Resolving the current corporate reporting crisis:
Creating a new model for corporate reporting based on three tiers that ensure full transparency

“There is a time to stand up and be counted – to stand up and offer one’s best. Hence this book, addressing a topic that has been forcibly brought to the world’s attention: the future of corporate reporting in a time when major business failures and a stiff critique of the practices of auditors and influential securities analysts have shaken the public trust. […] Crisis is opportunity. Virtually every participant in what we have called the Corporate Reporting Supply Chain is looking for new answers, new ways to assure investors and other stakeholders that the information they are receiving enables them to understand companies in detail and in depth. We hope that this book stimulates dialogue among all of us who are responsible for building public trust in the markets, on which the progress of society in all parts of the world depends."

                      Samuel A. DiPiazza Jr. and Robert G. Eccles

The strongest cries for reform of corporate reporting have come from the United States in the wake of the largest bankruptcy in the country’s history, the abrupt and unanticipated failure of Enron. Not surprisingly, many accusations are being made, many lawsuits have been filed, and proposals for new regulations and laws are under review in many countries. While the debate about a reform of corporate reporting is not new and many bright people have been working on proposals for a new corporate reporting model (such as in an SEC-inspired task force, which came up with their report “Strengthening Financials Markets” in May 2001, the Danish Agency for Trade and Industry’s research project that culminated in it’s November 2000 publication “A Guideline for Intellectual Capital Statements” – about both I have reported earlier several times on this website -  or in the “Business Reporting Research Project” of the U.S. FASB that released it’s report on January 2001), this has not led to fundamental change initiatives by regulatory bodies yet – until now.

The awakening brought about by the Enron disaster and by others that followed it is the proverbial straw that broke the camel’s back. After other business failures in a number of countries and after the burst of the Internet bubble it was Enron, which was the last straw. Because of the Enron case, public trust has been shaken in the institutions on which the global capital markets depend for getting the information needed to make a wide range of investment decisions. But the two authors believe, that the Enron bankruptcy is not the most important issue. Instead, it is how the aftermath of this business failure can serve as a lens to sharpen our collective focus on the key elements that create public trust in markets and, therefore, allows those markets to allocate capital efficiently.

Building Public trust is a call to institute the necessary reforms to ensure that public trust does not disappear. And DiPiazza and Eccles believe that the foundation for those reforms lies in corporate reporting. Therefore they propose to re-examine the Corporate Reporting Supply Chain, how they call it. It begins with the corporate executives, who prepare the financials statements that are reported to investors and other stakeholders. These financial statements are approved by an independent board of directors, attested by an independent auditing firm, analysed by sell-side analysts, and broadcasts by information distributors, including data vendors and the news media.

A new model for corporate reporting based on three tiers that ensure full transparency

The book offers a vision of the future of corporate reporting – a vision based on a revised model of corporate disclosure, a fresh view of the responsibilities of every participant in the corporate Reporting Supply Chain, and suggestions about technologies, such as Extensible Business Reporting Language (XBRL), that can help make the vision to become reality. The intention of the two authors with this book is, to spur action towards the reforms that will build up public trust and initiate a dialogue among all participants of the Corporate Reporting Supply Chain to make that happen.

Their basic recipe for a new corporate reporting model is, in order to improve the information corporate reports provide to investors and thus increase their trust in corporations and in the capital markets at large, to significantly broaden the scope of corporate reports. With Building Public Trust, DiPiazza and Eccles are introducing a three tier model for corporate transparency:

§      Tier 1: A set of truly global generally accepted accounting principles (Global GAAP)

§      Tier 2: Standards for measuring and reporting information that are industry-specific, consistently applied, and developed by the industries themselves.

§      Tier 3: Guidelines for company-specific information such as strategy, plans, risk management practices, compensation policies, corporate governance, and performance measures unique to the company.

Why a three tier model?

Much is being done today to improve corporate reporting. But each group involved has its own goals and its own rather narrow view of what will make things better. Therefore many of these different initiatives focus on one of these tiers. But the authors state, that the market requires a larger organizing framework that will focus all of these efforts to become part of one integrated model that can ensure that investors and other stakeholders get the information they need to make appropriate decisions. And investors will benefit fully only if companies communicate the information in each tier in an integrated fashion that provides a holistic view of the enterprise – its marketplace opportunities, its strategies and their implementation, its value drivers, and its financial outcomes.

