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ORP31 - Rhetoric and argument in financial reporting - disclosures in profit forecasts and takeover documents
Brennan and Gray 2000
Executive summary
Introduction
Despite the importance of profit forecasts to investors, little attention has been given so far to their publication, presentation and content.
The object of the paper is two-fold.
- First, the paper examines disclosures in profit
forecasts and in takeover documents, from the perspective of rhetoric and
argument, to show how managements use accounting information to defend their
own position and rebut the arguments of the other side. Persuasion in
forecasts and the verbal jousting and argument between bidder and target
managements during contested bids, are considered.
- Secondly, the paper reproduces and discusses examples concerning disclosures in profit forecasts and in takeover documents. This is intended as useful precedent material for practitioners involved in preparing profit forecasts. The paper is supported by a more comprehensive set of examples available from the ACCA website at http://www.acca.org.uk/resources
The report reviews financial reporting in profit forecasts, based on a systematic analysis of the disclosure practices in 250 profit forecasts disclosed during 701 public company takeover bids in the UK in the five year period 1988 to 1992. There were 74 examples selected from the 250 forecasts to illustrate particular practices which are commented on and discussed in the text. The examples shown do not necessarily illustrate best practice. It is intended that they highlight the wide variety of disclosure-related issues to be taken into consideration in preparing a forecast for publication. It is hoped these examples will act as useful precedent material to be consulted by practitioners involved in preparing profit forecasts for publication in the future.
In selecting material to reproduce, there was particular emphasis on disclosures used by management for rhetorical purposes – to persuade shareholders or to attack the other side in the bid.
Findings and recommendations
The research showed that there was some evidence of strategic information disclosures by management in the accounting practices employed in preparing forecasts, in the variability of levels of disclosure and in the choice of wording used in some disclosures. In particular, the choice of disclosure practices by management may be used to provide protection if the forecast is not subsequently achieved, thus serving management’s own self-interest.
The following recommendations are made to improve reporting practices.
- Specification of minimum levels of disclosure in
forecasts would reduce the flexibility in reporting practices, which would
result in greater consistency between companies in forecast items disclosed.
- The role of the reporting accountants and financial advisers should be expanded to require them to consider and report on the objectivity and consistency of disclosures in takeover documents.
Background to the study
Profit forecasts are often included in documents issued by companies listed on the Stock Exchange, even though there are no legal or Stock Exchange regulations requiring publication of such forecasts. Profit forecasts are frequently included in prospectuses by companies raising new capital or by companies during a takeover bid. Under stock exchange rules these forecasts must be reported on by both reporting accountants and the merchant bankers advising on the deal. The format of the forecasts is at the discretion of individual companies.
Although historical financial statements provide valuable information, they alone do not meet investors’ needs in today’s dynamic business environment. Potential investors are eager for insights into a company’s future performance. Investors recognise that future estimates from those most knowledgeable about the business are as valuable, if not more valuable, than historical results of the past.
Studies of users’ needs have shown forecast information to be one of the most important financial disclosures a company can make (see Courtis (1992) for a summary of this research). Given the perceived importance of future-orientated information, it is surprising that there has not been more research examining disclosure of forecasts and their content.The purpose of this paper is to discuss and analyse financial reporting practices relating to profit forecasts. Examples are examined from a comprehensive, in-depth survey of accounting practices and disclosures in profit forecasts in the UK during the five year period 1988 to 1992.
Types of profit forecasts
Any wording that enables calculation of an approximate amount for future profits constitutes a forecast. A forecast need not be expressed in numerical amounts (e.g. ‘profit will be greater than last year’). A forecast made in advance of completion of financial statements for a period expired is referred to as an ‘estimate’.Neither the Stock Exchange’s ‘Yellow Book’ (London Stock Exchange, 1997) nor the Takeover Panel’s City Code (Panel on Takeovers and Mergers, 1998) define the term ‘profit forecast’. If directors make a statement about the prospects of the company, that projection, even though not quantified, may be deemed a profit forecast if the company subsequently becomes involved in a takeover bid. A profit forecast may encompass published but unaudited profit figures (usually referred to as a profit ‘estimate’). Forecasts made with the publication of interim results may be treated as profit forecasts, and may have to be reported on if a bid is subsequently made.
All statements on earnings in takeover documents formally reported on by accountants/financial advisers as profit forecasts or profit estimates are treated as profit forecasts in this research.
Circumstances in which forecasts are made public
Although user surveys rank forecast information very highly, the practice is for companies not to disclose such forecasts. Forecasts are rarely disclosed in the UK except in prospectuses and circulars, and during takeover bids. Thus, most UK research into disclosure of profit forecasts is based on disclosures in prospectuses, circulars and in takeover documents.Forecasts may be disclosed during takeover bids by bidder and/or target companies. Such forecasts may be included in offer documents issued by bidders or in defence documents issued by targets. Offer documents may include forecasts for bidders, targets or pro-forma forecasts for the combined entity should the takeover go ahead. Defence documents include target forecasts only.
