The Accounting Onion

Financial Statement Presentation: The Sequel

Two readers, including Robert Bloomfield, Cornell accounting professor (my alma mater!) and Director of the Financial Accounting Standards Research Initiative (FASRI) of the FASB, were kind enough to point out an error in my previous post. Here is the gist of what Prof. Bloomfield had to say (his full comment is here):

"… you link readers to the 7-page summary document, but there is a lot more than that. …The discussion paper is quite long and detailed, including elaborate examples of a manufacturing and a banking company.

Also, one very interesting aspect of the proposal is a reconciliation footnote that would reconcile, line by line, the cash flow statement to the income statement. The differences are broken into various categories including accruals, fair value remeasurements, other remeasurements, etc.

So if you are opposed to capitalized interest, you are likely to be able to undo a fair bit of that through the footnotes."

Indeed, I mistook the summary of the DP, which was separately posted on a different page on www.fasb.org, for the entire document. My bad. I guess the page numbering in the summary should have tipped me off that there was more to come. But as a feeble defense, the FASB could have made the project page more user-friendly by posting a link to the complete DP right on the project page itself.

Much more important, is that I am happy to have discovered that the Boards may be proposing some significant changes that can result in incremental information for financial statement users. But, in all of the extra data, what may be some of the most sensitive items are still artfully concealed. Notwithstanding Prof. Bloomfield's statement that I should be able to discover more about interest capitalization, "more" is not enough when "all" is easily achievable and principles-based.

Along the same lines, there is nary a scintilla of disaggregated information regarding the effects of foreign currency translation on earnings, assets and liabilities. As I have pointed out in previous posts, FAS 52 creates some pretty crazy effects: translating the fixed assets on the books of foreign subsidiaries at current exchange rates is nothing more than random number generation; gains and losses on foreign-currency-denominated monetary items held by foreign subsidiaries are not presented in a manner consistent with identical exposures that happen to be on the books of domestic subsidiaries.

Making Financial Statement Presentation Simpler – and Much Better

Even though the Boards hide behind a self-imposed constraint to excuse themselves from consideirng recognition and measurement issues, they can still make the effects of some of their most ridiculous rules much more transparent than they are currently proposing. Here's three frustratingly simple things, which if implemented would far exceed the benefits of their current proposal:

1. Along the lines of the logic I presented by the name Largest Possible Entity, maintain a strict and principled separation between financial and non-financial elements in the balance sheet and income statement. Call me cynical, but I simply can no longer accept that giving management any discretion whatsoever over financial statement presentation will result in higher quality or especially more comparable information (the putative goal of IFRS and U.S. GAAP convergence). Every student of finance is apprised at some point that Modigliani and Miller received their Nobel Prizes in large part for seeding the conversation that financial decisions are fundamentally different than whatever one cares to call the rest of the things that management does. The LPE concept is merely an accounting child of their enduring insights.
   
2. Mandate the direct method for the statement of cash flows. The format for the statement of cash flows proposed in the DP is pretty cool, and so is the reconciliation of cash flows to comprehensive income. I also like the new definition of operating cash flows that would comprehend expenditures on assets. But, all of that is icing on the cake compared to simply eliminating the indirect method alternative that was provided at the eleventh hour by the FASB in SFAS 95. Waiting for this simple change seven years after Enron has conditioned me to not ask for too much in this regard.
   
3. Require a reconciliation of the beginning and ending balances of each account on the balance sheet (I still can't bring myself to 'statement of financial position' for an accounting that suspends rules of arithmetic I learned in first grade). If reconciliations are done properly, users can unwind all sorts of silly things – of which the aforementioned interest capitalization, random number generation through foreign currency 'translation' and inconsistent treatment of foreign exchange gains/losses are but three examples.

   The proposed reconciliation information is much too vague, and again is subject to obfuscation by management. Get ready for the naysayers to dismiss this suggestion as impracticable. But, if Worldcom's auditors had actually reconciled the beginning and ending PP&E balances, they would have been heroes instead of goats – and Cynthia Cooper, the Worldcom employee who blew the whistle on Bernie Ebbers et. al. would be memoirless. Especially in these days post S-OX 404, shouldn't each and every consolidated balance sheet account be reconciled? If not, what's the point of "internal controls over financial reporting"?

   In my next post, I'll provide a couple examples of the simple form of reconciliation I have in mind.

Some Additional Tidbits

First, the first paragraph of the DP states that Phase A of the project addressed "statements that constitute a complete set of financial statements… and … Phase B would address more fundamental issues relating to presentation and display of information … including … reconsidering the use of a direct or an indirect method of presenting operating cash flows." [para. 1.1, italics supplied]

Fundamental? More like "highly controversial"! Maybe I'm missing the boat here, but Phase A is the "fundamental" issue, and Phase B is detail—albeit important detail. The DP process could be much more constructive if the Boards would simply set forth the reasons why investors would benefit from a direct method cash flow statement; and more important, why issuers stubbornly resist the wishes of investors. The absence of a willingness to openly acknowledge the actual controversies does not bode well for a satisfactory outcome.

