Thursday, November 08, 2007

The Benefits of Quarterly Reporting

Maybe it is just because I used to be an auditor and am very familiar with financial reporting, but I never seem to stop hearing about how horrible it is that companies have to report their earnings every quarter. The common refrain is that quarterly reporting encourages myopic thinking and makes executives focus on the "short term" rather than invest in long term projects that supposedly could increase America's competitiveness.

But here, right in our faces, is a clear example of the benefits of quarterly reporting. The CDO market has "seized up", tied to a liquidity crisis in the credit market which manifests itself in the home mortgage business. In laymans' terms, the marginal borrowers can't buy homes, the "packagers" of CDO's can sell the mortgages to third parties, and the companies that make fees from this process or were sitting on inventory when the music stopped (just like "duck, duck, goose") all were screwed.

What happened? Well, if companies didn't have to report earnings quarterly, not much would have happened. Sure, it looks like losses are there for the taking IF companies have to sell now, but an annual reporting company (only) would "hold out" and wait for the markets to turn, if they didn't have to "fess up" and report their losses on a quarterly basis (tied to an audit with an external accounting firm that has a lot in stake in not approving the financial statements for a company that subsequently "goes bust").

But companies DID have to report their earnings quarterly. And what happened? The head of Merrill Lynch, O'Neal, had to resign. The head of Citicorp, Prince, had to resign. And other companies had to cough up billions and billions of dollars in losses tied to these investments, with the potential of more to come. So far over $30 billion has been written down, and loss estimates range as high as $500 billion per a WSJ article called "Carnage Estimate in Fixed-Income"

It isn't true that quarterly reporting causes companies to shun long term investments. If this is true, why did the market keep funding internet and bio-tech start ups, that run up losses every quarter? This is because the market can listen to management and see the long term, as well as assess the risk that this never happens.

A few months from now when you hear someone reflexively criticize the "short term" view of quarterly earnings, ask them if you think O'Neal and Prince would have "come clean" about their losses and faced up to them, or held on to their jobs that much longer? I know my answer.

Cross posted at Chicago Boyz

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