs, specificallytheir views on the transitions impacton corporate results and disclosure,managements communication of thatimpact, and whether IFRSs improvedinvestors understanding of overallcorporate performance.

Its a definite positive to havethe fair value available there.

In some cases I think its justa matter of getting up a newlearning curve in terms ofunderstanding it.

Its more complex to mebecause its new.

Many investors had concerns about themove to IFRSs prior to the transition,but as the transition progressed,investors became more comfortable with IFRSs.

I was looking forward tothe adoption of consistent standards around the world... I thought it was a good step forward.

I would say that we were quiteapprehensive beforehand. Once we got into [it] we found that[for] a lot of the companies-- it wasnt that big a deal.

I was uncomfortable beforeit happened... I didntknow exactly what was going to happen so I wasuncomfortable Well nowthat its done Ive seen thenumbers so now Id like

to say Im comfortable, withthe caveat that maybe theresadded complexity that I dontknow is there.

Detailed findings

1 Transition toIFRSs

2 Market value | Detailed findings


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Investors reported that companies hadgenerally communicated the materialimpact of various changes brought on byIFRS prior to the transition, so surprises were reduced to a minimum.

The companies I follow weredoing a great job in terms of guidance.

Respondents suggest that IFRSs aregenerally not considered to be morecomplex than Canadian GAAP. When asked whether they thought the IFRS transitionsignificantly changed companies financial

results, those who reported significantchanges slightly outnumbered those whonoticed only minor change. This differenceof opinion likely reflects the varying impactof the transition on different industrysectors. The majority of investors who didnotice a change in financial disclosuresunder IFRSs reported no significantimprovement in their understanding ofcompanies performance. The investorssurveyed also hold opposing views as to whether the additional disclosures underIFRSs are useful.

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More disclosure, but I think its not complicated.

The obvious areas [of change] would be REITs and financialcompanies moving towards more market value accounting. It makes a lot of prior historical comparisons invalid so youdont have a context anymore.

Some of the assumptions have been useful, although I find a lotof companies have already outlined them.

The amount of information that comes at us now is far too much to make a proper decision.

Market value | Detailed findings


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We asked investors to tell us whichelements of formal financial reportingthey use on a regular basis and theimportance of these documents to theirinvestment decisions.

All the investors we interviewed usefinancial reports on a regular basis,in a number of different ways, andemphasize that almost all aspects offinancial reporting are important totheir decision making.

When I pick up a financial statement the first place I go: cash flow, balance sheet,

income statement the financials are like a map.

I use it to establish historicaltrends in profitability, cash flow, debt equity ratios, financial strengths and so on.

Usually you start with readingthe MD&A, the financial statements and the press

release and then you lookat that within the context of whats happening out therein the world as relevant to whatever this industry is. Fromthere you talk to the companieson the conference call andclarify things that are notnecessarily well articulated.

Investors rely on formal financialreports, such as the MD&A, financialstatements and associated notes, asthe basis for building and updating valuation models on the companiesthey follow and to assist in the ultimate

investment decision. More than half ofthe surveyed investors also indicate thatthey use financial reports to double-check or supplement other sources ofinformation as part of the investmentdecision making process.

Its the source documents, thethings these guys file. Theyrereally the only things that

matter in the model.Our process doesnt use predictive models extensively.Our process looks a lot at whats happened in the past.We use a lot of historicalinformation.

[Financial statements] are veryimportant but I would say

the notes that go along withthem are equally important formaking companies comparableto each other.

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2 How investors usefinancial reporting



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Several investors also remarked on theusefulness of the Annual InformationForm (AIF) as a good tool forunderstanding the company or business.

Annual Information Form forbusiness risks Im not alwayslooking for [the] upside Imlooking for the potential blowup or downside scenario.

The AIF is a good documentbecause it provides a historythat is quite useful and moredetailed. The explanation of

the industry and linking allof that together is important.

Investors believe that a clean auditopinion is a prerequisite to investing,but they do not gain additional comfortor insight from the content of thestandardized auditors report.

Well its important if its notthere. Its important like airand water is important youllnotice if its missing.

While a minority of investors usequarterly reporting in the same wayas annual reporting, the majority ofinvestors use annual reporting as theprimary source of detailed and completeinformation, supplemented with

quarterly disclosures.

We find the full years resultsmore fulsome more detailand aligns more with ourinvestment process, whichis more of a long-term timehorizon.

So we spend less time trying to predict quarters and more timetrying to predict 2-3 years out.

We dont use annual reporting, we use quarterly reporting. By the time it comes out March 31 is Q1.

Most of the investors we surveyedstated they would find it useful to havethe Canadian annual report presentedas one single document, similar to the10-K report found in the United States.Reasons for this include the ease of

finding information and a reduction inrepetition of the same information overseveral documents. However, a numberof investors pointed out that they wouldrather not jeopardize the timelinessof the releases for the aggregation of asingle report.