Second, the third paragraph of the DP states that FARSI, Prof. Bloomfield's group, "…will study investor use of financial statements prepared using the proposed presentation model by conducting a series of controlled tests." [para 1.3] To test what? What parts of the DP are even amenable to controlled experiments?

Notwithstanding the unnecessary vagaries, I have to say that I'm not sure that any testing will provide actionable results. Controlled experiments in accounting overwhelmingly tend to address very narrow research questions whose results are difficult, if not impossible, to validly generalize. My fear is that results that merely weakly support the preliminary views expressed in the DP will be over-generalized by vocal proponents of an anti-investor agenda.

But, setting that cavil aside, my greater concern is that investors will provide some "statistically significant" indication that the new presentation format represents an "improvement" over the mishmash of statement and disclosures currently being fed to them – a pretty low hurdle given the current sad state of financial reporting. That "empirical evidence" will be seen as supporting the proposed changes, tepid as they are, and thereby rendering really needed changes to the bottom of the priority pile for another twenty years. If you need evidence, see FAS 115 and that ugly "other than temporary impairment" standard that currently plagues us in the midst of our economic crisis; or SFAS 95, allowing the indirect method. GAAP is littered with disastrous standards that were passed by narrow margins with at least some board members expressing disappointment, but justifying their "yea" votes as compromises in the name of some modicum of progress. Will the Boards be playing the same sorry tune one more time?

Third, the absence of any discussion of XBRL in the DP indicates that both Boards might prefer that XBRL's significant implications for disaggregation of financial information – the more the better – be swept under the rug for a while. Soon may come the day, perhaps even before a final standard becomes effective, that the value of static presentations will fade to dust compared to simple software programs that generate financial statements in accordance with each user's very own preferences. Thus, the real reporting issue of the near future is not presentation, but rather disaggregation.

Having said all that, I'll conclude by stating that I fundamentally object to a management approach. I also have little confidence that the detailed disclosures regarding cash flows, much less the direct method, will be accepted by the IASB. Financial statement presentation was not designated as a convergence topic in the fabled Norwich Agreement, and I believe that the FASB erred in agreeing to conduct the project jointly with them. I believe they chose to form a cartel on this one, because not to have done so would have once again spotlighted the IASB's record of reluctance to push back against their funding sources.

Evidently, the FASB feels that it is a far better outcome to end up with a watered-down presentation standard that won't be revisited for another twenty years than it is to jeopardize IFRS adoption in the U.S.

The "Preliminary Views" on Financial Statement Presentation: Seven Years of Deliberation for This?

This past October, the FASB and IASB issued a joint discussion paper with their preliminary views on financial statement presentation:

"[The IASB and FASB initiated the joint project on financial statement presentation to address users' concerns that existing requirements permit too many alternative types of presentation and that information in financial statements is highly aggregated and inconsistently presented…" [¶ S1]

Both boards commenced work on separate projects in 2001, and seven years later have barely anything to show for it except for this five-page document, which amounts to little more than a proposal to re-arrange the living room furniture. For the sake of completeness, I should also point out that the IASB did also make a few minor alterations to IAS 1 that mainly catch up IFRS to GAAP in respect to reporting dirty surplus – whoops, I meant "other comprehensive income."

To give you some sense of the nature of these deliberations, such as they have been, I can draw on a personal experience. After the Enron debacle, the lack of transparency afforded by the indirect method of presentation for the statement of cash flows rightly became a focus of critics. In Enron's case, it would have been kinda sorta nice to be aware of how little cash Enron was getting from its customers. Six months following Enron's implosion, I attended the annual reunion of alumni from the SEC's Office of the Chief Accountant. At a presentation to our group, the erstwhile Chief Accountant assured us that the direct method of presentation of cash flows would soon become required. Supposedly, there was a clear consensus that this was the right thing to do.

That was more than six years ago, and nothing whatsoever has changed, other than that we're knee deep in another financial debacle. The preliminary views document disingenuously continues to spout the party line in support of the direct method, and even for further disaggregation of cash flow information. If this were solely an FASB decision, and if President-Elect Obama appoints a non-partisan SEC Chair (I'm rooting for Charles Niemeier), then I might have some reason to hope. But, there's no way this sort of change will find its way into IFRS. EFRAG (European Financial Reporting Advisory Group), and perhaps China, will contrive some sort of excuse that it would harm the ability of companies in their part of the world to compete; and the proposal will fade to black yet one more time.

Another proposal that would have some merit if it weren't watered down with weasel words is, "An entity should further disaggregate its income and expense items by their nature within those functions to the extent that this disaggregation will help users in predicting the entity's future cash flows." [¶ S11, italics supplied] For example, cost of sales would be disaggregated into materials, labor and other components. But, who would decide what "will help users"? Answer: management, of course, because that is the consistent theme of IFRS – trust management to do what is right. If this were an FASB-only project, I'd bet that the document would include examples and illustrations of the principle functional categories to be disaggregated, together with the principle components of the disaggregation.

