Busn 1001 Business Reporting And Analysis
A Comprehensive Business Reporting
Model
Financial Reporting for Investors July 2007
Financial Reporting for Investors July 2007
CFA Institute Centre Comprehensive
Business Reporting Model Staff Kurt Schacht, CFA
Managing Director
Rebecca McEnally, CFA
Capital Markets Policy Group
Georgene Palacky, CPA
Director Financial Reporting Group
Members of the Comprehensive Business Reporting Model Subcommittee and the Corporate Disclosure Policy Council Gerald I. White, CFA, Chair
Grace & White Inc. New York, NY United States
Robert F. Morgan, CFA
Forbes Morgan Consulting Mont Royal, Quebec Canada
Patricia McConnell, CPA, Past Chair
New York, NY United States
Trevor W. Nysetvold, CFA
ExxonMobil Fairfax, VA United States
Jane Adams, CPA
Maverick Capital New York, NY United States
David E. Runkle, CFA
Trilogy Global Advisors, LLC New York, NY United States
David C. Damant, FSIP
London United Kingdom
Toshihiko Saito, CFA
Capital International Research Chiyoda-ku Tokyo Japan
Christian B. Dreyer, CFA
Tertium datur AG Unterägeri Switzerland
Ashwinpaul (Tony) Sondhi
A.C. Sondhi & Associates, LLC Maplewood, NJ United States
Barry Ehrlich, CFA
Och-Zeff Management Europe London United Kingdom
Edward (Ted) Stevens, CFA
BlackRock, Inc. Wilmington, DE United States
Anthony Good, ASIP
Norwich, Norfolk United Kingdom
ISBN 978-1-932495-70-6
A COMPREHENSIVE BUSINESS REPORTING MODEL:
Financial Reporting for Investors
CFA Institute Centre for Financial Market Integrity July 2007
Preface
The project to develop A Comprehensive Business Reporting Model: Financial Reporting for Investors began in 2002 with a limited objective: to update a 1993 CFA Institute white paper, Financial Reporting in the 1990s and Beyond.1 This widely cited paper set forth the views of CFA Institute and its global membership on financial reporting and investors’ information requirements. Between 1993 and 2002, however, standard setters and regulators worldwide made many changes and improvements to financial reporting. In addition, a number of new business practices had developed that were not contemplated at the time of the original paper. Finally, several surveys of our members highlighted serious deficiencies in the financial reporting framework, problems that hampered their ability to analyze companies and make wellinformed financial decisions. Consequently, those CFA Institute staff and volunteer members who have the responsibility of advocating for high-quality financial reporting thought that the time had arrived for the views in the white paper to be refreshed and extended to better reflect the changed circumstances. Once the work was underway, however, the project scope was expanded to consider both conceptual issues as well as revisions to financial statement display—that is, the business reporting model in its entirety. A special group of CFA Institute volunteer members was assembled—the Business Reporting Subcommittee—and tasked with developing the new paper. The Subcommittee comprised a subset of members from two existing standing CFA Institute committees: (1) the Global Financial Reporting Advocacy Committee (GFRAC), which was responsible for addressing proposals of the International Accounting Standards Board (IASB), and (2) the Financial Accounting Policy Committee (FAPC), which had similar responsibilities for proposals of the U.S. Financial Accounting Standards Board (FASB). The Subcommittee held extensive discussions over the next several years and developed a set of cohesive principles as well as revisions to the fundamental business reporting model. The proposed changes were designed to better meet the information needs of investors, to provide clearer and more complete information than currently available, and to present the information in a format that would make the information readily accessible to investors. The Subcommittee expected that their proposals would be gradually considered and implemented over the long term as standard setters revised their agendas to incorporate new projects and consider new reporting questions. As preliminary decisions were made by the Subcommittee, the proposals were submitted for discussion and comment to the full membership of the GFRAC and FAPC (and later, the Corporate Disclosure Policy Council, CDPC).2 Based upon that feedback, the proposals were clarified or modified as needed. When the project reached an early stage of completion, the draft was submitted for comment to the CFA Institute management and Board of Governors, the Advisory Council of the CFA Institute Centre for Financial Market Integrity, and the “Friends of the Centre,” a group of CFA Institute members who have expressed a particular interest in the Centre’s projects, including financial reporting matters. In October 2005, the draft of the reporting model was released for consideration by the full global membership of CFA Institute, a process that included three separate requests for comment. Surveys of CFA Institute member views were conducted on key points, such as fair value measurement for financial instruments as well as other assets and liabilities. Comments were also solicited in a series of meetings held with a variety of national and global regulators and financial reporting standard setters, including the IASB, FASB, U.S. Securities and Exchange Commission, International Organization of Securities Commissions, Canadian 1 At that time, CFA Institute was known as the Association for Investment Management and Research. The name was changed in 2004 to CFA Institute. 2 With the founding of the CFA Institute Centre for Financial Market Integrity in 2004, the GFRAC and FAPC were merged into a single committee, the Corporate Disclosure Policy Council.
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©2007, CFA Institute
A Comprehensive Business Reporting Model: Financial Reporting for Investors
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Accounting Standards Board, and U.K. Accounting Standards Board. In addition, the document was presented in whole or in part to more than two dozen other major bodies, for example: the Financial Stability Forum, U.S. Federal Reserve Bank, U.S. Congress House Committee on Financial Services—Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, U.N. Committee on Trade and Development, American Accounting Association, and others. Comments were also sought from individual academics, auditors, statement preparers, and other practitioners. This lengthy public comment period produced a substantial number of comments and observations. Based upon this extensive input, the text was revised to increase the clarity and understandability of the concepts and to reflect refinements in the positions over the comment period. A work of this scope and depth could not have been completed without the sustained and concerted efforts of a large number of experts in the field. We express our profound appreciation to those persons whose efforts and contributions have been fundamental to the success of the Comprehensive Business Reporting Model project. First, we are deeply grateful to Patricia McConnell, former chair of the CDPC, the GFRAC, the FAPC, and the Business Reporting Subcommittee, and to Gerald White, CFA, current chair of the CDPC, former chair of the FAPC, and a member of the Business Reporting Subcommittee. Both have been instrumental in the success of this project, and the work has been shaped largely by their vision. Other CFA Institute volunteer members of the Business Reporting Subcommittee devoted countless hours to the project and brought their varied professional experiences and deep knowledge to their deliberations. Members of the GFRAC, FAPC, and CDPC provided numerous comments on the proposals, for which we are grateful. We must give special thanks to James Leisenring, board member of the IASB. Indeed, we have greatly appreciated the time, effort, and considerable thought that regulators, standard setters, and others in a public position have expended on the proposals. Their comments and observations in public sessions as well as private discussions have been of enormous benefit. Several CFA Institute staff members have contributed to the development of the project, and I am especially grateful to them for their work and dedication. Timothy McLaughlin, CFA Institute chief financial officer and managing director of financial and corporate support, provided valuable insights and dozens of helpful comments. Patricia Walters, CFA, former senior vice president for advocacy at CFA Institute, provided strong support and encouragement at the initiation of the project in 2002. Pat also worked directly on the project for a time in 2004, helping to move the deliberations forward. Maryann Dupes, Kara Morris, and Christine Kemper have provided superb editorial support. Rebecca McEnally, CFA July 2007
Chapter 1.
Why Does Financial Reporting Matter to Investors and Investment Professionals?
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Introduction
The business reporting model is the lens through which investors perceive and understand the wealth-generating activities of a company and the results of those activities. The model will succeed or fail based upon its capacity to communicate these activities clearly and completely. Businesses continually evolve, entering or leaving markets, developing new products and services, and finding new ways to attract and retain customers. These changing business practices require that the business reporting model evolve as well so that it can always meet investors’ needs for the information required to evaluate investments and make financial decisions. Corporate financial statements and their related disclosures are fundamental to sound investment decision making. The well-being of the world’s financial markets, and of the millions of investors who entrust their financial present and future to those markets, depends directly on the information financial statements and disclosures provide. Consequently, the quality of the information drives global financial markets. The quality, in turn, depends directly on the principles and standards managers apply when recognizing and measuring the economic activities and events affecting their companies’ operations. We believe that opportunities exist for making significant improvements in the financial reporting model.3 In the chapters that follow, we propose changes that we believe will enhance the usefulness of the current reporting model, particularly for the benefit of investors. A summary of our proposed principles, current practices, and the reasons why reforms are necessary is provided in Appendix A. We recognize that these changes must be made in an orderly fashion as standard setters gradually revise the reporting standards, and some will take many years to realize. But a number of the changes—including our recommendations for improvements to the way currently available financial information is presented in the financial statements—can be made in the near term. Other near-term improvements include full fair value reporting for all financial instruments, fair value reporting for the consolidation of acquisitions and on-balance-sheet fair value reporting of all financial activities that are currently off balance sheet, including securitizations and leases (both assets and liabilities). Since 1934, when Benjamin Graham and David Dodd first published their classic text Securities Analysis, the practice of investment analysis and valuation has been virtually synonymous with what it means to be an investment professional. We serve our investing clients and, ultimately, the financial markets, by assessing the risk and value of an investment opportunity and evaluating its suitability for each client’s particular circumstances. Whether this process leads to valuation of an entire company, a specific equity, a fixed-income security, a derivative, or other security, the goal of analysis must be to provide a reasonable and adequate basis upon which to make an investment recommendation to clients or to take an investment action on their behalf. The ability to make high-quality, independent, objective, and reliable investment decisions depends not only on our expertise in the use of analytical and valuation techniques but also on the quality of the information available for us to collect, analyze, and incorporate into our valuation models. Headquartered in Charlottesville, Virginia, with offices in London, Hong Kong, and New York, CFA Institute, formerly known as the Association for Investment Management and Research (AIMR), is a global professional organization of individual members, most of whom hold the CFA designation. Our members generally are active in the investment business but all must agree to abide by the CFA Institute Code of Ethics and Standards of Professional Conduct. Societies may also be admitted to CFA Institute membership, but they are nonvoting members. This paper was developed by the CFA Institute Centre for Financial Market Integrity, the unit of CFA Institute responsible for advocacy and standard-setting, with the assistance of many of our members. Please see the Preface for further details. ©2007, CFA Institute A Comprehensive Business Reporting Model: Financial Reporting for Investors 3AFM 211 Financial Accounting 1
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Because corporate financial statements are the primary source of the information employed in financial analyses, we support efforts to achieve the highest quality in financial reporting principles and standards and will work with standard setters to achieve these objectives. Our goal is to ensure that financial statements and their accompanying disclosures provide all the information we need in a readily accessible and useful form. We believe that the current financial reporting model can and should be improved, and we intend to contribute to this effort. Investors require timeliness, transparency, comparability, and consistency in financial reporting. Investors have a preference for decision relevance over reliability. As CFA Institute stated in 1993 and as reiterated in this paper, “analysts need to know economic reality—what is really going on—to the greatest extent it can be depicted by accounting numbers.”4 Corporate financial statements that fail to reflect this economic reality undermine the investment decision-making process. The basic issues of greater recognition and measurement, better disclosure, and increased transparency have not changed very much in the last decade and a half. This observation is underscored by the corporate reporting scandals and bankruptcies in the opening years of this century, a problem that continues with the currently expanding stock option backdating investigations. Nevertheless, we must acknowledge the major improvements that have been made in a number of financial reporting standards, including the required expensing of the fair value of stock options and improved reporting for derivatives and employee benefit plans. We believe that investors will be best served if the revisions to the financial reporting model involve fundamental reforms rather than superficial, cosmetic changes. Consequently, we will work with purpose and determination to assist standard setters to address the underlying problems of the current dated accounting model. Innovation and creativity have affected the nature of companies and the products and services they provide. Although manufacturing and merchandising companies will continue to exist and thrive, service businesses—especially those in the financial sector—constitute a major and growing portion of the global economy. Many of the largest companies worldwide are either primarily financial services businesses or derive a substantial amount of their revenues and earnings from such activities. Companies with manufacturing or merchandising core businesses have added a variety of financial services to their product lines and provide customer financing from their own subsidiaries. The reporting model must be able to provide investors with the information they require to understand financial services companies and the various aspects of their operations. Today, many companies in global markets are driven by the creation and use of intangible assets. Indeed, much of the major economic growth worldwide is attributable to such assets. The current reporting model is deficient in its requirements for transparent recognition and disclosure for intangibles. High priority should be given to improvements in the reporting of intangibles so that investors will have the information they need to understand, analyze, and value intangibles-dependent companies. Investors require much more comprehensive disclosure about financial statement items, and the company activities and events that underlie them, than is generally available. Investors need this expanded information to evaluate company performance and understand companies’ wealth-generating processes. These items were our primary focus in 1993 and remain so today. In fact, the financial statements cannot be fully understood without extensive, clear, and complete supporting disclosures. We believe that disclosures should be considered jointly with the setting of the related recognition and measurement standards. Furthermore, they should be held to the same standards of relevance, reliability, clarity, and completeness.
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Financial Reporting in the 1990s and Beyond (Charlottesville, VA: AIMR, 1993), p. 3. ©2007, CFA Institute
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Finally, we would encourage standard setters to refocus their approach to the development of accounting standards. Financial statements must serve the needs of all investors, whether equity investors, creditors, or other suppliers of capital to the company. However, we believe it should be helpful in standard-setting and ensuring completeness, transparency, and relevance of the reported information if financial statements are viewed from the position of an investor in the common shares of the company. Existing common shareowners are the residual claimants in the net assets generated by a company. All other claims are senior to theirs and must be fully satisfied before common shareowners may exercise their claims. Hence, we believe that if the information needs of existing common shareowners are fulfilled, the primary needs of other prior claimants will be met as well. To succeed in bringing changes to financial reporting that will improve the usefulness of the information for those who must rely upon it, a partnership is needed among standard setters, common shareowners, and other investors to bring full transparency and the highest integrity to the standards as well as to the processes by which those standards are developed. CFA Institute and the CFA Institute Centre for Financial Market Integrity are committed to improving financial market integrity in the 21st century.
