Management reports not up to mark

ACCOUNTANCY

Every publicly listed company in India is required to supplement financial statements in its annual reports with a management discussion and analysis report (MD&A) covering the performance and prospects of the firm in non-financial terms.

Clause 49 of the listing agreement between a company and the stock exchange in which the securities of that company are listed requires the publication of the MD&A and specifies that, within the limits set by the company's competitive position, it should discuss the following: industry structure and developments; opportunities and threats; segment-wise and product-wise performance; outlook; risks and concerns; internal control systems and their accuracy; discussion on financial performance with respect to operational performance; and material developments in human resources/industrial relations front, including the number of people employed.

Given this broad scope, the inclusion of MD&A in the annual report definitely has the potential of immensely increasing transparency in corporate reporting. Yet, this potential remains mostly unfulfilled. This is the result of a lack of any specific disclosure norms in Clause 49 beyond the mere specification of the issues to be discussed.

The fundamental expectation from MD&As is that they will present an analysis of the business as seen through the eyes of the board of directors. Therefore, it is appropriate that elements of information used in managing the company, including subsidiary companies, should be disclosed in the report. In taking managerial decisions, board of directors use non-financial information extensively. Unfortunately, they are extremely reluctant to disclose this non-financial information unless compelled by a specific regulatory directive.

Let us take an example from Bharti Airtel Limited's MD&A Report dated March 31, 2006. In the telecom industry, 'customer churn' (also known as 'customer attrition rate') is an important key performance indicator (KPI), and the board of directors of each company in this industry closely monitors this metric. There is no reason to assume that Bharati Airtel would be an exception to this. Yet, the discussion of 'customer churn' in the MD&A report under discussion is too vague to be of much use. In one paragraph under Threats," the report says: "Introduction of number portability may impact our business...Number portability can lead to high customer attrition rate, as the inability to retain a telephone number is currently a significant exit barrier for a customer in the intensely competitive Indian market. We may experience increased price competition as operators seek to retain or attract subscribers as well as incur an increased acquisition cost per subscriber".

In absence of any quantitative information on current 'customer churn' or an estimate of the impact of number portability on customer churn, the report fails to convey what is needed by shareholders to understand the strategy of the company and its sustainability and growth potential.

Bharti should have explained the definition and calculation of customer attrition rate and provided quantified targets and quantified data on the churn rate for the current and previous years. It should also have provided the source of the underlying data.

Let us take another example. Hero Honda Motors Limited, in its MD&A dated March 31, 2006, concludes its discussion on the business outlook as "We anticipate double digit growth in the two-wheeler and motorcycle market during the next three years. Your company expects to register a growth rate that is higher than the average growth of the two wheeler industry." It neither quantifies the expected market size nor presents quantified target of market share.

In May 2005, the Accounting Standards Board (ASB) of the UK issued Reporting Standard-1 that set out the reporting standard for Operating and Financial Review (OFR)""a report similar to our MD&A. The standard, to be applicable from financial year 2005, requires listed companies to provide information similar to that required by the Indian Clause 49. However, this standard goes beyond regulations like Clause 49 in two important ways. First, it also requires listed companies to provide information about environmental matters and about social and community issues. This will help shareholders of a company to know whether their company gives only lip service to 'sustainability and development' or really incorporates these concerns in its business strategy. It is also expected that the standard will force companies to provide quantitative details of investment in 'corporate social responsibility', thereby allowing a more transparent evaluation of its actual commitment towards 'social responsibility'.

Even more importantly, the standard goes beyond just listing heads under which information should be provided to specifying concrete requirements that ensure the quality of disclosure. It requires listed companies to disclose key performance indicators (KPI) and to provide information that enables members (shareholders) to understand each KPI disclosed in the OFR. It requires that for each KPI disclosed in the OFR a company should provide the following information: the definition and its calculation method should be explained; its purpose should be explained; the source of underlying data should be disclosed and, where relevant, assumptions should be explained; quantification and commentary on future targets should be provided; where information from the financial statements has been adjusted for inclusion in the OFR, that fact should be highlighted and a reconciliation should be provided; where available, corresponding amount for the financial year immediately preceding the current year should be disclosed; and any changes to KPIs should be disclosed and the calculation method used compared to previous financial years, including significant changes in the underlying policies adopted in the financial statements, should be identified and explained.

In preparing MD&As, companies should comply with the spirit of the requirement rather than a legalistic approach to compliance. In absence of a 'safe harbour' clause, the report is addressed to shareholders and not to investors in general to enforce accountability, but to avoid liability. The safe harbour clause protects directors from liabilities arising from an untrue statement of a material fact or omission of a material fact necessary to make the forward looking statement not misleading. Moreover, each company adds a cautionary statement that 'actual results could differ materially from those expressed or implied' to limit the potential liability of its board of directors. Therefore, companies should take innovative approach in presenting the report.

Most Indian companies, just like companies everywhere in the world, are unlikely to improve the quality of MD&As voluntarily. Therefore, India also needs a reporting standard similar to the UK Standard.

The writer is prof, finance control at IIM-C