Annual reports haven't yet become open books

The idea, roughly speaking, is for corporate chief executives to sit down once a year and write their investors a clear, concise and frank assessment of the company's recent performance and future prospects. What went wrong and what went right? How does the company rate by the key industry measures? What are the biggest risks ahead?

It sounds reasonable. But for corporate America, it would represent nothing less than a cultural revolution, one the Securities and Exchange Commission (SEC) is trying desperately to foment in the post-Enron, post-Arthur Andersen era.

Since December, SEC Chairman Harvey Pitt and his staff have issued a steady stream of speeches, proposed regulations and official guidance aimed at turning annual reports into models of corporate candor. No spin. No obfuscation. No glossing over unpleasant truths.

Now that the first crop of post-Enron annual reports and related documents is in, however, it's clear Pitt faces an uphill battle. The reports are definitely fatter, with additional information about accounting policies, off-balance-sheet arrangements and transactions with company insiders — the items the SEC specifically enumerated.

But Alan Beller, director of the SEC's division of corporate finance, has said that even though the reports' overall quality was better, there was little evidence of the change in corporate mind-set the SEC is seeking.

"Too much of the disclosure is still written from the perspective of how to minimize the risk" of shareholder lawsuits, he said, rather than "how to be genuinely informative."

Some private analysts agree. "They've certainly gotten longer, but I'm not sure they are better," said David Blitzer, chief investment strategist at Standard & Poor's.

Jay Hartig, SEC liaison at the accounting firm PricewaterhouseCoopers, says, "A lot of it is just repackaged information. Certainly it's not as robust as the SEC had hoped for."

The framework of the reports is generally unchanged, requiring a reader to wade through scores of pages, much of it repetitious boilerplate, to learn what's really going on.

Bad news is generally ignored or blamed on uncontrollable factors such as the weather, the economy, the stock market or government regulation. Long lists of undifferentiated "risk factors" make it impossible to determine which are really of concern.

There is precious little data and analysis on the key operating measures that executives themselves look at to assess the company's performance — measures such as inventory turns or the cost for each new subscriber or the average transaction size.

There is no suggestion in all this that most companies are engaging in the kinds of illegal accounting fraud or material misrepresentation alleged in the Enron and Andersen cases. Rather, the concern is with the widespread game-playing between corporations and Wall Street, in which executives go to great lengths to manage analysts' expectations of company earnings and ensure those targets are met.

Pitt hopes to root out the gamesmanship by putting less emphasis on the quarterly numbers while requiring executives to come clean with shareholders on the fundamental dynamics driving the business.

The payoff from corporate candor, according to Pitt, would be higher stock prices — and thus a lower cost of capital for companies — as investors feel more confident that they're getting the straight scoop and won't be hit with unexpected surprises.

A few companies have made huge steps in making their reports more investor-friendly; analysts often cite International Business Machines and Merck. But lawyers, executives, accountants and academics say companies hesitate to reveal too much about their operations and strategies for several powerful reasons.

Foremost is the fear that discussing what went wrong, or predicting too much of what may be ahead, will invite more shareholder lawsuits.

"The advice from the lawyers is often to craft something defensible but not helpful," said one former SEC attorney who now sits on the other side. "That's the best way to lower the litigation risk."

There is also concern that being too candid will simply arm competitors, suppliers, lenders and customers with information that will put the company at a disadvantage in the marketplace.

"The more they talk about directions, risks, strategy, threats, opportunities, the more their competitors can identify their vulnerabilities," said Alan Anderson, senior vice president of the American Institute of Certified Public Accountants.

The reluctance to level with shareholders certainly reflects the normal human reluctance to admit problems or mistakes. But it is reinforced by strong incentives executives have to try to boost their company stock price by painting the rosiest possible picture.

Those incentives include millions of stock options whose value is tied to a rising stock price. Equally powerful are the psychological incentives offered by a rising share price that, like it or not, is how the company is judged by its employees, creditors, customers, the press and even the executives themselves.

"There's a public-relations component to this that you can't get away from," said Les Silverman, a securities lawyer with Cleary Gottlieb Steen & Hamilton in New York. "That doesn't justify misstatements or glaring omissions. But, on the other hand, I think it's unrealistic to expect that companies are going to completely do away with the spin."

Silverman and other lawyers say a final reason is that the rules have been left intentionally vague.

The SEC, to avoid the trap of issuing one-size-fits-all regulations, simply asks companies to address significant "trends, events or uncertainties" as they appear "through the eyes of management" and "using language and formats that investors can be expected to understand."

"Unfortunately, these general injunctions did not produce enough of what we wanted," the SEC's Beller said.