Chapter 2.
A Conceptual Framework for the Comprehensive Business Reporting Model
A conceptual framework for business reporting must provide a sound foundation for every accounting standard, proposal, and interpretation. We believe, however, that a properly conceived and executed framework should serve also as a benchmark by which the quality of a proposed standard may be judged. The framework should guide standard setters in their deliberations on the development of new reporting pronouncements, but it should also provide a template for assessing whether the standard-setting work is finished or remains deficient in one or more material aspects. We and others believe that the current conceptual frameworks in use by major financial reporting standard setters are in need of updating and refinement. This work has already begun. In recognition of the deficiencies, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have begun a multiyear joint project to revise, update, and work cooperatively toward convergence of their respective frameworks. The ultimate objective is to develop a single, high-quality set of concepts and principles. We agree with this objective. In a joint publication of the FASB and the IASB, Halsey Bullen and Kimberley Crook have this to say about the importance of the project: Although the current concepts have been helpful, the IASB and FASB will not be able to realize fully their goal of issuing a common set of principles-based standards if those standards are based on the current FASB Concepts Statements and IASB Framework. That is because those documents are in need of refinement, updating, completion, and convergence.5
We agree with these goals. Similarly, in addressing the question “Why revisit the framework?” in an issue of The FASB Report, L. Todd Johnson, senior technical adviser and project manager for the Conceptual Framework revisions, states: Although the Board continues to utilize the framework in making decisions, most of the framework was developed 20 or more years ago. Because the framework has not kept up with changing times and changing business practices, it needs updating and refining. Moreover, certain aspects of the framework are inconsistent with other aspects of it, and those inconsistencies need to be eliminated. Furthermore, some parts of the framework that originally were planned were not ultimately completed, even though conceptual guidance in those areas continues to be needed. For those reasons, the framework is gradually becoming less helpful in providing guidance to the Board for making standard setting decisions. The need to revisit the framework has become more pronounced with the Board’s decision to move toward producing accounting standards that are “principle-based.” Such standards, by their very nature, must be soundly grounded in a coherent and cohesive set of concepts that is up to date, internally consistent and comprehensive.6
AFM 101 Introduction to Financial Accounting We strongly support this project and encourage the standard setters to implement needed changes. We do not intend here to develop or propose a completely new conceptual framework. We believe that much of the existing scheme is sound. Rather, our intent is to outline those additional guiding concepts that we believe are essential to ground our proposed model. 5 Halsey G. Bullen and Kimberley Crook, “A New Conceptual Framework Project,” Revisiting the Concepts, IASB/FASB (5 May 2005), p. 2. 6 L. Todd Johnson, “Understanding the Conceptual Framework,” The FASB Report, No. 263-D (28 December 2004), p. 6.
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Necessarily, some of the concepts we propose conflict in some way with some of the most basic concepts in the current conceptual framework. That is an inevitable concomitant of fundamental change. However, at the same time, we will also reinforce some of the principles in the current framework that are critical to the model. We must make clear that our proposed additions and other amendments to the framework are not considered lightly but are based upon the changes to the current financial statements that investors routinely must make in order to try to generate the data they need to analyze and value securities. Perhaps the most compelling argument for requiring that the reporting changes be made is that if investors must transform financial statements, and the information they contain, into a different form so that they can use the information in their decision making, then the statements and information should be presented in that form in the first place. Such a change would promote both market efficiency and effectiveness. A second reason for requiring fundamental changes is that the current reporting model does not provide sufficient information to enable investors to make the needed changes. The extreme degree and inconsistent pattern of aggregation and netting of items in the statements—along with the obscured, even opaque, articulation of the financial statements— make such analysis ineffective or impossible. As a result, investors must resort to estimates and best guesses to arrive at information essential for financial decision making. The decisions made can be no better than the quality of the information that supports them. If inadequate financial statements are an impediment to sound financial decision making, then their quality should be improved. We believe that, when fully implemented, our proposed changes to the conceptual framework will resolve some of the most pervasive problems in financial analysis. Other issues, however, will remain. For example, investors’ ability to understand financial information is a direct function of how the information is communicated and not of the information itself. Communicating in a way that is understandable to the investor is a fundamental responsibility of managers who use the investor’s capital. Information must be presented clearly, described in a way that is intended to communicate rather than obfuscate, and disclosed in sufficient detail to facilitate understanding by investors. An essential characteristic of any conceptual framework on which accounting standards are based must be that the resulting financial statements present a “true and fair” view of a company’s financial position and any changes to that position. As a consequence, when standards are based on such a conceptual framework and are applied fully and impartially, there is no need for the so-called true and fair view override. In other words, if application of the conceptual framework does not lead to a true and fair view, then the framework itself must necessarily be deficient and should be revised. A frequently heard argument against standard setters’ proposals to require additional disclosures is that investors already suffer from information overload and cannot assimilate any more. We counter that more accurate and useful information does not result in overload. First, whether it is used by investors in every case does not bear on the fact that such information may be essential to present a true and fair view of the company and its operations. Second, what burdens investors is extraneous information—disclosure that neither informs nor enlightens, the typical boilerplate prose that remains in companies’ financial reports year after year unchanged or amended in any way. Useful disclosure communicates information clearly and succinctly, in formats designed to convey the substance of the company’s current sources of value and how those sources of value have changed and why.
A. Objective of Financial Reporting and Disclosure
Financial statements should serve the needs of all those who provide capital to a company and bear risk as a result, including the various classes of creditors as well as equity owners. However, among all classes of capital providers, common shareowners are the residual risk bearers in a company. Hence, we believe that one of the primary objectives of financial
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reporting and disclosure must be to provide all of the information that owners of common equity require to evaluate their investments. Common shareowners use the information to make forecasts of future cash flows, evaluate the sustainability of the company’s business model, and assess its cash-generating ability. This information, in turn, is used to estimate the investments’ value and future changes in such value. Johnson, in The FASB Report, states the following regarding the objectives of financial reporting: . . . (T)he objectives focus on information about an entity’s economic resources, the claims to those resources, and changes in them (including measures of the entity’s performance). That information is useful to investors and creditors in assessing the entity’s cash flow prospects. The objectives, therefore, focus on matters of wealth. Investors and creditors seek to maximize their wealth (within the parameter of the risks that they are willing to bear). Likewise, business entities also seek to maximize their wealth. It follows, then, that information about the wealth of those entities and the changes in it is relevant to investors and creditors that are seeking to maximize their wealth by investing in or lending to those entities.7
We agree and believe that if the information needs of the residual risk bearers are fully met, then the needs of those with senior claims will generally be met as well. To be useful in making investment and other financial decisions, reported information must be timely, accurate, understandable, and comprehensive. The financial statements must recognize, as they occur, all events or transactions that affect the value of the company’s net assets and, hence, common shareowners’ wealth. Furthermore, the associated disclosures must provide sufficient information so that investors can understand how the numbers reported in the financial statements were generated, including full descriptions of any estimation models and assumptions that were used to produce the numbers. The disclosures also must fully explain all risk exposures and possible future occurrences whose effects could be expected to affect investors’ wealth.
B. Concepts
Consistent with the financial reporting objective, the Comprehensive Business Reporting Model we propose is based upon the following 12 concepts.
1.
The primary financial statements must provide the information needed by equity investors, creditors, and other suppliers of risk capital.
Investors and creditors need timely, relevant, complete, accurate, understandable, comparable, and consistent information in order to be able to evaluate the potential risk and return properties of securities and to determine appropriate valuations for them. The purpose of audited financial statements, prepared according to high-quality financial reporting standards, is to provide the needed information. Investors and other suppliers of capital are generally not in a position to be able to command the information they need to evaluate and value potential investments. For this reason, market regulators have generally required that companies accessing markets to raise risk capital be required as a condition of registration to provide audited financial statements prepared according to a system of generally accepted accounting principles (GAAP). However, for varying historical reasons, GAAP has not always required full and complete recognition of assets and obligations in the primary financial statements or has permitted some items, such as certain contingencies and executory contracts, to escape recognition and disclosure altogether. Thus, we believe that a fundamental principle of financial reporting must be that financial reports should provide the information that capital providers need to evaluate their investments. 7
2. In financial reporting, standard-setting, as well as statement preparation, the entity must be viewed from the perspective of an investor in the common equity issued by the company. For a common shareowner—the residual risk bearer in a company—events and transactions that can affect assets, liabilities, and equities and therefore affect the wealth of that shareowner are material and should be reported and explained. For example, off-balancesheet financing activities can affect the company’s revenues, expenses, cash flows, and risk exposures and can require the transfer of assets to others or create liabilities, thus directly affecting shareowner wealth. Consequently, the effects of such activities on the company’s assets and liabilities should be reported on a comprehensive basis in the balance sheet,8,9 with changes in those items reported in the income and cash flow statements. If shareowners’ information needs are met, the needs of other external financial statement users will most likely be met as well. For example, it is our view that providers of debt capital to the company hold an interest in financial reporting nearly identical to that of shareowners and also will be well served by comprehensive reporting.10 The IASB would seem to concur with our view in this section from the IASB framework, paragraph F–10:11 . . . [T]here are needs which are common to all users. As investors are providers of risk capital to the entity, ACC 103 Economics for Management
the provision of financial statements that meet their needs will also meet most of the needs of other users that financial statements can satisfy.
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From time to time, the argument is made that financial reporting that serves shareowner interests may damage the public interest by failing to place the interests of other stakeholders above those of the investor. For example, in the debate over the expensing of stock options in the United States, representatives of some companies that use options extensively for compensation argued that if expensing were to be required, thereby fully recognizing the compensation component of the company’s production costs, the resulting reduction in earnings would cause such companies to have to reduce or otherwise ration the use of options. They argued that this would reduce the amounts of compensation companies could pay employees and limit their ability to attract the most talented employees. They argued further that this would stifle innovation and reduce the competitiveness of U.S. companies. Put slightly differently, these representatives stated that we must choose between complete, truthful financial statements and healthy markets. We object to such statements, both because we believe them to be erroneous and because they interject non-financial reporting objectives into a traditionally neutral and independent standard-setting process. Financial reporting exists to serve the needs of investors who otherwise cannot command the information they require. In global capital markets, ownership is generally dispersed. Reporting standards, which prescribe financial reporting, are independently created and promulgated in the public arena. Shareowners in publicly traded companies share a common interest in having information to forecast the risk and returns of potential investments. In the context of these global markets and for the purposes of financial reporting, we believe that shareowner interests are congruent with the public interest because efficient allocation of capital is critical for economic growth. We believe that our view of the entity is entirely consistent with the objective stated in FASB’s Statement of Financial Accounting Concepts No. 1, p. 5, that financial reporting should provide information: . . .[A]bout the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners’ equity), and the effects of transactions, events, and circumstances that change its resources and claims to those resources…[and] that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. . . . 8
We recognize, however, that some current accounting standards continue to permit some transactions (e.g., some financing vehicles, operating leases, pension liabilities, and executory contracts) to not be fully reflected in the balance sheet or, worse, to escape balance sheet recognition altogether. Such standards tend to rely on “bright line” rules, distinctions that we believe to be arbitrary and that fail to serve the best interests of investors. 10 We believe that fixed-income analysis differs from equity analysis only in emphasis. For high-yield investments, the difference from equity analysis is especially small. 11 Framework for the Preparation and Presentation of Financial Statements, International Accounting Standards Committee (1989), adopted by the IASB in 2001. ©2007, CFA Institute A Comprehensive Business Reporting Model: Financial Reporting for Investors
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3. Fair value information is the most relevant information for financial decision making. Currently, the extant conceptual frameworks contain a list of measurement attributes but lack a fully developed measurement concept. Our goal is for fair value to be the measurement attribute for assets and liabilities. In 1993, CFA Institute observed: It is axiomatic that it is better to know what something is worth now than what it was worth at some moment in the past . . . Historic cost itself is in reality historic market value, the amount of a past transaction engaged in by the firm. . . . Historic cost data are never comparable on a firm-to-firm basis because the costs were incurred at different dates by different firms (or even within a single firm). There is no financial analyst who would not want to know the market value of individual assets and liabilities.12
Fair value measures reflect the most current and complete estimations of the value of the asset or obligation, including the amounts, timing, and riskiness of the future cash flows attributable to the asset or obligation. Such expectations lie at the heart of all asset exchanges. In the last decade and a half, an increasing number of global financial reporting standards have been based upon fair values, a trend we would wish to see accelerate. If asset exchanges and financial decisions are based upon fair values, then market efficiency would be enhanced if the information upon which such decisions are made is reported at fair value. The implication is that items in the balance sheet should be reported at current fair value. Furthermore, changes in these values should be reported in the income statement as they occur. We recognize that historical cost or contractual amounts may be needed for some purposes, such as tax determinations and for assessing some contractual commitments and obligations. We would recommend that such information be provided in tabular form in the notes, along with the relevant fair values for the individual items. If, for example, a credit rating analyst were evaluating the creditworthiness of a particular debt security, the analyst may find it useful to understand the contractual obligation entered into by a company. However, we believe it would be useful as well for the analyst to have at hand the relevant fair value of the obligation. The fair value may provide the analyst with information useful in evaluating the probability of repayment because fair values are likely to reflect the most up-to-date market assessments of that probability. With respect to the measurement of fair value, we believe that managers should look first to the most objective sources of fair value, for example, observable prices for the same or similar assets or liabilities in liquid markets. In the absence of such market-determined measurements, managers must report the best estimate of fair value as determined by widely accepted and applied valuation methods and by using market-based inputs. Our views on fair value measurement are consistent with the principles laid out in FASB’s recently issued Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurement.13 Currently, financial statements include some items reported at historical cost while others are measured at fair value, the so-called mixed-attribute system. Consequently, investors who rely on fair values for decision making must expend considerable effort trying to restate to fair value those decision-relevant financial statement items that are measured at historical cost. Their success depends on the sufficiency of disclosure and on the relative reliability of the measurements in the disclosures. Most, if not all, of this effort would be eliminated if the 12 13
Financial Reporting in the 1990s and Beyond (Charlottesville, VA: AIMR, 1993), p. 39. The FASB released SFAS No. 157, Fair Value Measurement in 2006. The IASB is currently exposing these provisions through its own due process and public comment period. This standard defines fair value and provides guidance on its application in the form of a hierarchy that is intended to foster consistency in its application and improve fair value disclosures. The standard does not prescribe fair value for any assets or liabilities. Rather, it defines how fair value measurement should be applied when such measurement is required by other standards. 9
financial reporting standards were to require that companies record assets and liabilities at fair value at inception with periodic revaluation. Indeed, the managers of companies are likely to have the best knowledge of the values of the assets and liabilities and, presumably, base their own investment decisions on behalf of the company on such values. Opponents of fair value reporting argue that measuring and recognizing assets and liabilities at fair value in the financial statements introduces volatility into the financial statements. We argue to the contrary: If fair value measurement results in greater volatility, then the measurement has merely unmasked the true economic reality that was already there. One of the most important evaluations investors must make is to ascertain the degree of risk to which an investment is exposed: The greater the volatility, the greater the risk. The risk is then weighed against the investment’s expected returns. Reporting methods that mask true volatility do a great disservice to investors, impair their ability to make well-founded investment decisions, and can result in inefficient allocations of capital. If managers choose to hedge economic risks, then comprehensive fair value reporting will better reflect the extent to which those hedging activities have been successful. To achieve this, the reporting should provide full fair value disclosure of both (1) the economic risks hedged and (2) the results of the hedging activities. That is, the fair values for the hedged items and their related hedges must not be netted or deferred, concealing both the underlying risks and management’s activities to alter or manage those risks. We have called for standard setters to implement a requirement for companies to record financial instruments, both assets and liabilities, at fair value.14 We recommend that standard setters make this project a priority and move to adopt and implement the standard. As a first step, we recommend that standard setters require that those financial instruments for which fair values are currently required to be disclosed in the footnotes be recognized at fair value in the balance sheet with changes in the fair values reported in the income statement as incurred. We would then propose that standard setters move to establish agenda projects for all other classes of financial assets and liabilities, including those that are off balance sheet. The projects should include the establishment of standards for footnote disclosures that provide the information investors need to understand the financial instruments and their reported measures. For example, the disclosures should explain the degree of uncertainty in a particular measurement. Similarly, investors need to know whether observed market prices or pricing models and assumptions were used to estimate the fair value and the extent to which management used judgment rather than market inputs to determine the measurement.15 For such measurements, sensitivity analysis is critical, especially when the effects of changes in market or other economic conditions on the fair value are nonlinear. Investors understand that uncertainty is a characteristic of the measurement of every recognized asset and liability. What is important is that managers disclose the degree of measurement uncertainty and its sources.