I think that would be quitehelpful as opposed to searchingaround looking for it all.

More streamlined [reporting] would be better.

5Market value | Detailed findings


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When asked which three metrics or lineitems they monitor, investors identifiedthe following most often:

EBITDA Free Cash Flow

Operating Cash Flow Operating Margin Revenue Gross Margin

Other significant ratios that investorsmonitor include cash flow-to-debt, debtcoverage ratios, return on equity, andreturn on assets.

Financial statements are investorsprimary source of financial information,though many also use other aspects offinancial reporting, such as the MD&A.Some also cited data consolidatorsas a source of financial information,particularly for non-GAAP measures.

The Income Statement, Balance Sheet,and Cash Flow Statement are allconsidered very important to investorsdecision making. In contrast, OtherComprehensive Income (OCI) is notconsidered useful and investors placed

little value on it, likely because it isnot widely understood. In terms ofspecific disclosures, almost all investorsconsider segmented information anddebt retirement schedules to be veryuseful to the decision making process.Most investors also agree that thedisclosure of assumptions used bymanagement in significant estimates is very useful to decision making.

The financial statements areobviously important becausethey allow you to do the(quants), but the colour, whichis almost equally important,comes from the footnotes andthe MD&A.

I may be one of the very few people who actually look atthe OCI and I find it extremelyuseful. But I think its like the greatest story never told typeof thing

The MD&A is useful because sometimes there is data therethat is not in the financial statements, and that might give segment information thats notin the financial statements.

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3 Evaluation offinancial informationused in decision

making



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4 Evaluation of non-financial informationused in decision making

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Investors use a number of sources for other information not generally found in the financial statements:

Non-Financial Information Most Cited Sources*

Meetingts withManagement MD&A

AnnualInformation

Form

FinancialStatements

ManagementInformation

Circular

Sell-sideResearch

Strategy

Competitive environment

Risk disclosures

Information about management(including compensation)

Industry-specific metrics & other KPIs

Environmental and social impact

Governance information

* Cited by 15% or more of our respondents



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Survey participants noted thatinformation on strategy and thecompetitive environment are themost important of these categories.Most investors believe that theyreceive adequate information about a

companys strategy, although only halfare satisfied with the information on thecompetitive environment.

Meetings with managementare nice to have, but I reallyrely on source documents.

I have to do so muchincremental work outside

of the scope of the financial statements. Most of mytime is spent doing my owncompetitive analysis, talking tocustomers, talking to vendors, global trends...

The quality of the informationreally depends on the company.

Information on strategy its

helpful, but the adequacy couldbe better. Some companies are great, for others its a head scratcher.

Theres very little informationon the competitiveenvironment.

I dont think companies needto give me more information

about their competitiveenvironment. Thats our job.

For many investors, risk disclosures,industry-specific metrics, governanceinformation and information aboutmanagement are also important to theirdecision-making. Of these disclosures,investors generally believe that both risk

disclosures and governance informationcould be greatly improved. Investorssuggested that risk disclosures could bemore entity-specific and ranked in orderof probability, while several respondentscategorized governance disclosures asseemingly a check the box exercise,rather than a communication of theunderlying ethics and culture of acompany.

Theyll state the issue but wont go into how likely it is the probability of it occurring.

There are forty risk statements,most of which may not even berelevant.

I would rather just have the topthree risks that are facing yourbusiness today.

I do look to see who is on the Board. I know most of the guys. Ill know if theyre independentor not from experience.

Im not sure youre ever goingto get a good self-assessment when it comes to governance.

We also asked investors how useful theyfound social impact and environmentalinformation. More than half of investorsagree that this is not useful informationfor their decision making. At the sametime, there are mixed views on the

adequacy of current disclosures. Someinvestors believe there is plenty ofinformation on these topics, but thatit is not useful, while others viewedenvironmental and social impactinformation as very useful, but foundthe current disclosures inadequate fortheir needs. Responses suggest that ifmore meaningful information aboutsocial and environmental factors wereto be communicated consistently byall companies, investors would placegreater emphasis on such factors whenassessing a company.

These disclosures are relativelynew. Everybody is learning andtrying to find out what assistsinvestors and regulators... its still a work in progress.

A lot of companies haveenvironmental reports and Ithink thats important, but I dont think its critical.

Some companies put out anentirely separate report. I cant say that I haveactually read one.

I dont think anyone has figured out yet what to actuallymeasure. So is it adequate? Probably not.

Internally, were trying to pushon the ESG thing. Its usefulinfo just done in a reallybad way.


