Annual reports were found to be much better at predicting good news than bad news.
The Securities and Exchange Commission mandated in 1980 that public companies' annual reports include a management's discussion and analysis (MD&A)
section that assesses the enterprises' liquidity, capital resources and operations in a way many investors can understand. One of the goals was to make public information about predictable future events and trends that may affect future operations of the businesses.
Has the SEC goal been fulfilled? This article examines that question and comes up with some disturbing answers.
Eight years after the MD&A ruling, the SEC concluded that the reports were not meeting this goal. As a result, the agency issued guidelines on exactly what data it expected companies to incorporate in MD&A statements. It said it wanted each business to provide information about company-specific and industry-specific trends affecting its bottom line. Currently, many in the SEC staff still are not satisfied the agency's original goals are being met.
CREATING A SAMPLE
To test that contention - and to determine whether the data in MD&As provide useful clues to a company's future performance - we randomly selected 25 companies from Moody's Handbook of Common Stocks. The publication evaluates public companies' performances on a quarterly basis, reviews their financial performances and stock prices and, most important for our purpose, lists events (labor conflicts, new competition, etc.) that appeared to influence a company's financial performance during the previous quarter.
To determine the value of each piece of information disclosed by the selected companies in their MD&As, we considered whether it related to their actual performances a year later. If the information was accurate and had any value, we would have expected a close correlation: A predominance of positive forecasts should have resulted in improved performance and a predominance of negative expectations should have produced the opposite.
Generally, this wasn't the case. While most companies did a good job of describing historical events, very few provided useful and accurate forecasts. Further, when prospective information was disclosed, we found a strong bias in favor of correctly projecting positive trends, but negative trends tended to be either ignored or not fully reported. In other words, we found MD&As to be much better at predicting good news than bad news.
To quantify our examination, we itemized all the important economic events Moody's reported as affecting each selected company. Then we classified each event as specific to the company, the industry or the overall economy. For example, if a toy manufacturer's sales decreased because a particular board game had declined in popularity, the decline was classified as company-specific. If the drop in sales was attributed to a decrease in consumers' interest in games in general, it was classified as industry-specific. And if the drop in sales was attributed to a general economic recession, it was considered specific to the economy. We also classified each statement as either positive or negative on the basis of its effect on company operations.
We also classified each MD&A statement into one of two categories: backward-looking, which included historical data, and forward-looking, which included prospective information and a discussion of trends and future demands, commitments, events and uncertainties. Within the forward-looking category, we further classified each statement according to the same categories used for economic events: company-, industry- and economy-specific. Finally, as already noted, we compared MD&A statements against actual company performance in the year following the MD&A statement disclosure.
Historical disclosures. All the companies provided at least minimal discussion of the historical items required by the SEC. …