The need for Global GAAP: Tier-One

At the foundation of DiPiazza’s and Eccles’s Three-Tier Model of Corporate Transparency is the existence of Global GAAP, a set of accounting standards for reporting a company’s financial performance for a defined period. Only Global GAAP can provide the information that investors need, to compare financial performance of companies from different countries. Just as markets for tangible products have become global, so have the capital markets. Investors want to invest around the world, just as companies want access to capital around the world. But the vast differences that exist among national and international accounting standards, and in the levels of transparency they create, impair the ability of investors to compare the financial performance of companies that report according to different sets of standards. The resulting uncertainty about the reliability of reported financial information can be reflected in a higher cost of capital through a lower share price. Conversely, if Global GAAP existed, investors could much more easily and accurately compare the performance of any company, in any country, in any industry.

But the lack of a global GAAP standard is not perceived as the only shortcoming of the current GAAP practice. Criticism about GAAP worldwide includes also that GAAP focus too much on short term earnings, thus fostering the so called earnings game. In addition, GAAP based financial reports do not account for or disclose certain types of information about intangible assets, and do not communicate adequate information about value creation. DiPiazza and Eccles believe that most of these problems can be resolved by adding additional information to the GAAP based financial numbers at Tier 2 and Tier 3 of their model. But the biggest problem at Tier 1 remains the lack of a Global GAAP standard. But we may be close to a solution. The authors name the efforts of the IASB (International Accounting Standards Board) that established the International Financial Reporting Standards (IFRS – before called the International Accounting Standards – IAS). While IFRS will become the standard in the European Union in 2005, where it will apply to companies that represent 25 percent of the world’s total market capitalization, the adoption in the U.S., with approximately 52 percent of the world’s market capitalization, will represent the decisive milestone for its global success.

The need for supplemental financial and non-financial industry specific information: Tier-Two

But what drives value, dramatically differs across industries. DiPiazza and Eccles are demonstrating that by comparing the pharmaceutical industry, where value creation is mainly driven by product innovation, with the telecommunication industry, which creates value mainly through marketing, customer retention, competitive pricing and other market related activities.

In order to compare one company’s performance to that of its industry competitors, investors need, in addition Global GAAP based figures, which provide a foundation, supplemental industry specific information, both financial and non-financial, to gain a more complete view of a company’s past performance and to make inferences about its future prospects. Because the competitive dynamics of specific industries, how those industries create value for shareholders, and what other stakeholders want to know (for example environmental and social NGO’s want different type of information depending on the industry) vary widely across industries, investors and other stakeholders require, in addition to tier 1 information (Global GAAP based), information about industry specific value drivers. This is called Tier-Two information by the authors.

To make such industry-specific information truly useful to both investors and companies, standards are needed, otherwise a company’s set of numbers could not be compared with those of other companies of the same industry. But how to create these standards?

DiPiazza and Eccles believe, that a few pioneering industries can lay the foundation for developing Tier-Two standards across many other industries. This requires a few pioneer companies within such an industry, that make a start in publishing corporate reports that include Tier-Two figures.

The need for information about good or bad enterprise management: Tier-Three

Assuming that both Global GAAP and global industry standards existed for all key financial and non-financial measures, investors and other stakeholders would still need a great deal of information specific to an individual company. In order to be able to assess the success of management, they need information about management’s strategy, identified risks, risk management and compliance, compensation policies, corporate governance, and company-specific performance measures on key value drivers. DiPiazza and Eccles state, that to report publicly and completely on these value drivers, within the bound of competitive good sense, is the very meaning of transparency.

Management turns its commitment to transparency into action by making its holistic value proposition understandable to stakeholders. Holistic here means how all things within the company, and between the company and its markets, are linked. By demonstrating to stakeholders the links between marketplace opportunities and strategy, between value drivers and measured results, and between management decisions and value creation, the company will deserve confidence of investors and all stakeholders in its performance. Good management and good reporting at Tier Three produces good results at Tier-One and Tier-Two. But this requires that management knows, how value is created, what the true risks and opportunities of the business are, and that it shares at least a portion of this insight with stakeholders and with the company’s board. It requires that management has a good performance management system in place (consisting of an appropriate performance measurement system and the right management processes¹) and that the company has implemented a good corporate governance system.

