My Favorite Presentation

The 11th International XBRL Conference–the happening thing at the Westin in
Boston for the past two days–was full of first-rate presentations. But I did
have a favorite. It was by Elmer Huh, Executive Director, Global Valuation
Services at Morgan Stanley.  Huh’s job is to look behind and beyond the
numbers that companies present in their income statements and balance sheets to
assess their REAL state of financial health. Putting his job in terms of used
cars, he is professionally trained to look beyond that fresh coat of paint and
new chrome to see the rust, body filler, and worn engine that is
underneath.  He showed the conference audience how they might use XBRL to
do this with spectacular effect on a good number of companies.

To understand the full import of what Huh is saying, it helps to understand
something about accounting. It is something that you have probably suspected all
along:  Accounting is not about THE TRUTH. (See? You knew that …)

I am not suggesting that anybody is being dishonest. Further, for a great
many things that are reported under Generally Accepted Accounting Principles (GAAP),
what you see is pretty close to what anyone would judge to be the real state of
affairs.

But there are a couple of areas where GAAP is in a state of flux, and
where–for historical reasons–accountants have decided that it is OK for
companies to report numbers that are substantially smaller than the actual
liabilities that a company might really have.

One of these areas has to do with reporting on pension liabilities. It wasn’t
long ago that companies did not report on these liabilities at all — they
simply recognized pension-related expense as they incurred it. But, as future
problems in dealing with pensions became more obviously important, it became
clear that it was important to reflect SOME of this pension liability on a
company’s balance sheet.

But is was also clear that if companies suddenly reflected ALL of this
liability, all at once, a great many companies would suddenly go from looking
like they were healthy to looking really burdened with liabilities. So, the
accounting standard setters decided to create a kind of compromise, where
companies must recognize some of this pension liability, but not all of it, all
at once. The rules for pension accounting are, frankly, a kludge. They are an
attempt to balance a number of concerns by using some arbitrary cut off points
and special boundary conditions. The result is that the relationship between
pension liability reported on the balance sheet and real liability is slippery,
at best.

A second area where the rules of financial reporting can result in some
strange distortions is with regard to accounting for operating leases.  If
you work the numbers right, you can effectively buy something expensive, like an
airplane, but not have it show up on your balance sheet. To which a good CFO
says, "Cool." All the advantages of productive assets and none of the
unpleasant downside of having to report increased debt.

Elmer Huh focused in on these two areas of potential distortion in his
analysis.  He showed graphs of debt to asset ratios using the reported
numbers for companies — and then showed the ratios figuring in operating lease
obligations and pension obligations.  The differences were dramatic and had
powerful explanatory value when applied to a number of companies that
"look" healthy but which are actually having trouble. It was a great, entertaining
presentation.

But it was also a good presentation because it said something true and
important about XBRL. The reason that Huh could do what he did is that most of
the information you need to see the real picture is, by law, disclosed in the
notes to the financial statements rather than in the actual balance sheet or
income statement. The information that Huh was using was, for the most part,
already there in the financial report, but presented in a way that makes it hard
to find and use.

In this case, the power of XBRL is in its ability to break free of the
standard accounting constraints to recast facts and relationships to see things
in new ways. To that, I say "Cool."

By the way, this same power to free content from presentation, and to
rearrange it and present it in new ways, is the flip side of the headache that I
described in an earlier
posting this evening, about assurance. 

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    Comments

    1. Does this mean that through XBRL the power of the “annual report” would effectively devolve to the analysts? For example, if key financial data has to be reported, and is in instantly readable format (XBRL), no matter how much the data is buried in footnotes, or otherwise spun, it could be parsed out by an XBRL application to reveal the true status of the company. An analyst might have a presentation waiting for the feeds, and as the data comes through, the “real” (to the analyst, anyway) annual report will be generated.
      This would be liberating from an investor standpoint, and rather horrifying if you worked in PR.
      Is this possible?

    2. XBRL is a good thing for analysts, no question about it. But I don’t think it represents the kind of fundamental shift in power that you ask about. The reason is that management is still–and will continue to be–responsible for the content of the financial statments. XBRL does not change that.

      For critical matters such as reporting on pension liabilities we are dealing with estimates, not with certainty. Management is still responsible for making those estimates. XBRL does not give analysts some kind of magic way around that.

      What XBRL does do is simplify and speed up the job of working with the estimates and other information contained in the notes to the financial statements. The analyst’s world–as Elmer Huh described it–is one in which you have a very limited amount of time, typically measured in hours, to analyze new financial statments from management, get insights, and report on them. The great advantage of XBRL, from his standpoint, was that rather than spending a substantial amount of that very finite time converting and compiling the picture, he can spend a much larger amount of time in substantive analysis.

      It would be accurate to say that XBRL undercut’s management’s power to minimize disclosure by sticking things in the notes — no small accomplishment.

      Note also that, as it stands today, the time and effort barrier to doing analysis, particularly across groups of companies, is so high that it tends to be work that only professional analysts and investors can do. Another view of the value of XBRL is that it disintermediates the analysis. This was the point made by Otmar Winzig at the XBRL conference. From this viewpoint, XBRL actually shifts power from the analysts back into the hands of small and mid-cap companies.

      Your question is a really interesting one–despite my cautious reply, I think that XBRL really does have the potential to change investing. I just don’t think that we are looking at an XBRL-driven, fundamental shift in the power over the impact of the annual report. Sarbanes-Oxley is probably having as much affect here as XBRL.

    3. The “power” that Brian refers to devolved upon equity analysts long ago, which is what made them worth suborning.
      XBRL may result in analyst disintermediation, but it could just as easily result in analysts “covering” a much larger universe than previously. The result to small and mid-cap companies would be the same, better recognition of their virtues by the capital markets.

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