4. Recognition and disclosure must be determined by the relevance of the information to investment decision making and not based upon measurement reliability alone. Relevance and reliability may seem simple concepts at first. When used in the context of financial reporting, however, they are actually quite complex. Information is relevant when it “influences the economic decisions of users by helping them evaluate past, present or future events or [when they are] confirming or correcting their past evaluations.”16 Letter from the Corporate Disclosure Policy Committee of the CFA Institute Centre for Financial Market Integrity to the FASB (31 October 2006). 15 SFAS No. 157 currently requires some but not all of this information. 16 Framework for the Preparation and Presentation of Financial Statements, International Accounting Standards Committee, paragraph 26. ©2007, CFA Institute A Comprehensive Business Reporting Model: Financial Reporting for Investors 14
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Consequently, investors, who must rely on financial statement information, need to receive all relevant information. Moreover, the information required may differ depending upon the requirements and focus of investors’ decisions and the analysis necessary to support those decisions. Timeliness is also an important attribute of relevance. Indeed, information that is not timely may no longer be relevant. While we recognize that the benefits of providing some items of minor relevance may not be justified when compared with the costs associated with measuring and reporting the items, we find altogether too often that these constraints serve as excuses for relevant information to be withheld from shareowners. Reliability has been much misunderstood and misused in the financial markets. Indeed, reliability has in some quarters been taken to mean certainty of occurrence and measurement. Such an interpretation was never intended by standard setters. Rather, reliable information is that which faithfully represents the events that it “purports to represent or could reasonably be expected to represent.”17 We think this aspect of reliability is essential in the debate over the trade-off between relevance and reliability. In fact, we believe that faithful representation is an essential attribute of relevant information. Even more problematic from our perspective is the role that a misunderstanding of the concept of reliability has come to play in debates regarding whether certain financial information should be required to be recognized in the primary financial statements, held off the balance sheet and disclosed only in the footnotes, or eliminated altogether. We cite as examples the U.S. debate on the treatment of pension obligations two decades ago and fair value reporting of derivatives in the European Union recently.ISYS 111 Fundamentals of Information Systems
5. All transactions and events must be recognized as they occur in the financial statements. We have already discussed the importance of the recognition of events in the financial statements as they occur. This issue is so fundamental to reporting, however, that we believe it must serve as a separate concept and benchmark criterion. Completeness requires the financial statement recognition and measurement of economic events that can affect investors’ wealth, including changes in fair value, as they occur. Thus, no accounting standard should permit assets or liabilities, and changes in them that can affect shareowners’ wealth, to escape recognition at the time they occur in the financial statements. For example, where assets are jointly owned or obligations are shared with one or more entities, then the amounts to be recognized should be based upon the company’s and, therefore, the shareowners’ potential risk exposures in those activities and their expected rewards for bearing the risks. Such recognition and measurement are entirely consistent with fair value reporting. This means, of course, that all activities that currently are off balance sheet as a result of accounting standards or other conventions must be recognized, including executory contracts. Executory contracts, arrangements for which performance by the various parties is still in progress, represent commitments entered into by the parties. These commitments will affect shareowners’ wealth and should be recognized as any other obligation would be.
6. Investors’ information requirements must determine the materiality threshold. Materiality must be evaluated from the perspective of whether the information under consideration would make a difference to an existing common shareowner’s assessment and valuation of the investment. The use of arbitrary quantitative thresholds, such as 5 percent of some income statement number, to assess materiality does not serve investor interests. We believe that if there is doubt about materiality, the item should receive separate recognition and measurement, accompanied by sufficient disaggregated disclosure.
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7. Financial reporting must be neutral.
It has long been established that an accounting treatment must be based solely on what method best captures the economic substance of an item or most faithfully represents the transaction or event and not on the form of the transaction or the consequences of the reporting. Therefore, decisions about the appropriate treatment to be applied must not be influenced by a company’s size, its geographic location, a manager’s intent, or any other attribute unrelated to the economic substance of the transaction. As we stated in The FASB Report: The purpose of financial reporting is to tell a company’s economic story, its financial position and the results of its operations, as completely, clearly, and faithfully as possible. In other words, its job is to tell the story as it is. The role of fiction is to tell the story as it isn’t now, and perhaps never was or ever can be, but rather as the author would like the story to be told. A writer of fiction may well have some other objective than merely spinning a good yarn, including possibly a desire to influence some outcome. To the extent that financial information is manipulated to achieve a particular outcome rather than to faithfully report economic events and activity, the resulting information is biased. Neutral information is free from bias. For information to have value to investors and other users, it is critical that it be neutral. Investors depend on financial information for their investment decision-making. For example, investors routinely use financial disclosures in evaluating a company’s growth prospects, its riskiness, and the long-term success of the company’s business model. These analyses also provide the inputs investors need to price individual securities and to make portfolio decisions. Taken altogether, the quality of investors’ pricing and capital allocation decisions affects the relative efficiency and effectiveness of financial markets.18
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Simply put, when financial disclosures do not tell the economic story as it really is, the prices of securities, and even the amounts of capital allocated to a company, are less likely to reflect the company’s actual economic position. Some standards currently permit wide flexibility in financial reporting choices and have led to earnings manipulation and abuse, which have further diminished net income’s usefulness in making economic decisions. This flexibility allows managers to report similar transactions in very different ways, producing widely different financial statement effects. As we have observed, the method chosen is frequently driven not by what best reflects the economic substance but by the outcome or consequences preferred by managers in order to position the company in the best light—a clear violation of neutrality. More importantly, what managers may deem to be the best light does not always mean the most unbiased and objective light. It is essential that economic transactions and events with similar economic substance be accounted for in the same way. We do not see the logic in permitting issuers choices in either recognition, measurement, or display based on attributes other than economic substance. Some investors believe that managers have an inherent bias toward overstating earnings and equity and that the financial reporting concept of conservatism does much to rein in management optimism. These investors prefer that management use caution when selecting from the unbiased range of accounting results for a particular measurement. With respect to insurance reserves, for example, they prefer that managers be conservative when selecting the point estimate to be reported from the acceptable range. Conservatism would push managers toward the high end rather than the low end of the likely range of losses. Conversely, fair value reporting demands that managers determine the unbiased expected value by forecasting the possible outcomes and by applying probabilities to each of the outcomes. The concerns of some investors about conservatism, on the one hand, and the concerns of others about the degree of bias (positive or negative) in a measure, on the other, can both be met if the standards require that the range be disclosed when the range about a 18
Rebecca McEnally and Patricia Walters, “The Critical Nature of Neutral Financial Reporting,” The FASB Report, Constituents’ Commentary (29 August 2003). A Comprehensive Business Reporting Model: Financial Reporting for Investors
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point estimate is large relative to the estimate: The wider the range, the more important the disclosure. A circumstance where disclosure of the range is critical is when managers decide that the point estimate should be zero, for example, when lawsuits have been filed against a company. Sensitivity analysis is particularly useful in such circumstances because the point estimate does not provide the necessary context in which to understand the reported amount.
8. All changes in net assets, including changes in fair values, must be recorded in a single financial statement, the Statement of Changes in Net Assets Available to Common Shareowners. As we have stated, all events and transactions that can affect assets, liabilities, and equities, and thus the wealth of an investor in a company, must be recognized in the financial statements. Changes in those items also must be recorded in a single, highly transparent, and comprehensive financial statement. That is, there should be no category of items, such as those currently recorded as other comprehensive income, that escapes recognition in the primary changes in net assets statement. One implication of this principle is that so-called recycling of gains and losses will be eliminated. That is, there will be no deferral of fair value changes by recording such changes in equity, with recognition contingent upon future events. An example of such delayed recognition is the current treatment of available-for-sale securities. Although these securities are marked to fair value in the balance sheet, the resulting period-to-period changes in fair values do not flow to the income statement for immediate recognition but rather bypass the income statement and are deferred in other comprehensive income in equity until they are sold. Under the current model, accrual net income or earnings is an accounting construct, not an economic measure. Net income is the result of the recognition of some revenues and gains on accounting transactions less some expenses and losses. As long as a single summary statistic— the net income number—is reported and reporting standards allow managers flexibility in reporting choices, we believe some managers will continue to manipulate the number to suit their needs rather than those of shareowners. Therefore, we are proposing a financial reporting model that does not focus on a single earnings number.19 This change would require investors to analyze the individual reported items and the financial statements as a whole to determine which information is relevant to their financial decision making. We would observe that investors routinely make these assessments in evaluating their investment opportunities. Currently, although financial statements must of necessity articulate (that is, how individual items flow from one to another of the statements; for example, for credit sales, receivables in the balance sheet, cash collections in the cash flow statement, and revenues in the income statement), that articulation is opaque to investors. The reason is that the various statements do not follow a consistent structure or the same pattern of aggregation. Only when all of the changes to individual items are made clear and the measurement characteristics of items are fully disclosed will investors be able to understand a company’s process of wealth generation and the prospects for their investments. We develop the Statement of Changes in Net Assets Available to Common Shareowners in Chapter 3.
19 D.
Eric Hirst and Patrick E. Hopkins in Earnings: Measurement, Disclosure, and the Impact of Valuation (Charlottesville, VA: Research Foundation of AIMR, 2000), pp. 13–14, state: . . . [A]nalysis of historical earnings is usually an important precursor to forecasting relevant inputs, [but] what are the relevant historical earnings? Net income? Operating income? Income before extraordinary items? Comprehensive income? Of course, the definitive answer is: It depends.