Confronting the Corporate Reporting Challenge: The ValueReporting^TM Framework

The authors are admitting, that the corporate reporting of few, if any, companies today provides the disclosure contemplated by the Three-Tier Model of Corporate Transparency and, within that model, the information requirements of Tiers Two and Three. But this is not surprising. Corporate commitment to greater transparency is still in its infancy, although it is maturing rapidly. DiPiazza and Eccles list five major challenges management must confront in order to practice greater transparency:

§      Model external reporting on internal reporting (eliminating of reporting gaps in external reporting: reporting externally on all issues that management find important for running the company)

§      Determine the information that stakeholders need in a systematic way (closing information gaps: disclosing information that investors and other stakeholders think is important for them)

§      Report relevant information from external sources (adding information that shows, how a company is performing against industry trends, such as competitor benchmarks)

§      Report on the real economic entity (report on the broader ecosystem of the company that may include subcontractors and how they behave from a social and environmental perspective)

§      Weigh the risks and costs against the benefits (identify and exclude information from the corporate reporting process that might put the company at a competitive disadvantage, is misleading, unreliable, too detailed to be clarifying, or to costly to assemble)

In order to report to shareholders and stakeholders in a logical and organized way all the information it has decided to disclose, the authors present the ValueReporting^TM Framework. The ValueReporting^TM Framework offers a solution that companies can use for organizing the information they report to stakeholders. Developed on the basis of PricewaterhouseCoopers’ capital market research, it should provide a comprehensive means of structuring internal and external reporting. The framework presents four basic categories of information. Together they create a coherent and complete medium-term picture of a business, against which short-term performance can be explained. The four categories link to and build on one another:

The ValueReporting^TM Framework:

The framework should not be viewed as a static medium for presenting discrete bits of information. Used properly and intergrated into internal management processes, it becomes a dynamic tool for assessing and monitoring all key aspects of performance and for communicating publicly their contribution to value creation.

Digitizing the Corporate Reporting Supply Chain: XBRL

Paper based communication formats will not be superseded any time soon for a wide range of purposes they serve effectively. But corporate information, in all its growing quantity and complexity, can be and must be communicated more effectively with the use of new technology. The authors believe, that reported information needs to break away from the constraints of paper-based formats. Even with today’s electronic technology, most content is still reported in formats that are very little more than electronic versions of paper, for example, the pdf format for annual reports found on Web sites. Transferring content to a spreadsheet for analysis for instance, almost always requires manually transferring of date to another format. This is labour intensive and time-consuming. In addition users get little or no help in analysing and understanding such an electronic document’s full content or in verifying its accuracy and authenticity.

In contrast, Extensible Business Reporting Language (XBRL) with its ability to “tag” any individual piece of information with a precise contextual description, facilitates the access and use of information by investors. The authors therefore introduce XBRL as the possible solution and next step to facilitate the Corporate Reporting Supply Chain and to make it more efficient and effective. When information is tagged in XBRL, stakeholders can simply make an information request from within their analytical software and in seconds the information or data they want will be incorporated into their analysis. As an example DiPiazza and Eccles quote that such tools can quickly find and extract information – for example, a company’s revenue recognition policy, buried in the footnotes of a 100-page annual report – and present only the specific information that the investor wants to analyse. In addition XBRL can also speed the company’s access to its own information by reducing internal barriers to consolidation information, thus making information sharing among disparate internal data warehouses much easier.

XBRL is not limited to the financial information at Tier-One of the Three-Tier Model of Corporate Transparency. It can tag virtually any type of information, including the non-financial, industry-specific, and company-specific information at Tiers-Two and -Three. It can also be used to collect relevant performance-related information from sources external to the company, such as benchmarking information on customer satisfaction levels, that originate from independent industry association’s customer satisfaction survey data or from a customer complaint database maintained by a third party, thus offering previously unattainable benefits to the Corporate Reporting Supply Chain.

But realizing the benefits that XBRL promises requires a much closer integration of all the Corporate Reporting Supply Chain participants. They must adopt it as the standard in business reporting. But XBRL is only as good as the quality of the information on which it is based. This is why the assurance function, according to the authors, plays such a critical role in building public trust.

Future Audits: The role of independent auditors and the new Corporate Transparency Model

Enron is just one example of a recent spate of business failures that occurred with virtually no prior public expression of concern over the reliability of the company’s financial reporting on the part of the independent auditing firm. The public outcry after the Enron crisis has struck the auditing industry at the heart of its professional values: objectivity, independence, and integrity. DiPiazza and Eccles therefore think, that auditing firms must address the questions raised about the quality and relevance of their work and quickly so, because public trust is fragile – easy to loose and hard to regain.