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More than half of the investors wesurveyed perceived an increase in theuse of non-GAAP measures since theadoption of IFRSs. Overall, investorsare positive about the perceivedincrease in non-GAAP measures, with

approximately 80% of respondentsfinding the measures useful.

My perception is that its morecommon not sure if thats IFRS or a general trend.

Some of those metrics are muchmore economic reality...muchmore the underlying business.

They provide more granularitythan the GAAP measures.

In the oil and gas industry its where they marry volumes with financial results... itscritical for understandingthe business.

IFRS doesnt have a whole lot

of say in a reserve evaluation, for example oil, gas, miningcompanies... I pay a lot ofattention to that.

Survey responses clearly indicate thatinvestors believe non-GAAP measuresprovide valuable additional information.However, investors are divided on whatmanagements motivations are for usingnon-GAAP measures. Some believe

non-GAAP measures give managementa chance to show underlying operatingand financial performance, whileothers believe management providesthe measures to show a better pictureof performance than would otherwisebe permitted by GAAP. A few investorshave a foot in both camps, stating thattheir view depends on the level of trustthey have in a companys management.

It depends on if you trustmanagement or not.

One answer could be to makethemselves look better. Forothers its to make themselvesmore comparable.

Its window dressing noquestion about that.

We need GAAP but its not theonly way to look at a company.These additional measures provide insight into theunderlying performance ofa business.

This is our earnings beforeinconvenient items.

5 Non-GAAPmeasures

12 Market value | Detailed findings


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Despite skepticism about managementsmotivations in disclosing non-GAAPmeasures, most investors are notconcerned that non-GAAP measuresare outside the scope of the financialstatements and thus are not audited.

However, many investors believe thatthere should be some assurance aroundcompliance with regulatory guidanceover non-GAAP financial measures.

As long as non-GAAP measuresare shown somewhere I dontcare where they are shown.

I want the auditors to do some

procedure on this so that thereis comparability, consistencyand so on because its beingdisclosed and its beingrelied upon.

I think it [assurance] would beuseful, at the right price.

Overall, investors seem to be content with the current rules regardingthe presentation, calculation anddisclosures of non-GAAP measures.In particular, investors value therequirement that a non-GAAP measure

must be defined, and that changes in itscomposition from year to year must behighlighted and explained. Investors aremost concerned with consistency, andbelieve that it would be preferable torestate a prior years non-GAAP measure when its composition changes, ratherthan only describing the change.

It would be very helpful...either go back and change what you presented before or reallyquestion whether you shouldbe changing your methodologyat all.

Even if its non-GAAP there should be comparability over periods. You want the trend.

We also asked whether non-GAAPmeasures should be presented onlyif they are used by management inrunning and assessing the business,but most investors disagree with thisrestriction. Investors believe that

providing commonly used non-GAAPmeasures, such as EBITDA or measurescommon across particular industries, isuseful even if management does not usethe measure internally.

If they dont use it internallybut the outside world uses it,its important.


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Finally, we asked investors for their wish list what three things would they mostlike management or standard-setters to improve about corporate reporting.The most common responses (in order of frequency of occurrence) given byrespondents as areas for improvement are:

1. Consistency, disclosure of calculations and appropriateness ofnon-GAAP measures

2. Improved segmented information and/or increased disaggregationof information to enhance users understanding of the underlyingoperations

3. Reduction in the volume of notes, but increased relevance andreadability of items disclosed within financial statements

4. Disclosure of pension solvency calculations

5. An enhanced MD&A, which provides a variance analysis betweenmanagements planned actions and actual results and eliminatesboilerplate disclosures

6. Better disclosures of significant assumptions used in financialstatement preparation would allow investors to re-perform calculations

7. Disclosure that distinguishes maintenance capital expenditures fromgrowth capital expenditures

8. More meaningful risk disclosures

9. Increased disclosures surrounding the constitution and calculation ofdebt covenants

10. Increased consistency of accounting policies between companies insimilar industries

6 Areas forimprovementin financial

reporting



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Non-GAAP measures

There should be some accountability when theres a departure fromindustry standards in terms of non-GAAP measures.

I would like to see more standards around how they are calculating the numbers.

I would like to see non-GAAP measures provided on a segmented basis.

Disaggregation of information

Segmentation really shows what goes on below the surface.

We need more disaggregation in the numbers... companiesaggregate so they can mask mistakes.

Id like to see more segmentation of the revenue line than I generally get.

Disclosure overload

Reduce the volume of information. When you ask people if they wantmore disclosure they always say yes, but it becomes too much.Theres very little added value.

Get rid of the boiler plate give me some meaningful disclosure.

What investors said about...


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2013 PricewaterhouseCoopers LLP, an Ontario limited liability partnership, Chartered Professional Accountants of Canada and Veritas Investment Research. All rights reserved.

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Documents

Market Value - Professional Investors Views on Financial Reporting in Canada