Econ 1101 Microeconomics 1
9. The cash flow statement provides information essential to the analysis of a company and should be prepared using the direct method only. The IASB, in International Accounting Standard (IAS) 7, describes some of the benefits of cash flow information: A cash flow statement, when used in conjunction with the rest of the financial statements, provides information that enables users to evaluate the changes in net assets of an enterprise, its financial structure (including liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities. Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash equivalents and enables users to develop models to assess and compare the present value of the future cash flows of different enterprises. It also enhances the comparability of the reporting of operating performance by different enterprises because it eliminates the effects of using different accounting treatments for the same transactions and events.20
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In order for users of the statements to be able to make these assessments, the information provided in the cash flow statement must be fully transparent. That is, the individual categories of cash inflows and outflows must be disclosed clearly and unambiguously. Current standards generally permit companies to choose between the indirect and the direct methods. The indirect method chosen by the vast majority of companies fails to provide adequate information for analysis. Instead of providing the essential information on cash inflows and outflows, the indirect method begins with net income and “patches” the income number, purging noncash elements and adjusting for changes in cash flows not reflected in currentperiod income. Put simply, the only pure cash flow number in the operating cash flow section of an indirect method cash flow statement is the total, Cash Flows from Operations. CFA Institute, reflecting on users’ experience with cash flow statements prepared under current accounting standards, observed in 1993: . . . Cash flow statements that have appeared in published financial reports have been much less useful in analysis than we might have expected. First, almost no public company presents its cash flows from operations using the direct format; virtually all use the indirect format. We have learned . . . that it is extremely difficult or impossible in most cases for financial statement users to calculate reasonable estimates of gross operating cash flows (direct method) using only the data provided in financial reports in the indirect format.21
If cash flow information is essential to investors when they are forecasting future cash flows, and the indirect method does not provide the needed information or enable investors to generate it from the data, then companies must be required to use the direct method.
10. Changes affecting each of the financial statements should be reported and explained on a disaggregated basis. For investors to be able to understand the changes that have occurred in financial statements and, consequently, to their wealth, it is essential that they be able to analyze the individual forces at work that affect the company’s performance. Accounting standards currently permit assets and related liabilities, revenues, and expenses, as well as investing and financing cash inflows and outflows, to be reported on a highly aggregated or netted basis, causing much important information to be obscured or lost altogether. The information loss can result in misleading analyses, distorted conclusions, and suboptimal investment decisions. Such aggregation and netting should not be permitted. Similarly, we do not believe that netting should be permitted for individual line items. For example, changes in the property, plant, and equipment account can arise as a result of (1) purchases and exchanges, (2) sales and abandonment, (3) self-construction, (4) mergers and divestitures, (5) leases, (6) foreign currency changes, (7) depreciation, and (8) impairment 20 21
IAS 7, Cash Flow Statements, effective 1 January 1994, paragraph 4. Financial Reporting in the 1990s and Beyond (1993), p. 65. A Comprehensive Business Reporting Model: Financial Reporting for Investors
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write-downs. Clearly, information as to the precise source of the change is essential if investors and other users are to evaluate managers’ investments in productive capital, the effectiveness of managers’ decisions to invest scarce capital, and the value of the company’s capital. It is important to note that IAS 16 requires a full reconciliation of the change in gross fixed assets and accumulated depreciation.22
11. Individual line items should be reported based upon the nature of the items rather than by the function for which they are used. By “nature,” we mean that items should be reported by the type of resource consumed, such as labor or raw materials, rather than by the function or purpose for which it is used, such as cost of goods sold or selling, general, and administrative expense. Categorization according to nature can greatly enhance comparability across companies and consistency within the statements of a single company. Currently, users of the statements cannot determine from the statements or related disclosures where individual items, such as pension expense and depreciation, are recorded in the income statement. The statistical distribution properties of the various resources consumed in operations behave very differently over time. Consequently, aggregation by function, the current practice, merges items with different properties, reducing the information content of the items and significantly reducing their value as decision-making factors. We believe that functional disclosure is best reserved for segment reporting where the categories are most likely to be more nearly homogeneous and, therefore, more meaningful for assessing the profitability of individual units.
12. Disclosures must provide the additional information investors require to understand the items recognized in the financial statements, their measurement properties, and their risk exposures. Although disclosures are not a substitute for recognition and measurement in the financial statements, they are essential if investors are to understand the statements. The role of disclosure is to provide a comprehensive explanation of events or transactions that have been recognized, including (1) the models, estimates, assumptions, and principles that were applied to measure the effects (2) and the sensitivity of the reported information to changes in those principles and assumptions. To the extent that financial statement line items present aggregated information, disclosures must enable investors to disaggregate. The same qualitative characteristics of financial reporting (including understandability, completeness, relevance, and comparability) apply equally to the written disclosures that supplement the financial statements. The information and measurements contained in such disclosures should not be any less reliable than those recognized in the financial statements and should be subjected to the same level of audit scrutiny that the numerical items in the statements receive. To the greatest extent possible, these written disclosures should pertain to the individual characteristics and circumstances of the company involved and avoid routine, legal boilerplate. Finally, until financial statements are of sufficient quality that they no longer require investors to make substantial fair value and other adjustments, disclosures must provide the essential information investors need to make these adjustments. As we have made clear, however, fair value recognition will not remove the need for disclosures about the fair value measurement process. When standard setters consider new or amended recognition and measurement criteria, disclosures must be developed concurrently, not after recognition and measurement decisions are made. Disclosures must be treated as essential and indispensable commentary to the financial statements, rather than as a mere postscript. 22 For a good example of IAS 16, Property, Plant, and Equipment, see footnote 15 of the 2006 financial statements of Roche, a Swiss multinational that reports using International Financial Reporting Standards (IFRS). This footnote shows the effects on the net book value of each class of fixed assets of acquisitions, divestitures, currency translation, depreciation, and impairment.
C. Definitions
The proposed amendments to the conceptual framework have important implications for the definitions of assets, liabilities, and equity. No single definition of assets, liabilities, or equity can answer all questions or address all recognition issues. Nonetheless, we believe that the definitions proposed by the staffs of the FASB and IASB for assets and liabilities, which are currently under consideration by the two boards, provide a sound starting point for addressing recognition.
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1.
Assets
The proposed asset definition is:
An asset is a present economic resource to which the entity has a present right or other privileged access. a. b. Present means that both the economic resource and the right or other privileged access to it exist on the date of the financial statements. An economic resource is something that has positive economic value. It is scarce and capable of being used to carry out economic activities such as production and exchange. An economic resource can contribute to producing cash inflows or reducing cash outflows, directly or indirectly, alone or together with other economic resources. Economic resources include non-conditional contractual promises that others make to the entity, such as promises to pay cash, deliver goods, or render services. Rendering services includes standing ready to perform or refraining from engaging in activities that the entity could otherwise undertake. A right or other privileged access enables the entity to use the present economic resource directly or indirectly and precludes or limits its use by others. Rights are legally enforceable or enforceable by equivalent means (such as by a professional association). Other privileged access is not enforceable but is otherwise protected by secrecy or other barriers to access.
c.
We believe that as a practical matter, assets should be identifiable and separable, capable of being transferred to others. We do not believe that hard to identify, vaguely defined, or ambiguous items, such as goodwill, should be recognized in the balance sheet.
2. Liabilities
The proposed liability definition is:
A liability is a present economic obligation of (or claim against) an entity. a. b. c. The entity is obligated to act or perform in a certain way (or refrain from acting or performing). The obligation exists at the financial statement date. The obligation is economic—it is an obligation to provide economic resources to others or to stand ready to do so.
3. Equity Interests
We believe that the definition should be narrowly defined to include only those components of equity that are associated with the common shareowner’s interest—that is, common stock, additional paid-in capital, and retained earnings. All other obligations, including those that are currently classified as liabilities, would be classified as “Claims.” This classification is consistent with Principle 2, “In financial reporting standard-setting as well as statement preparation, the company must be viewed from the perspective of an investor in the company’s common equity.” The position is also consistent with our view that all financial instruments other than common equity should be recorded at fair value in the balance sheet with changes in fair value recognized as they occur in the income statement. Common shareowners’ equity is the interest of the current owners of common equity, the last residual claimants, in the net assets (assets minus claims) of the enterprise. Hence, all other interests, including all remaining classes of shareowners whose interests precede and are preferential to those of the residual common shareowners, should be recognized as senior ©2007, CFA Institute A Comprehensive Business Reporting Model: Financial Reporting for Investors
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claims to the common equity and accounted for consistently. These interests would include shares representing ownership in a specific division or subsidiary of the company (i.e., minority interest) as well as the various forms of preferred stock. In general, financial instruments masquerading as equity instruments whose terms provide the holders with prior or preferential access (relative to the residual interest of common shareowners) to company cash flows or other assets should be classified as claims. Similarly, instruments, such as stock options, that require the future transfer of a portion of the net assets of current common shareowners to the holders of the instruments must also be classified as claims. Depending upon the terms of the instruments, they should be classified as Short-Term Claims, Long-Term Claims—Definite Maturities, or Long-Term Claims—Indefinite Maturities. In this context, our call for all financial instruments other than the residual common interest to be valued at fair value in the balance sheet with changes in the fair value recognized currently in the income statement would apply to other equity interests as well. That is, claims against the net assets that are senior to the residual common shareowners’ interest should be reflected at fair value. We would reiterate that we believe that the historical cost or contractual amounts of such interests should be disclosed in the footnotes to the statements when appropriate. These disclosures are consistent with our general view that financial statements should be presented from the point of view of the ultimate risk bearer in the company, the current residual common shareowner. However, claims against the current residual net assets that are prior or senior to those of the residual common shareowner should be presented as just that, senior claims. In addition, sufficient information should be provided in the statements and footnotes about each class of senior claims to enable users of the statements to fully understand the nature of the claims, their settlement terms, the contractual commitments against the net assets that they represent, and their current fair values.
D. Specific Implications of the Conceptual Framework
These proposed amendments and changes to the conceptual framework and the proposed definitions of assets, liabilities, and equity have important implications for current financial reporting standards. We would like to discuss just a few of these implications here. Deferral of defined-benefit plan actuarial gains and losses is incompatible with fair value reporting. All changes in the fair values of the liabilities must be included in pension expense in the period in which they occur. The corridor approach is an unfortunate result of the improper objective of smoothing the accounting recognition of economic events, and it conflicts with several of the concepts mentioned previously. From the perspective of current common shareowners, the granting of stock options to employees creates an obligation that transfers wealth from current common shareowners to employees. Therefore, it is irrelevant whether the obligation will be settled with cash, or other assets, or settled with equity; the obligation must be classified as a liability. Special hedge accounting is an artifact of the mixed-attribute model, is based upon managers’ intent, and results in the selective recognition of only some fair value gains and losses. The fact that it exists only to permit managers to offset losses with gains, thereby reducing reported volatility, is arbitrary. Only when all transactions are fully and separately accounted for at fair value and on a disaggregated basis will investors have a clear picture of both the risks to be hedged and the effectiveness of any hedging instruments or strategies used. The objective of financial reporting is to describe in accounting conventions what the actual financial condition of a company is and not what managers would like it to be. Several of the concepts we propose are diametrically opposed to, and would help prevent, accounting as determined by intent. The rationale for managers’ engaging in particular transactions or business strategies is best included in the disclosures. These disclosures must also include quantitative information that clarifies managers’ effectiveness in achieving their objectives. A Comprehensive Business Reporting Model: Financial Reporting for Investors ©2007, CFA Institute
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When viewed from the perspective of current shareowners, a downward change in the company’s credit rating necessarily means that wealth is transferred from existing bondholders, who have already committed to an interest rate and thus bear the risk of changes in the interest rates, to shareowners. If bondholders had waited to purchase the obligations, they may well have received a higher interest rate. What is unsettling to many, however, is the fact that the fair value recognition of a negative credit change results in a gain to the company and an increase in shareowners’ wealth. Such an occurrence is not a fluke of fair value reporting but rather is the inevitable result of the differential contractual claims of the bondholders and shareowners. We should note, however, that the increase in shareowners’ wealth resulting from the credit downgrade is generally offset by asset impairment, operating losses, or other factors that reduce equity.
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Chapter 3.
The Comprehensive Business Reporting Model—Our Proposals for Revision
We believe that the current business reporting model requires a number of major changes so that it can fully and clearly communicate the operations of a 21st century company to its investors and better serve their needs for information. Briefly, we propose a set of revised financial statements and one new statement. As we have expressed in Chapter 2, we believe that because fair value is the most relevant basis for financial decision making, fair value should be the preferred measurement attribute used in the financial statements. We have a responsibility, however, to propose statements that can serve investors well with today’s mixed-attribute model and during the period of transition to the fair value model. Consequently, the statements that we propose accomplish this objective as well. One by-product of accommodating the mixed-attribute model during the transition is that our proposed model lays bare many of the infirmities of the current model. Investors are interested in a number of major questions, including: • • • • How companies create value; How sustainable is the value-generation process; How value is dispersed to the various senior stakeholders; and How value accrues to the last residual claimants, the ultimate risk bearers in the company, who are generally the common shareowners.
It is apparent from this list that investors cannot rely solely on a single earnings number to make their investment decisions. Rather, investors require information about a variety of different concerns, including: • • • • • Resources available to the company; Obligations to transfer resources to others; The ability of the company to generate long-term, sustainable net inflows of resources; The ability of the company to convert the new resource inflows to cash; and The risks to which these resource-generating activities and cash flows are exposed, both in the near term and in the long run.