One of the central propositions of the authors in their book is that when investors have access to more reliable and more timely information about company performance, that is in large measures, the information that executives use to run their business, better investment decisions will be possible. If markets begin to reward companies that swiftly, fully, and accurately describe their performance, the pressure to play the earnings game – and for auditors to acquiesce in it – will be relieved. The Three-Tier Model of Corporate Transparency provides the information that is relevant to investors and other stakeholders for the decisions they must make. The reliability of this information is assured by subjecting it to an audit by an independent and objective third party. It will require auditors to better respond to the market’s demand for audit opinions that say more about the information on the health of the business – especially in the U.S..

In the future, the authors believe, the role of independent auditors will be refocused to give investors and other stakeholders assurance on a much broader range of information as embodied in the Three-Tier Model of Corporate Transparency. At all three tiers, management will prepare the information, the board will approve it, and an independent auditing firm will provide assurance on it. Providing assurance an a broader range of relevant information will make the audit opinion itself more relevant.

How does corporate reporting look like in ten years after Enron?

In their epilogue, the two authors present three different scenarios that may emerge in ten years after Enron:

Scenario 1 - Disorder: All efforts to achieve significant and broad reform of corporate reporting have long since foundered. One version of GAAP is pitched against another, and informed access to global capital has become prohibitively cumbersome and expensive, except for the very few. Companies publish more data than ever on their Web sites, more pages of number and text. But the meaning of what they publish has become more impenetrable than ever. In this disordered future, corporate mistakes are often hidden until revealed by journalists.  The markets have become a global casino, fortunes won and lost on a single roll.

Scenario 2 - Bureaucracy: The regulators are now firmly in charge. The fear of chaos in the capital markets and of flawed corporate reporting proved to be so great that the capital markets gradually became national and regional fortresses overseen by powerful agencies whose primary interest is making and enforcing rules. Closed borders prevent access to foreign capital, and investors have no option but to invest at home. The quality of assurance is only as high and delivered only as fast as can be expected from government work. Rather than moving toward daily closing of the corporate books, the pace has slowed. As a result, the only publicly reported news is old news. Meanwhile analysts have gone underground, and black market research abounds. The earnings game plays on, but now behind tightly closed doors.

Scenario 3 – Transparency: The future of corporate reporting is now firmly in place, the Three-Tier Model has become a reality, powered by XBRL, auditors have both the appearance and the reality of practicing at the highest level of professional skills, ethics, and independence. As a result, capital is being allocated more efficiently all over the world and the overall cost of capital has come down. Innovation flourishes wherever bright minds and the entrepreneurial spirit converge.

Summary

DiPiazza’s and Eccles book was published at the right moment. The time is ripe for new corporate reporting concepts that replace the traditional model focuses solely on financial earnings and balance sheet figures that capture only 20 percent of a company’s economic reality today and does not reflect any more the value creation model of today’s enterprises. Samuel A. DiPiazza Jr. and Robert G. Eccles and their co-workers at PricewaterhouseCoopers did an outstanding job in bringing the different concepts that had been developed so far and the results of many different research work together into their Three-Tier Model. Building Public Trust: The Future of Corporate Reporting is clearly a must read for everyone interested in corporate reporting, investing, and corporate performance management. The book continues and deepens thinking first presented in another book: The ValueReporting Revolution: Moving Beyond the Earnings Game, by Robert G. Eccles, Robert H. Herz, E. Mary Keegan, and David M.H. Phillips.

About the authors:

Samuel A DiPiazza Jr. is the CEO of PricewaterhouseCoopers. He has enjoyed a long career with PricewaterhouseCoopers, which he joined 1973. He most recently served as Senior Partner and Chairman of the U.S. firm with executive responsibility for U.S. operations.

Robert G. Eccles is founder and President of Advisiory Capital Partners, Inc. (ACP), and a Senior Fellow of PricewaterhouseCoopers. Prior to founding ACP, Dr. Eccles was a full professor at Harvard Business School, where he was a faculty member for fourteen years, receiving tenure in 1989.

Building Public Trust: The Future of Corporate Reporting
by Samuel A. DiPiazza Jr. and Robert G. Eccles

Hardcover - 188 pages (July 2002)
John Wiley & Sons Inc; ISBN: 0471261513

¹ for the concept of a new performance management systems that is suited for today’s companies see also: Juergen H. Daum, “Intangible Assets and Value Creation”, John Wiley & Sons Ltd. Chichester, 2002 (German Version: Juergen H. Daum, Intangible Assets oder die Kunst Mehrwert zu schaffen, Galileo Press Bonn, 2002)

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