Separating Financing from Everything Else

No presentation format can be satisfactory unless it assists readers in assessing the performance of a company, independent of any decisions regarding financing that management made. That's why I am so strenuously opposed to the capitalization of interest costs in any way shape or form: assets values should be reported independent of how they are financed, and financial items affecting profitability should be separated from all other revenues and expenses.

Thus, the cockles of my heart warmed as I read these noble words:

"The proposed presentation model requires an entity to present information about the way it creates value (its business activities) separately from information about the way it funds or finances those business activities (its financing activities)." [¶ S4]

But, then, reality intruded upon my reverie as I read the following:

"The classification decision would reside with management…. The Boards support a management approach to classification rather than a prescriptive approach because they believe it will result in financial statements that reflect how management views and manages the entity and its resources." [¶ S6, italics supplied]

In other words, what constituted financing or "business activities" would be subject to the discretion of management. That's not quality financial reporting, it's farcical financial reporting. But perhaps the boards saw no other way to protect interest capitalization, that sop to the oil and gas industry. Also, don't count on management to disaggregate the interest component of cost of sales, or the cost of anything else.

The main point of this post is to demonstrate that the choice between a "prescriptive approach" and a "management approach" is a false choice. A third alternative, as always, is a principles-based approach.

The Principle of the Largest Possible Entity

The late Tom Burns, one of my mentors, once remarked that the most fundamental problem of financial reporting was choosing the entity of account: in other words, the boundaries that marked the affairs of the entity, and the affairs of others. I didn't fully appreciate that statement until too many years later. I was trying to think of a way to explain to my students in a managerial accounting course how the topics for such a course were selected. I eventually decided that managerial accounting explored decision making scenarios in which managers would decide which "real", or "productive" resources a business should acquire, and how best to put them to use. Questions of financing the resource acquisitions would be explored elsewhere in the curriculum.

That was fine and good, but I needed to have a way to explain what was "real" versus merely "financial." This is when, and I can't explain why, I came back to Tom Burns' observation. I asked myself, what would financial statements look like for the largest possible entity (LPE) – as if the universe were one big happy family? In other words, what if all the entities that existed, personal, corporate, government, etc. were consolidated/combined? This is my depiction (units of measure are arbitrary and only for purposes of illustration):

The Largest Possible Entity
Consolidated/Combined Balance Sheet
December 31, 20x1
Inventories	$   100
Plant and equipment	200
Natural resources	300
Knowledge	400
Total assets	$1,000
Equity	$1,000
Consolidated/Combined Income Statement
Year ended December 31, 20x1
Production revenue	$ 500
Utilization of resources in production	400
Net income	$100

 

The most important lesson from the balance sheet is that all of the assets that remain upon elimination of reciprocal accounts are the "real" assets. Therefore, financial assets and liabilities are distinguished by their absence on the balance sheet of the LPE. For example:

• There is no cash on the LPE's balance sheet. The entity already owns and controls all of the goods and services in the economy, so cash is of no use, except perhaps for the paper it is printed on.
• There are no receivables, derivatives of any kind, or liabilities. They all offset, or eliminate, as "intercompany" transactions.
• There are no investments in other entities, because the LPE can't recognize an investment in itself as an asset.

The only categories of revenue and expense that can appear on the LPE's income statement are revenues from the production of real goods and services and expenses from the use of the assets as inputs to the production of those goods and services. Like all receivables and payables, financial revenues and expense are reciprocal items that cancel out.

From the above, I derive the following simple principles that can be the fundamental basis for a financial statement presentation standard:

• Only those assets that are not eliminated in the consolidation/combination process to arrive at the balance sheet for the "largest possible entity" (LPE) are "real," or call them "operating" if you want. All other assets and liabilities are to be reported as financial in their own separate categories.
• Operating expenses are the utilization of real assets in the production or real goods and services. All other expenses are financial.
• Operating revenues are either (1) the measure of the assets (real or financial) that an entity becomes entitled to for having transferred real resources or for having provided real services; or (2) the measure of the reduction in liabilities that an entity is entitled to from having transferred real resources or provided real services. All other revenues are financial.

Thus, the fundamental distinction to be made in financial presentation is between those items on financial statements that are, or are derived from, real versus financial assets and liabilities. If the boards want to give management the discretion to decide what is "operating" and what is "non-operating", that would be fine with me, just so long as financial items are not conflated with real items in any financial statement. Especially after this latest financial debacle, the potential usefulness of this fundamental distinction should be more apparent than ever.

The day may yet come when we will be freed from the eccentricities of financial statement presentation foisted upon investors by managers who have no interest in giving shareholders more information about their actual performance. Sad to say, after seven years of waiting for a five-page, joint preliminary views document, that day will be no closer if the next generation of SEC leadership doesn't give the accounting standard setters a swift kick in the pants.

On that note, I even sent the gist of my LPE principle to a senior staff member of the IASB a number of years ago, not long after the IASB announced the commencement of its financial statement presentation project. His initial reaction was positive, but after I offered to help develop the idea further, I received no further response. I now invite you, kind reader, to be the judge.