In order to answer the questions listed above, investors must understand (1) the economic activities reported in the financial statements and (2) the processes managers have used to produce the financial statements and disclosures. If investors are not able to distinguish the underlying economic activities from the effects of financial reporting, then they will not be able to address the larger questions. Their ability to do so depends directly on the business reporting model, its clarity, its completeness, the transparency of its articulation, and the quality of its measurements.23 The financial statements are all interrelated. To understand one statement, investors must have the means to understand them all. If investors are to better understand how companies are creating value, whether their activities are increasing or decreasing the value of their investors’ investments, and whether the value-generation process is sustainable, much greater attention must be paid to the balance sheet and cash flow statements, to the quality of measurement of items reported in them, and to the relationships among the items. With respect to the balance sheet, because value can be created or lost simply by holding assets and liabilities, we believe that the fair values of both recorded and currently unrecorded assets and liabilities must be reported. 23
Of course, distinguishing between the economics and the effects of GAAP application depends as well on the good faith of managers in applying the model fully and completely and striving for clarity and understandability whether the news is good or bad rather than obscuring any negative or undesirable outcomes. ©2007, CFA Institute
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At present, the balance sheet includes measurements of dubious relevance that are generated using a variety of different measurement bases, including historical cost, amortized cost, observed fair market values, and managers’ estimates of values. The different measurements are mixed together with, in some cases, insufficient information in the disclosures for investors to determine which bases have been used and whether the accounting processes have captured the underlying economics. An equally problematic issue is that changes in these measurements are not required to be recognized in one statement. Rather, they are dispersed between the income statement and, increasingly, Other Comprehensive Income, a category of equity that bypasses the income statement altogether. The ultimate objective of the wealth-generation process is to generate cash. Thus, it is critically important for investors to understand how companies generate cash and how they manage cash receipts and payments. Investors will achieve this understanding only when the business reporting model communicates the process clearly and completely. Investors need a reporting model that better communicates the risks and uncertainties implicit in the events and transactions and thus in the amounts recognized in the financial statements. This information should be reported in such a manner that it can directly support the development of forward-looking estimates of sustainable cash flows. Academic research confirms that “disaggregating earnings into cash flow and the components of accruals enhances earnings’ predictive ability relative to aggregate earnings.”24 It is not surprising that disaggregating the earnings series would improve predictive ability, a primary purpose of financial reporting, because information lost in the aggregation process is preserved in the separate series. In addition, separate reporting of cash flows and accruals permits investors with different analysis and investment objectives to apply different weights to the series in developing forecasts and valuations. This research supports our call for a new business reporting model, one that disaggregates the jumbled income statement and cash flow numbers and that clearly and completely communicates both cash flow information and accruals. Research by Eric Hirst and Patrick Hopkins, as well as work by Ann Tarca et al., shows that how and where reported information is displayed affects investors’ understanding of the reported information as well as their ability to incorporate all relevant information into their valuation models.25 Because of the difficulty inherent in assessing the relevance and persistence of the…[financial statement] amounts, users of financial accounting information often must sort through voluminous notes and nonfinancial information to effectively forecast the future earnings, cash flows, or intrinsic value of a company. This wide dispersion of value-relevant information increases the direct and indirect cost of valuation activities.26
Transparency and accessibility of information are as important as relevance and reliability if investors are to incorporate the data into their analyses and judgments. We believe that a complete cost–benefit analysis would show that it is more costly for many investors to independently engage in search-and-estimate missions than it is for companies to display information succinctly, clearly, consistently, and in accessible formats. Hence, to achieve this objective, we propose a set of new financial statements with revisions to the remaining old ones. The statements retain the most useful characteristics of the old statements but also: • • • Expand the information sets presented; Disaggregate cash flow and accrual information; Distinguish among the measurement bases for such items as cash flows, accruals, and fair value measurements;
Mary E. Barth, Donald P. Cram, Karen K. Nelson, “Accruals and the Prediction of Future Cash Flows,” Accounting Review, vol. 76, no. 1 (January 2001), pp. 28–58. 25 Ann Tarca, Philip Brown, Phil Hancock, David Woodliff, Michael Bradbury, and Tony van Zijl, “Identifying Decision Useful Information with the Matrix Format Income Statement,” working paper. 26 D. Eric Hirst and Patrick E. Hopkins, “Comprehensive Income Reporting and Analysts’ Valuation Judgments,” Journal of Accounting Research, vol. 36, Supplement (1998), pp. 47–75. ©2007, CFA Institute A Comprehensive Business Reporting Model: Financial Reporting for Investors
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• •
Disaggregate functional categories to provide disclosure by the nature of the item; and Reveal the articulation of the individual line items in the financial statements.
We propose that standard setters provide investors with a revised set of four financial statements. All statements are of equal importance. The first three statements provide information at a higher level of aggregation. The fourth statement provides a level of disaggregation that is missing today and that is critical to investors’ understanding of how the other statements, and the items in them, articulate. This set of financial statements comprises: 1. Comparative Balance Sheets—Minimum of three years (three balance sheets and two income and cash flow statements provide two full years of data), with accounts listed in order of decreasing liquidity within each category. Comparative Cash Flow Statements—Minimum of two years, prepared using the direct method, with a supplemental schedule of significant noncash financing and investing activities. (New) Comparative Statements of Changes in Net Assets Available to Common Shareowners—Minimum of two years, that: a. Identify and distinguish among: i. Current-period cash and accrual transactions; ii. Estimates; and iii. Changes in the fair values of balance sheet accounts. b. Provide information by nature of each resource consumed rather than the function for which it is consumed; and c. 4. Display transactions with owners that affect net assets, such as dividends and new share issuances. Reconciliation of Financial Position—Reconciles the comparative balance sheets by further disaggregating the amounts in the statements mentioned previously and by clearly showing how the statements articulate.
2.
3.
In the remainder of this chapter, we explain and illustrate the details of each of these four statements. We provide sample financial statements and the relevant journal entries for TransGlobal Exports, Ltd., a fictional small specialty manufacturer of tools. These statements are the (1) proposed balance sheet, (2) direct method cash flow statement, (3) statement of changes in net assets, and (4) reconciliation statement. In addition, consistent with our view that fair values should be used for the measurement of assets and liabilities, we believe it is important that we provide a more detailed example of the information than we would expect to see in actual practice in the proposed financial statements. Therefore, we provide an example of an interest rate swap in Table 6A,27 which is already measured at fair value under U.S. GAAP, illustrating how the initial and subsequent transactions would be reflected in the proposed statement of changes in net assets and in the reconciliation. The latter also shows the information that would appear in the balance sheet and cash flow statement. The journal entries are those that would be recorded under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities.
B. Classification: Business—Operating and Investing—and Financing Standard setters worldwide, working in a variety of contexts, have sought without success to define those activities that should be classed as operating and to provide a sharp distinction between such activities and other classifications, such as nonoperating, investing, and financing. Indeed, drawing the line between operating and investing activities is fraught with ambiguities, particularly in the case of financial institutions and manufacturing companies 27
Patricia A. McConnell, “Derivatives and Hedging: The FASB Solution,” Accounting Issues, Bear Stearns Equity Research (5 February 1998), pp. 24–29. ©2007, CFA Institute
A Comprehensive Business Reporting Model: Financial Reporting for Investors
21
that provide long-term financing to their customers. As a result, many observers feel that sharp distinctions cannot always be clearly made between operating and financing activities. Some financing from such sources as suppliers, banks, and other investors is inextricably linked to operations and the level of a company’s business activity. Other third-party financing—for example, the issuance of long-term bonds—is of a much more general nature and is at best indirectly linked to operations. We believe that greater clarity may be achieved by classifying third-party financing separately as financing activities. All other financing arrangements arising from relationships with customers, vendors, or other related parties should be classified as business—that is, operating and investing activities. We also believe that classifying investing activities as a separate category of business activities would better reflect the actual economics of most modern companies, particularly those in which customer or vendor financing is an intrinsic part of the business model. It is important for consistency and comparability that all transactions and events related to these various activities be similarly classified, including their foreign exchange consequences. Income tax, however, cannot be disaggregated because it is a statutory charge against activities in a particular jurisdiction. Therefore, we believe that income tax expense, cash payments, and deferred assets and liabilities should not be classified.
C. Balance Sheet
The balance sheet provides investors with information about a company’s assets and the claims against those assets: 1. 2. 3. 4. The resources available to it; The relative liquidity of the resources; Recognized and contingent claims against those resources; and The relative time to maturity of these claims.
The importance of the balance sheet to investment decision making has diminished in recent decades. Arguably, this is a result of such factors as: • • • Models that focus on reported earnings and cash flows rather than accounting net worth; The reduced relevance of historical cost–based numbers for decision making given both general inflation and price changes for specific assets and liabilities; The omission from the balance sheet of major classes of resources and obligations (for example, intangible assets and operating leases and other off-balance-sheet financing arrangements); and Accounting choices that limit comparability.
•
We believe that it is time to refocus attention on the balance sheet, to correct its deficiencies, and to restore its usefulness as a communicator of essential information about companies. In Chapter 2, we made clear that we believe that: 1. 2. 3. 4. 5. 6. 7. All assets available to the company and all obligations and commitments that can consume the net assets available to investors should be recorded in the balance sheet; All balance sheet assets and liabilities should be reported at fair value, starting with all financial instruments as soon as possible; All balance sheet items should be disaggregated; Assets and liabilities should not be netted; Income statement components and related balance sheet items should be reported by nature rather than function; Related assets and liabilities should be classified together by category; and All assets and liabilities should be ordered by liquidity, specifically by decreasing liquidity, within their respective categories. A Comprehensive Business Reporting Model: Financial Reporting for Investors
©2007, CFA Institute
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These principles are not routinely followed in the current balance sheet process, reducing its transparency and usefulness to investors. An investor should be able to readily determine the company’s true net assets at the balance sheet date and, in conjunction with the cash flow statement, be able to evaluate the company’s ability to liquidate claims and obligations from the balance sheet. See Table 1 for an example of a balance sheet constructed using these principles.
D. Cash Flow Statement
In 1986, when the FASB issued its exposure draft for SFAS No. 95, Statement of Cash Flows, to replace the funds flow statement, we urged the board . . . to require a cash flow statement that clearly discloses flows of cash (and cash equivalents) through the entity. The cash flow statement itself should focus only on cash flows and not have its utility and relevance diluted by unwarranted injection of accrual accounting concepts.28 [Emphasis added.]
At that time, we requested that a single format for the statement be prescribed, and we requested that “as long as net income was considered to be of primary importance, the objective of the statement of cash flows should be to facilitate an understanding and analysis of the income statement.”29 By 1990, four short years later, when the International Accounting Standards Committee (IASC) issued a similar exposure draft, we had reconsidered our views. In our 27 July 1990 comment letter, we explained that our . . . support [for the indirect method] was based, in part, on the need of financial statement users to understand how reported net income differs from cash from operations and to be able to reconcile the two. We also believed that users who wished to prepare a direct method statement would be able to do so using the data provided in the indirect method reconciliation.30 [Emphasis added.]
Our experience since then confirms our view that it is impossible for even the most skilled analyst to create a reliable direct method cash flow statement for most companies from existing reported data. The analysis required to even approximate a direct method cash flow statement from the available data is difficult and time consuming. The real challenge, however, is not the enormous effort required but rather the fact that the articulation between the balance sheet and the income statement is almost always obscured. For example, most companies provide insufficient information to permit a skilled analyst to cleanly decompose the entries affecting accounts receivable and to determine cash inflows from sales, the amounts of cash collected from customers. Cash collected from customers is perhaps the single most important direct cash flow number and is a primary indicator of the company’s cash-generating ability. Gross estimates must be made, greatly reducing the reliability and usefulness of the information generated by the exercise. The same is true to a greater or lesser extent for all of the other numbers in a direct method statement. In addition, it is often impossible to align the adjustments in the indirect method cash flow statement with any single income statement line item.
28
Patricia McConnell and Gerald I. White, “Comment Letter of the Financial Accounting Policy Committee of the Financial Analysts Federation to Financial Accounting Standards Board” (15 October 1986), p. 1. 29 Ibid, p. 3. 30 Patricia McConnell and Gerald I. White, “Comment Letter of the Financial Accounting Policy Committee of the Association for Investment Management and Research to the International Accounting Standards Committee” (27 July 1990), pp. 1–2. A Comprehensive Business Reporting Model: Financial Reporting for Investors ©2007, CFA Institute
Table 1. Trans-Global Exports, Ltd., Comparative Balance Sheets at 31 December 20X3 and 20X4 31 December 20X3
Assets
23
20X4 € 5,918,411 196,100 845,000 (70,500) 774,500 619,694 25,756 722,250 4,260,000 (275,000) € 3,985,000 €12,241,711
Cash Marketable securities Accounts receivable Less: Allowance for bad debts Net accounts receivable Inventory Leased asset Investment in affiliate Building Less: Accumulated depreciation Net building Total assets Claims and Common Shareowners’ Equity
€4,000,000 0 595,000 (20,000)* 575,000 850,000 0 0 3,600,000 (100,000) €3,500,000 €8,925,000
Accounts payable Accrued liabilities Advances from customers Interest payable Income taxes payable Dividends payable Current portion of lease liability Short-term debt Accrued stock compensation Lease liability Deferred income tax liability Accrued pension liability Bonds payable Minority interest Perpetual preferred stock Total claims Common stock Additional paid-in capital Treasury stock Retained net assets Total common shareowners’ equity Total claims and common shareowners’ equity *Parentheses indicate negative numbers.