Forecasts are normally made during takeover bids to support arguments being put forward by directors. Forecasts may be used by target company directors to show that shares are more valuable than the bid price or to show that the forecast profits justify their recommendation of the offer. Bidding company directors may wish to provide evidence in support of the value placed on shares offered as consideration for the acquisition. An unwelcome takeover bid is often resisted by financial rather than legal tactics. One important tactic is a statement by directors about future prospects and profits in documents sent to shareholders either by target or bidder companies.
The Companies Act, 1989 requires directors’ reports to include an indication of likely future developments in the business of the company. Such statements are generally vaguely worded. Forecasts are rarely disclosed in annual reports (Steele, 1982; Walsh and Horgan, 1990).
Content of profit forecasts
There are few regulations governing the content of profit forecasts. Forecasts published in prospectuses for new share issues and in takeover documents must be reported on by accountants and by the financial advisers to the transactions. Consequently, profit forecasts follow a fairly standard layout, but vary considerably in content and in the range of items and assumptions disclosed and in the level of detail disclosed. Thus, there is considerable variability in the disclosure practices followed in preparing these forecasts.Rhetoric and argument in financial reporting
Takeover bids, financial disclosures in takeover documents and, in particular, the competitive nature of contested takeover bids, provide a unique setting in which to study rhetoric and argument in financial reporting.
Aspects of interest include the verbal jousting between bidders and targets arguing about profit forecasts, and the way in which profit forecasts and disclosures in takeover documents are used persuasively to bring shareholders around to management’s point of view. A study of financial disclosures in this setting can add insights to our understanding of the ways in which management manipulates financial reporting to influence shareholders to support its strategies and goals.
To date there has been little research examining rhetoric and argument in accounting. Rhetoric is defined as
the art of using language so as to persuade or influence others; speech or writing expressed in terms calculated to persuade or impress (often in a deprecatory sense), language characterised by artificial or ostentatious expression (Oxford English Dictionary, 1989, p. 857).
Covaleski, Dirsmith and Samuel (1995, p.26) comment that ‘...accounting is not only an instrument for representing an economic reality…but also a rhetorical device for setting forth…’. Thompson (1991) states that the way theories are justified and legitimated becomes much more one of a debate, conversation or argument in which the attempt is to persuade an assumed sceptical audience. Hence the interest in rhetoric and in the protocols of argumentation.
Arrington and Schweiker (1992) consider rhetoric and argument in the context of accounting research. The ‘art of argumentative persuasion’ — rhetoric — is necessary to convince colleagues, students etc. Rhetoric is seen to be, on the one hand persuasive, and, on the other hand, argumentative. Fogarty, Hussein and Ketz (1994) discuss rhetoric — the discourse employed in the process of persuasion — and recommend that it be applied to the study of the politics of accounting standards setting. Warnock (1992) examines the role of rhetoric and argument in the text of accounting standards, while Warnock (1997) analyses arguments and rhetoric in submissions from interested parties on documents published by standard setters on accounting for goodwill. He calls for further application of the principles of rhetoric and argumentation to be applied to financial reporting (Warnock, 1993).
Adelberg (1979) considers corporate reporting from the perspective of manipulating investor reactions. He found that non-standardised messages in annual reports were subject to management manipulation. Nelson, Megill and McCloskey (1987, p.16) state:
There is no doubt in our minds that enterprising managers are focusing increasingly on their companies’ communication strategies – and that the use of rhetoric may well be frequently implicated in the implementation of such strategies. But who is ultimately served by the rhetorical nature of these strategies? In the case reviewed the entrepreneurs appeared to gain at the expense of the investors.
Hooper and Pratt (1995) provide evidence of managers gaining at the expense of investors. In a case study of the New Zealand National Land Company, they show how accounting rhetoric was used to obfuscate the dealings of European directors at the expense of local Maori shareholders.
The audience for the financial information reported in forecasts disclosed during takeovers is more complex than in routine reporting situations (such as annual reports). Profit forecasts are included in takeover documents (offer documents or defence documents) sent to shareholders. Therefore, shareholders are the primary audience for the information. In a contested bid, however, each party to the bid (i.e. the bidder / target) will be very conscious that management of the other party will also receive and carefully read the takeover documents.
The terms rhetoric and argument are used loosely in this research. Profit forecasts will be examined from the perspective of how persuasive and convincing are the disclosures by management. Profit forecasts are considered as a means of communicating a message. They may also be used to convey or imply a different message than the explicit communication of the forecast.
The plausibility and credibility of the language used and arguments offered are analysed. Disclosures in profit forecasts are considered from the perspective of their ability to persuade – the fairness and appropriateness of some of the techniques/methods of persuasion are considered. The arguments of the other side to the bid, and refutation of financial information reported in forecasts, is also examined.