€ 850,000 28,000 15,000 0 54,639 0 0 0 6,000 0 23,699 2,400 0 100,000 300,000 € 1,379,738 € 600,000 4,000,000 (100,000) 3,045,262 € 7,545,262 € 8,925,000
€
375,000 78,000 190,000 125,000 75,451 35,000 9,208 500,000 13,500 24,870 56,819 4,800 2,500,000 100,000 300,000
€ 4,387,648 € 600,000 4,000,000 (100,000) 3,354,063 € 7,854,063 €12,241,711
©2007, CFA Institute
A Comprehensive Business Reporting Model: Financial Reporting for Investors
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There is an additional issue that is critical for investors’ use of cash flow information. As our 1990 letter explained, academic research provides evidence that the individual components of cash flow from operating activities have explanatory power that is superior to that of the currently reported total cash flow from operations.31 That is, information useful for forecasting cash flows is lost in the aggregated single number, cash flow from operations, the only cash flow amount in an indirect method cash flow statement. The most useful and revealing cash flow components are only available in a direct method cash flow statement. In the 1993 Financial Reporting in the 1990s and Beyond and again in a 1996 comment letter to the Canadian Accounting Standards Board, we repeated our request for a statement of cash receipts and disbursements (that is, a direct method cash flow statement). We repeated our belief that such a statement is more useful than the indirect method of adjusting net income to remove noncash items and to patch for cash flow items not recognized in the income statement. We believe that the cost required to develop even an approximation of a direct method cash flow statement clearly overrides any cost–benefit objections issuers might have for providing it. Investors use cash flow information as an important reality check on the quality of reported earnings. To the extent that cash flows and earnings diverge, a result of noncash accruals changing at a faster rate than the related cash flow number, investors are put on warning that the reported accrual numbers may be less than reliable indicators of the company’s performance and thus of its value-generating ability. The divergence may also signal cash flow difficulties at some time in the future. Information about significant noncash operating, investing, and financing transactions is also important. Therefore, to provide transparency for transactions that are not disclosed in the cash flow statement, a supplementary schedule of these transactions must be required. See Table 2 for an example of such a direct method cash flow statement. (In Table 5, we provide the supporting journal entries for the items reported in the cash flow statement.) Note that these entries include the accruals for the period and fair value adjustments as well, which are not relevant for the cash flow statement.
E. Statement of Changes in Net Assets Available to Common Shareowners Our proposed Statement of Changes in Net Assets replaces both the Income Statement and the Statement of Comprehensive Income. This statement is designed to: • • • Provide the information investors need to understand a company’s operations and the events and transactions affecting those operations; Require full recognition in a single statement of all events and transactions that affect common shareowners’ equity; Increase the transparency and understandability of the behavior of individual items and the effects these have on a company’s operations by requiring that items be reported by nature rather than function; Provide information on all investing and financing activities; Provide information on the company’s transactions with investors, the company’s common shareowners; and Deemphasize the focus on accounting net income, a single arbitrary performance indicator.
• • •
This statement fully reflects our views on the necessity of providing shareowners with complete and understandable information on all activities, events, and transactions that can affect investors’ wealth. As we made clear in Chapter 2, no transactions affecting investor wealth should be allowed to escape recognition in the primary financial statements. Rather, all transactions and events that change net assets must be recognized in a timely fashion in this single statement, not merely those that are generally considered to be performance indicators. This requirement means that financial reporting standards would no longer permit either selective disclosure of activities or deferral or allocation of other items to other periods. 31
Ibid, p. 2. ©2007, CFA Institute
Table 2. Trans-Global Exports, Ltd., Cash Flow Statement and Significant Noncash Financing and Investing Activities for the Year Ended 31 December 20X4 Cash Flow Statement
Business Activities Collections from customers Payments for inventory purchases Payment for labor Payment for rent Payment for other services Pension contribution Net operating cash flows Purchase of investment in affiliate Capital expenditure—building Purchase of marketable securities Dividends received Net investing cash flows Net cash flows from business activities Financing Activities Interest payment Dividend payment Issuance of short-term debt Issuance of bonds Net cash flows from financing activities Payment of income taxes Net change in cash
25
20X4
€ 2,700,000 (1,750,000)* (210,000) (120,000) (100,000) (1,200) € 518,800 (710,000) (500,000) (185,000) 9,250 €(1,385,750) € (866,950)
Supplemental Disclosures Collections from customers Cash sales Advances Collections on credit sales Total Payments for inventory purchases Cash purchases Payment for prior period purchases Credit purchases current period Total
€ 250,000 200,000 2,250,000 €2,700,000 € (300,000) (850,000) (600,000) €(1,750,000)
Noncash Financing and Investing Activities Investing Activity Leased building and land Financing Activity Lease obligation—building and land
€ 31,700 €(31,700)
(125,000) (35,000) 500,000 2,500,000 € 2,840,000 (54,639) € 1,918,411
*Parentheses indicate negative numbers.
We believe that performance assessment is the responsibility of the investor, not managers. The statement of net assets will allow the investor to select those performance measures that are pertinent to the investor’s particular perspective, analytical requirements, and objectives. Such a statement would continue to meet the needs of all users of financial statements and at the same time provide the richer dataset that long-term common equity investors need. We believe that investors will not be able to assess the values of their investments and their prospects unless they are able to understand the forces at work that can increase or decrease that value. This means that individual line items must be reported by the nature of the item (e.g., labor cost) and not by the function for which a resource is consumed (e.g., cost of goods sold). Aggregation of disparate items results in information loss, and as we have observed, that loss reduces predictive power and analytical value. This new statement also includes the effects of all investing and financing activities because they are integral to a company’s value generation. Indeed, it is frequently difficult to clearly distinguish among the categories, as we have observed. Investors’ understanding of a company’s operations will be greatly improved if investing and financing transactions and events are required to be recognized in this statement. At present, investors are left to guess at many such transactions, frequently involving highly material amounts. ©2007, CFA Institute A Comprehensive Business Reporting Model: Financial Reporting for Investors
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One direct implication of this comprehensive statement is that it may well have the effect of reducing what we believe to be the market’s unwarranted focus on earnings per share (EPS). We believe that this myopic focus on a single number, which is highly susceptible to manipulation, leads to exaggerated market reactions that serve to fuel unproductive and unwarranted market volatility and the “short-termism” of stock market speculators—a disservice to investors with a longer-term perspective. Indeed, long-term investors are concerned primarily with forecasting total return to the investment horizon. The richer dataset may also encourage analysts to develop better forecasting methods that could result in more efficient and effective capital allocation. Consistent with our view on the components of the statement of changes in net assets, we do not support the continued reporting of a single arbitrarily defined EPS number. As we have stated, the earnings used in the numerator of the ratio is an accounting artifact, an aggregate of some revenues and gains and some expenses and losses, rather than a transparent, economics-based measure of performance. Indeed, most professionally trained analysts today are forced to routinely adjust the earnings number to better reflect economic reality. Disclosure of the weighted-average number of shares outstanding would be used to create investor-specific per share metrics as inputs to valuation models. The benefits of these changes would ultimately accrue to the investing public. Finally, we see no logical reason why transactions with shareowners must be relegated to a separate statement or footnote disclosure. We believe that it is both more effective and cost efficient if such events are recorded in the statement of changes in net assets as a financing activity. Recording all events in a single statement will be particularly helpful in the current environment in which some financial instruments blur the distinction between liabilities and equities. We have designed the proposed format for the Statement of Changes in Net Assets so that it can be implemented for the current mixed-attribute accounting model. It is also intended, however, to be completely appropriate and adaptable to the full fair value model. As the accounting for particular assets and liabilities transitions to fair value measurement, we expect that most estimates will shift to the Changes in Fair Value column. See Table 3 for an example of a statement of changes in net assets and see Table 5 for some sample journal entries. Following are the top-level definitions of the different transactions and other economic events that would be reported: 1. Current-Period Transactions (Column 1): Exchange transactions that increase or decrease assets and liabilities in the current reporting period. The items recorded in Column 1 are the traditional accrual transactions—for example, sales revenue, use of labor and other operating services, purchase of raw materials or goods for resale, interest expense, and gains or losses on sales of fixed assets. These transactions must be measured at the gross amounts. Whether a transaction is recorded in this column is not affected by the measurement attribute of the balance sheet account in which they are recorded. Examples of transactions that are recorded in this column include: a. Sales: Sum of (1) the gross amounts recorded to accounts receivable (assumes cash sales are recorded as credit sales with immediate recording of cash collected) and (2) advances from customers. b. Interest: i. Gross increase in amount payable on debt securities. ii. Gross increase in amount receivable from investments in debt securities. c. Income tax: i. Gross increase in amount payable. ii. Gross increase in amount receivable. d. Gain on sale of fixed asset: Gross amount of difference between carrying amount of fixed assets and the cash or other assets received in exchange. ©2007, CFA Institute
Table 3. Trans-Global Exports, Ltd., Statement of Changes in Net Assets Available to Common Shareowners for the Year Ended 31 December 20X4 Current-Period Transactions Business Activities Sales Bad debt expense Purchases of inventory Ending inventory less beginning inventory Direct labor Other compensation expense Rent expense Pension expense Depreciation expense Amortization expense Other operating expense Net operating activities Revaluation of building to fair value Dividend income—marketable securities Marketable securities: revaluation to fair value Equity in earnings of affiliate Net investing activities Financing Activities Interest expense Net financing activities Income tax Net change in net assets before transactions with owners Dividends declared Change in net assets € 780,422 (70,000) € 710,422 €(572,721) €171,100 € € 2,775,000 € (50,500)* (1,275,000) (230,306) (110,000) (107,500) (120,000) (1,200) (1,505,306) (110,000) (107,500) (120,000) (3,600) (175,000) (5,944) (150,000) € 0 160,000 9,250 11,100 12,250 21,500 (252,378) € (252,378) € 0 € 0 €(108,571) €(572,721) €171,100 € 0 €171,100 € 547,150 160,000 9,250 11,100 12,250 € 192,600 (252,378) € (252,378) € (108,571) € 378,801 (70,000) € 308,801 €2,724,500 Change in Fair Value of Related Assets & Liabilities Change in Net Assets
27
Estimates
(2,400) (175,000) (5,944) €(464,150)
(150,000) € 1,011,300
*Parentheses indicate negative numbers.
2.
Estimates (Column 2): Noncash items that approximate price and other changes of assets and liabilities. Examples of items recorded in the current mixed-attribute model include the following: a. Bad debt expense, sales returns, and allowances b. Change in the balance of inventory (this estimate is required for calculating cost of goods sold when items are reported by nature rather than function) c. Deferred taxes d. Inventory lower-of-cost-or-market write-down e. Current-period stock compensation expense (a period allocation of the grant date fair value) f. Depreciation expense (an allocation, using any of a variety of methods, of the historical cost of a fixed asset over an assumed useful life)
©2007, CFA Institute
28
g. i. j. k. 3.
Overhead allocations Foreign currency translation effects for assets and liabilities not measured at fair value Amortization of bond discounts and premiums Interest capitalized
h. Pension accruals for defined-benefit pensions
Changes in Fair Value (Column 3): Currently in the mixed-attribute model— Nontransaction valuation adjustments derived from adjusting the carrying amount of an asset or liability (net of related accrual valuation accounts, such as Allowance for Bad Debts) to its fair value at the reporting date. Examples of such adjustments that would be recorded in the current mixed-attribute model: a. c. Change in market value of available-for-sale investments Interest rate swap fair value adjustment b. Foreign currency translation effects for assets and liabilities measured at fair value d. Fair value adjustment for securities held for trading
We believe that this new set of financial statements, which reflects our view that fair value is the most relevant measurement attribute, can serve investors well with the current mixedattribute model and during the period of transition to the fair value model. Moreover, we believe that the proposed Statement of Changes in Net Assets as described can enhance investment decision making throughout this process. As these adjustments reveal, during the period of transition from the current mixed-attribute model to the fair value model, Column 3, the fair value adjustments column, will include pure current-period fair value adjustments for those items currently carried at fair value in the balance sheet. However, for those items carried at adjusted historical cost—that is, historical cost plus or minus an estimate or allocation such as depreciation—the number recorded in Column 3 will be the amount necessary to adjust the current carrying value to fair value. As additional assets and liabilities are measured at fair value, the estimate and allocation events related to those assets and liabilities will no longer be needed. Consequently, the amount of the fair value adjustment recorded in Column 3 will be the gross amount of the revaluation. For example, we expect the following changes will occur: 1. Accounts Receivable: a. Estimates of uncollectible amounts will no longer be recorded (although full disclosure of the fair value estimation method and assumptions used will be required).
b. The amount recorded as the Change in Fair Value will be the total change in fair value from the beginning of the period. 2. Inventory: The inventory change due to price (rather than quantity) changes will be measured and recorded as a Change in Fair Value (Column 3) rather than an estimate (Column 2). Fixed Assets: a. Depreciation will no longer be recorded as an Estimates item (Column 2); rather, an estimate of the fair value of productive capacity used in the current period will be disclosed separately.
3.
b. The Change in Fair Value of Fixed Assets will be the total change in fair value from the beginning of the period. 4. Income Taxes: The change in the tax liability or asset will be recorded as a Change in Fair Value.
29
5.
Stock Compensation: a. The amount necessary to restate the obligation to fair value will be recorded as a Change in Fair Value.32
6.
b. The change in fair value from the services provided during this period must be disclosed separately. Foreign Currency Translation: Each effect would be recorded as a change in fair value for the assets and liabilities related to Operating, Investing, and Financing, respectively.
F. Reconciliation of Balance Sheet, Cash Flows, and Other Changes in Net Assets Financial statements articulate; that is, the items in the transactions and events statements (currently, the Statements of Income, Cash Flow, Comprehensive Income, and Shareowners’ Equity) flow from one to another of the statements, including the balance sheet, and should be traceable and directly observable by investors. Indeed, the knowledge gained from analyzing such flows is critical to an investor’s understanding of a company’s value-generation process. Currently, as we have described in the discussion of the Cash Flow Statement, this articulation is at best obscured, making it impossible for even the most skilled investor to dissect this articulation in order to perform a thorough analysis. The articulation is hidden by (1) the very different and inconsistent aggregation and netting processes in the various statements and (2) the impossibility of directly comparing the operating section of the indirect method cash flow statement with the income statement or the investing and financing sections with changes in the balance sheet. Therefore, we propose to add a completely new statement—the Reconciliation of Balance Sheet, Cash Flows, and Other Changes in Net Assets—to the set of statements shareowners and investors currently receive. We consider this to be essential to our goal of increasing the transparency and understandability of companies’ financial reporting and disclosures. Although our preference is for the reconciliation to be provided as a required statement, we fully understand that it may be lengthy and, therefore, better positioned as a required supplementary disclosure that would be fully audited. We should not, however, compromise on the presentation of the statement, which should make the disclosures most accessible to investors. The reconciliation must appear as a single disclosure and must not be disaggregated with separate sections appearing in multiple locations throughout the disclosures. Indeed, disaggregation would subvert the very purpose of the statement. This statement should not be costly to prepare. The cost is in the data production, all of which is currently available to managers, not the data display. Investors should not be forced to expend additional costs to put the puzzle back together. See Tables 4A and 4B.
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Econ 200 Principles of Business EconomicsManaging Director
Rebecca McEnally, CFA
Capital Markets Policy Group
Georgene Palacky, CPA
Director Financial Reporting Group
Members of the Comprehensive Business Reporting Model Subcommittee and the Corporate Disclosure Policy Council Gerald I. White, CFA, Chair
Grace & White Inc. New York, NY United States
Robert F. Morgan, CFA
Forbes Morgan Consulting Mont Royal, Quebec Canada
Patricia McConnell, CPA, Past Chair
New York, NY United States
Trevor W. Nysetvold, CFA
ExxonMobil Fairfax, VA United States
Jane Adams, CPA
Maverick Capital New York, NY United States
David E. Runkle, CFA
Trilogy Global Advisors, LLC New York, NY United States
David C. Damant, FSIP
London United Kingdom
Toshihiko Saito, CFA
Capital International Research Chiyoda-ku Tokyo Japan
Christian B. Dreyer, CFA
Tertium datur AG Unterägeri Switzerland
Ashwinpaul (Tony) Sondhi
A.C. Sondhi & Associates, LLC Maplewood, NJ United States
Barry Ehrlich, CFA
Och-Zeff Management Europe London United Kingdom
Edward (Ted) Stevens, CFA
BlackRock, Inc. Wilmington, DE United States
Anthony Good, ASIP
Norwich, Norfolk United Kingdom
ISBN 978-1-932495-70-6
A COMPREHENSIVE BUSINESS REPORTING MODEL:
Financial Reporting for Investors
CFA Institute Centre for Financial Market Integrity July 2007
Preface
The project to develop A Comprehensive Business Reporting Model: Financial Reporting for Investors began in 2002 with a limited objective: to update a 1993 CFA Institute white paper, Financial Reporting in the 1990s and Beyond.1 This widely cited paper set forth the views of CFA Institute and its global membership on financial reporting and investors’ information requirements. Between 1993 and 2002, however, standard setters and regulators worldwide made many changes and improvements to financial reporting. In addition, a number of new business practices had developed that were not contemplated at the time of the original paper. Finally, several surveys of our members highlighted serious deficiencies in the financial reporting framework, problems that hampered their ability to analyze companies and make wellinformed financial decisions. Consequently, those CFA Institute staff and volunteer members who have the responsibility of advocating for high-quality financial reporting thought that the time had arrived for the views in the white paper to be refreshed and extended to better reflect the changed circumstances. Once the work was underway, however, the project scope was expanded to consider both conceptual issues as well as revisions to financial statement display—that is, the business reporting model in its entirety. A special group of CFA Institute volunteer members was assembled—the Business Reporting Subcommittee—and tasked with developing the new paper. The Subcommittee comprised a subset of members from two existing standing CFA Institute committees: (1) the Global Financial Reporting Advocacy Committee (GFRAC), which was responsible for addressing proposals of the International Accounting Standards Board (IASB), and (2) the Financial Accounting Policy Committee (FAPC), which had similar responsibilities for proposals of the U.S. Financial Accounting Standards Board (FASB). The Subcommittee held extensive discussions over the next several years and developed a set of cohesive principles as well as revisions to the fundamental business reporting model. The proposed changes were designed to better meet the information needs of investors, to provide clearer and more complete information than currently available, and to present the information in a format that would make the information readily accessible to investors. The Subcommittee expected that their proposals would be gradually considered and implemented over the long term as standard setters revised their agendas to incorporate new projects and consider new reporting questions. As preliminary decisions were made by the Subcommittee, the proposals were submitted for discussion and comment to the full membership of the GFRAC and FAPC (and later, the Corporate Disclosure Policy Council, CDPC).2 Based upon that feedback, the proposals were clarified or modified as needed. When the project reached an early stage of completion, the draft was submitted for comment to the CFA Institute management and Board of Governors, the Advisory Council of the CFA Institute Centre for Financial Market Integrity, and the “Friends of the Centre,” a group of CFA Institute members who have expressed a particular interest in the Centre’s projects, including financial reporting matters. In October 2005, the draft of the reporting model was released for consideration by the full global membership of CFA Institute, a process that included three separate requests for comment. Surveys of CFA Institute member views were conducted on key points, such as fair value measurement for financial instruments as well as other assets and liabilities. Comments were also solicited in a series of meetings held with a variety of national and global regulators and financial reporting standard setters, including the IASB, FASB, U.S. Securities and Exchange Commission, International Organization of Securities Commissions, Canadian 1 At that time, CFA Institute was known as the Association for Investment Management and Research. The name was changed in 2004 to CFA Institute. 2 With the founding of the CFA Institute Centre for Financial Market Integrity in 2004, the GFRAC and FAPC were merged into a single committee, the Corporate Disclosure Policy Council.
iii
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A Comprehensive Business Reporting Model: Financial Reporting for Investors
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Accounting Standards Board, and U.K. Accounting Standards Board. In addition, the document was presented in whole or in part to more than two dozen other major bodies, for example: the Financial Stability Forum, U.S. Federal Reserve Bank, U.S. Congress House Committee on Financial Services—Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, U.N. Committee on Trade and Development, American Accounting Association, and others. Comments were also sought from individual academics, auditors, statement preparers, and other practitioners. This lengthy public comment period produced a substantial number of comments and observations. Based upon this extensive input, the text was revised to increase the clarity and understandability of the concepts and to reflect refinements in the positions over the comment period. A work of this scope and depth could not have been completed without the sustained and concerted efforts of a large number of experts in the field. We express our profound appreciation to those persons whose efforts and contributions have been fundamental to the success of the Comprehensive Business Reporting Model project. First, we are deeply grateful to Patricia McConnell, former chair of the CDPC, the GFRAC, the FAPC, and the Business Reporting Subcommittee, and to Gerald White, CFA, current chair of the CDPC, former chair of the FAPC, and a member of the Business Reporting Subcommittee. Both have been instrumental in the success of this project, and the work has been shaped largely by their vision. Other CFA Institute volunteer members of the Business Reporting Subcommittee devoted countless hours to the project and brought their varied professional experiences and deep knowledge to their deliberations. Members of the GFRAC, FAPC, and CDPC provided numerous comments on the proposals, for which we are grateful. We must give special thanks to James Leisenring, board member of the IASB. Indeed, we have greatly appreciated the time, effort, and considerable thought that regulators, standard setters, and others in a public position have expended on the proposals. Their comments and observations in public sessions as well as private discussions have been of enormous benefit. Several CFA Institute staff members have contributed to the development of the project, and I am especially grateful to them for their work and dedication. Timothy McLaughlin, CFA Institute chief financial officer and managing director of financial and corporate support, provided valuable insights and dozens of helpful comments. Patricia Walters, CFA, former senior vice president for advocacy at CFA Institute, provided strong support and encouragement at the initiation of the project in 2002. Pat also worked directly on the project for a time in 2004, helping to move the deliberations forward. Maryann Dupes, Kara Morris, and Christine Kemper have provided superb editorial support. Rebecca McEnally, CFA July 2007
Chapter 1.
Why Does Financial Reporting Matter to Investors and Investment Professionals?
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Introduction
The business reporting model is the lens through which investors perceive and understand the wealth-generating activities of a company and the results of those activities. The model will succeed or fail based upon its capacity to communicate these activities clearly and completely. Businesses continually evolve, entering or leaving markets, developing new products and services, and finding new ways to attract and retain customers. These changing business practices require that the business reporting model evolve as well so that it can always meet investors’ needs for the information required to evaluate investments and make financial decisions. Corporate financial statements and their related disclosures are fundamental to sound investment decision making. The well-being of the world’s financial markets, and of the millions of investors who entrust their financial present and future to those markets, depends directly on the information financial statements and disclosures provide. Consequently, the quality of the information drives global financial markets. The quality, in turn, depends directly on the principles and standards managers apply when recognizing and measuring the economic activities and events affecting their companies’ operations. We believe that opportunities exist for making significant improvements in the financial reporting model.3 In the chapters that follow, we propose changes that we believe will enhance the usefulness of the current reporting model, particularly for the benefit of investors. A summary of our proposed principles, current practices, and the reasons why reforms are necessary is provided in Appendix A. We recognize that these changes must be made in an orderly fashion as standard setters gradually revise the reporting standards, and some will take many years to realize. But a number of the changes—including our recommendations for improvements to the way currently available financial information is presented in the financial statements—can be made in the near term. Other near-term improvements include full fair value reporting for all financial instruments, fair value reporting for the consolidation of acquisitions and on-balance-sheet fair value reporting of all financial activities that are currently off balance sheet, including securitizations and leases (both assets and liabilities). Since 1934, when Benjamin Graham and David Dodd first published their classic text Securities Analysis, the practice of investment analysis and valuation has been virtually synonymous with what it means to be an investment professional. We serve our investing clients and, ultimately, the financial markets, by assessing the risk and value of an investment opportunity and evaluating its suitability for each client’s particular circumstances. Whether this process leads to valuation of an entire company, a specific equity, a fixed-income security, a derivative, or other security, the goal of analysis must be to provide a reasonable and adequate basis upon which to make an investment recommendation to clients or to take an investment action on their behalf. The ability to make high-quality, independent, objective, and reliable investment decisions depends not only on our expertise in the use of analytical and valuation techniques but also on the quality of the information available for us to collect, analyze, and incorporate into our valuation models. Headquartered in Charlottesville, Virginia, with offices in London, Hong Kong, and New York, CFA Institute, formerly known as the Association for Investment Management and Research (AIMR), is a global professional organization of individual members, most of whom hold the CFA designation. Our members generally are active in the investment business but all must agree to abide by the CFA Institute Code of Ethics and Standards of Professional Conduct. Societies may also be admitted to CFA Institute membership, but they are nonvoting members. This paper was developed by the CFA Institute Centre for Financial Market Integrity, the unit of CFA Institute responsible for advocacy and standard-setting, with the assistance of many of our members. Please see the Preface for further details. ©2007, CFA Institute A Comprehensive Business Reporting Model: Financial Reporting for Investors 3AFM 211 Financial Accounting 1
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Because corporate financial statements are the primary source of the information employed in financial analyses, we support efforts to achieve the highest quality in financial reporting principles and standards and will work with standard setters to achieve these objectives. Our goal is to ensure that financial statements and their accompanying disclosures provide all the information we need in a readily accessible and useful form. We believe that the current financial reporting model can and should be improved, and we intend to contribute to this effort. Investors require timeliness, transparency, comparability, and consistency in financial reporting. Investors have a preference for decision relevance over reliability. As CFA Institute stated in 1993 and as reiterated in this paper, “analysts need to know economic reality—what is really going on—to the greatest extent it can be depicted by accounting numbers.”4 Corporate financial statements that fail to reflect this economic reality undermine the investment decision-making process. The basic issues of greater recognition and measurement, better disclosure, and increased transparency have not changed very much in the last decade and a half. This observation is underscored by the corporate reporting scandals and bankruptcies in the opening years of this century, a problem that continues with the currently expanding stock option backdating investigations. Nevertheless, we must acknowledge the major improvements that have been made in a number of financial reporting standards, including the required expensing of the fair value of stock options and improved reporting for derivatives and employee benefit plans. We believe that investors will be best served if the revisions to the financial reporting model involve fundamental reforms rather than superficial, cosmetic changes. Consequently, we will work with purpose and determination to assist standard setters to address the underlying problems of the current dated accounting model. Innovation and creativity have affected the nature of companies and the products and services they provide. Although manufacturing and merchandising companies will continue to exist and thrive, service businesses—especially those in the financial sector—constitute a major and growing portion of the global economy. Many of the largest companies worldwide are either primarily financial services businesses or derive a substantial amount of their revenues and earnings from such activities. Companies with manufacturing or merchandising core businesses have added a variety of financial services to their product lines and provide customer financing from their own subsidiaries. The reporting model must be able to provide investors with the information they require to understand financial services companies and the various aspects of their operations. Today, many companies in global markets are driven by the creation and use of intangible assets. Indeed, much of the major economic growth worldwide is attributable to such assets. The current reporting model is deficient in its requirements for transparent recognition and disclosure for intangibles. High priority should be given to improvements in the reporting of intangibles so that investors will have the information they need to understand, analyze, and value intangibles-dependent companies. Investors require much more comprehensive disclosure about financial statement items, and the company activities and events that underlie them, than is generally available. Investors need this expanded information to evaluate company performance and understand companies’ wealth-generating processes. These items were our primary focus in 1993 and remain so today. In fact, the financial statements cannot be fully understood without extensive, clear, and complete supporting disclosures. We believe that disclosures should be considered jointly with the setting of the related recognition and measurement standards. Furthermore, they should be held to the same standards of relevance, reliability, clarity, and completeness.
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Financial Reporting in the 1990s and Beyond (Charlottesville, VA: AIMR, 1993), p. 3. ©2007, CFA Institute
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Finally, we would encourage standard setters to refocus their approach to the development of accounting standards. Financial statements must serve the needs of all investors, whether equity investors, creditors, or other suppliers of capital to the company. However, we believe it should be helpful in standard-setting and ensuring completeness, transparency, and relevance of the reported information if financial statements are viewed from the position of an investor in the common shares of the company. Existing common shareowners are the residual claimants in the net assets generated by a company. All other claims are senior to theirs and must be fully satisfied before common shareowners may exercise their claims. Hence, we believe that if the information needs of existing common shareowners are fulfilled, the primary needs of other prior claimants will be met as well. To succeed in bringing changes to financial reporting that will improve the usefulness of the information for those who must rely upon it, a partnership is needed among standard setters, common shareowners, and other investors to bring full transparency and the highest integrity to the standards as well as to the processes by which those standards are developed. CFA Institute and the CFA Institute Centre for Financial Market Integrity are committed to improving financial market integrity in the 21st century.
Chapter 2.
A Conceptual Framework for the Comprehensive Business Reporting Model
A conceptual framework for business reporting must provide a sound foundation for every accounting standard, proposal, and interpretation. We believe, however, that a properly conceived and executed framework should serve also as a benchmark by which the quality of a proposed standard may be judged. The framework should guide standard setters in their deliberations on the development of new reporting pronouncements, but it should also provide a template for assessing whether the standard-setting work is finished or remains deficient in one or more material aspects. We and others believe that the current conceptual frameworks in use by major financial reporting standard setters are in need of updating and refinement. This work has already begun. In recognition of the deficiencies, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have begun a multiyear joint project to revise, update, and work cooperatively toward convergence of their respective frameworks. The ultimate objective is to develop a single, high-quality set of concepts and principles. We agree with this objective. In a joint publication of the FASB and the IASB, Halsey Bullen and Kimberley Crook have this to say about the importance of the project: Although the current concepts have been helpful, the IASB and FASB will not be able to realize fully their goal of issuing a common set of principles-based standards if those standards are based on the current FASB Concepts Statements and IASB Framework. That is because those documents are in need of refinement, updating, completion, and convergence.5
We agree with these goals. Similarly, in addressing the question “Why revisit the framework?” in an issue of The FASB Report, L. Todd Johnson, senior technical adviser and project manager for the Conceptual Framework revisions, states: Although the Board continues to utilize the framework in making decisions, most of the framework was developed 20 or more years ago. Because the framework has not kept up with changing times and changing business practices, it needs updating and refining. Moreover, certain aspects of the framework are inconsistent with other aspects of it, and those inconsistencies need to be eliminated. Furthermore, some parts of the framework that originally were planned were not ultimately completed, even though conceptual guidance in those areas continues to be needed. For those reasons, the framework is gradually becoming less helpful in providing guidance to the Board for making standard setting decisions. The need to revisit the framework has become more pronounced with the Board’s decision to move toward producing accounting standards that are “principle-based.” Such standards, by their very nature, must be soundly grounded in a coherent and cohesive set of concepts that is up to date, internally consistent and comprehensive.6
AFM 101 Introduction to Financial Accounting We strongly support this project and encourage the standard setters to implement needed changes. We do not intend here to develop or propose a completely new conceptual framework. We believe that much of the existing scheme is sound. Rather, our intent is to outline those additional guiding concepts that we believe are essential to ground our proposed model. 5 Halsey G. Bullen and Kimberley Crook, “A New Conceptual Framework Project,” Revisiting the Concepts, IASB/FASB (5 May 2005), p. 2. 6 L. Todd Johnson, “Understanding the Conceptual Framework,” The FASB Report, No. 263-D (28 December 2004), p. 6.
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Necessarily, some of the concepts we propose conflict in some way with some of the most basic concepts in the current conceptual framework. That is an inevitable concomitant of fundamental change. However, at the same time, we will also reinforce some of the principles in the current framework that are critical to the model. We must make clear that our proposed additions and other amendments to the framework are not considered lightly but are based upon the changes to the current financial statements that investors routinely must make in order to try to generate the data they need to analyze and value securities. Perhaps the most compelling argument for requiring that the reporting changes be made is that if investors must transform financial statements, and the information they contain, into a different form so that they can use the information in their decision making, then the statements and information should be presented in that form in the first place. Such a change would promote both market efficiency and effectiveness. A second reason for requiring fundamental changes is that the current reporting model does not provide sufficient information to enable investors to make the needed changes. The extreme degree and inconsistent pattern of aggregation and netting of items in the statements—along with the obscured, even opaque, articulation of the financial statements— make such analysis ineffective or impossible. As a result, investors must resort to estimates and best guesses to arrive at information essential for financial decision making. The decisions made can be no better than the quality of the information that supports them. If inadequate financial statements are an impediment to sound financial decision making, then their quality should be improved. We believe that, when fully implemented, our proposed changes to the conceptual framework will resolve some of the most pervasive problems in financial analysis. Other issues, however, will remain. For example, investors’ ability to understand financial information is a direct function of how the information is communicated and not of the information itself. Communicating in a way that is understandable to the investor is a fundamental responsibility of managers who use the investor’s capital. Information must be presented clearly, described in a way that is intended to communicate rather than obfuscate, and disclosed in sufficient detail to facilitate understanding by investors. An essential characteristic of any conceptual framework on which accounting standards are based must be that the resulting financial statements present a “true and fair” view of a company’s financial position and any changes to that position. As a consequence, when standards are based on such a conceptual framework and are applied fully and impartially, there is no need for the so-called true and fair view override. In other words, if application of the conceptual framework does not lead to a true and fair view, then the framework itself must necessarily be deficient and should be revised. A frequently heard argument against standard setters’ proposals to require additional disclosures is that investors already suffer from information overload and cannot assimilate any more. We counter that more accurate and useful information does not result in overload. First, whether it is used by investors in every case does not bear on the fact that such information may be essential to present a true and fair view of the company and its operations. Second, what burdens investors is extraneous information—disclosure that neither informs nor enlightens, the typical boilerplate prose that remains in companies’ financial reports year after year unchanged or amended in any way. Useful disclosure communicates information clearly and succinctly, in formats designed to convey the substance of the company’s current sources of value and how those sources of value have changed and why.
A. Objective of Financial Reporting and Disclosure
Financial statements should serve the needs of all those who provide capital to a company and bear risk as a result, including the various classes of creditors as well as equity owners. However, among all classes of capital providers, common shareowners are the residual risk bearers in a company. Hence, we believe that one of the primary objectives of financial
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reporting and disclosure must be to provide all of the information that owners of common equity require to evaluate their investments. Common shareowners use the information to make forecasts of future cash flows, evaluate the sustainability of the company’s business model, and assess its cash-generating ability. This information, in turn, is used to estimate the investments’ value and future changes in such value. Johnson, in The FASB Report, states the following regarding the objectives of financial reporting: . . . (T)he objectives focus on information about an entity’s economic resources, the claims to those resources, and changes in them (including measures of the entity’s performance). That information is useful to investors and creditors in assessing the entity’s cash flow prospects. The objectives, therefore, focus on matters of wealth. Investors and creditors seek to maximize their wealth (within the parameter of the risks that they are willing to bear). Likewise, business entities also seek to maximize their wealth. It follows, then, that information about the wealth of those entities and the changes in it is relevant to investors and creditors that are seeking to maximize their wealth by investing in or lending to those entities.7
We agree and believe that if the information needs of the residual risk bearers are fully met, then the needs of those with senior claims will generally be met as well. To be useful in making investment and other financial decisions, reported information must be timely, accurate, understandable, and comprehensive. The financial statements must recognize, as they occur, all events or transactions that affect the value of the company’s net assets and, hence, common shareowners’ wealth. Furthermore, the associated disclosures must provide sufficient information so that investors can understand how the numbers reported in the financial statements were generated, including full descriptions of any estimation models and assumptions that were used to produce the numbers. The disclosures also must fully explain all risk exposures and possible future occurrences whose effects could be expected to affect investors’ wealth.
B. Concepts
Consistent with the financial reporting objective, the Comprehensive Business Reporting Model we propose is based upon the following 12 concepts.
1.
The primary financial statements must provide the information needed by equity investors, creditors, and other suppliers of risk capital.
Investors and creditors need timely, relevant, complete, accurate, understandable, comparable, and consistent information in order to be able to evaluate the potential risk and return properties of securities and to determine appropriate valuations for them. The purpose of audited financial statements, prepared according to high-quality financial reporting standards, is to provide the needed information. Investors and other suppliers of capital are generally not in a position to be able to command the information they need to evaluate and value potential investments. For this reason, market regulators have generally required that companies accessing markets to raise risk capital be required as a condition of registration to provide audited financial statements prepared according to a system of generally accepted accounting principles (GAAP). However, for varying historical reasons, GAAP has not always required full and complete recognition of assets and obligations in the primary financial statements or has permitted some items, such as certain contingencies and executory contracts, to escape recognition and disclosure altogether. Thus, we believe that a fundamental principle of financial reporting must be that financial reports should provide the information that capital providers need to evaluate their investments. 7
2. In financial reporting, standard-setting, as well as statement preparation, the entity must be viewed from the perspective of an investor in the common equity issued by the company. For a common shareowner—the residual risk bearer in a company—events and transactions that can affect assets, liabilities, and equities and therefore affect the wealth of that shareowner are material and should be reported and explained. For example, off-balancesheet financing activities can affect the company’s revenues, expenses, cash flows, and risk exposures and can require the transfer of assets to others or create liabilities, thus directly affecting shareowner wealth. Consequently, the effects of such activities on the company’s assets and liabilities should be reported on a comprehensive basis in the balance sheet,8,9 with changes in those items reported in the income and cash flow statements. If shareowners’ information needs are met, the needs of other external financial statement users will most likely be met as well. For example, it is our view that providers of debt capital to the company hold an interest in financial reporting nearly identical to that of shareowners and also will be well served by comprehensive reporting.10 The IASB would seem to concur with our view in this section from the IASB framework, paragraph F–10:11 . . . [T]here are needs which are common to all users. As investors are providers of risk capital to the entity, ACC 103 Economics for Management
the provision of financial statements that meet their needs will also meet most of the needs of other users that financial statements can satisfy.
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From time to time, the argument is made that financial reporting that serves shareowner interests may damage the public interest by failing to place the interests of other stakeholders above those of the investor. For example, in the debate over the expensing of stock options in the United States, representatives of some companies that use options extensively for compensation argued that if expensing were to be required, thereby fully recognizing the compensation component of the company’s production costs, the resulting reduction in earnings would cause such companies to have to reduce or otherwise ration the use of options. They argued that this would reduce the amounts of compensation companies could pay employees and limit their ability to attract the most talented employees. They argued further that this would stifle innovation and reduce the competitiveness of U.S. companies. Put slightly differently, these representatives stated that we must choose between complete, truthful financial statements and healthy markets. We object to such statements, both because we believe them to be erroneous and because they interject non-financial reporting objectives into a traditionally neutral and independent standard-setting process. Financial reporting exists to serve the needs of investors who otherwise cannot command the information they require. In global capital markets, ownership is generally dispersed. Reporting standards, which prescribe financial reporting, are independently created and promulgated in the public arena. Shareowners in publicly traded companies share a common interest in having information to forecast the risk and returns of potential investments. In the context of these global markets and for the purposes of financial reporting, we believe that shareowner interests are congruent with the public interest because efficient allocation of capital is critical for economic growth. We believe that our view of the entity is entirely consistent with the objective stated in FASB’s Statement of Financial Accounting Concepts No. 1, p. 5, that financial reporting should provide information: . . .[A]bout the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners’ equity), and the effects of transactions, events, and circumstances that change its resources and claims to those resources…[and] that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. . . . 8
We recognize, however, that some current accounting standards continue to permit some transactions (e.g., some financing vehicles, operating leases, pension liabilities, and executory contracts) to not be fully reflected in the balance sheet or, worse, to escape balance sheet recognition altogether. Such standards tend to rely on “bright line” rules, distinctions that we believe to be arbitrary and that fail to serve the best interests of investors. 10 We believe that fixed-income analysis differs from equity analysis only in emphasis. For high-yield investments, the difference from equity analysis is especially small. 11 Framework for the Preparation and Presentation of Financial Statements, International Accounting Standards Committee (1989), adopted by the IASB in 2001. ©2007, CFA Institute A Comprehensive Business Reporting Model: Financial Reporting for Investors
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3. Fair value information is the most relevant information for financial decision making. Currently, the extant conceptual frameworks contain a list of measurement attributes but lack a fully developed measurement concept. Our goal is for fair value to be the measurement attribute for assets and liabilities. In 1993, CFA Institute observed: It is axiomatic that it is better to know what something is worth now than what it was worth at some moment in the past . . . Historic cost itself is in reality historic market value, the amount of a past transaction engaged in by the firm. . . . Historic cost data are never comparable on a firm-to-firm basis because the costs were incurred at different dates by different firms (or even within a single firm). There is no financial analyst who would not want to know the market value of individual assets and liabilities.12
Fair value measures reflect the most current and complete estimations of the value of the asset or obligation, including the amounts, timing, and riskiness of the future cash flows attributable to the asset or obligation. Such expectations lie at the heart of all asset exchanges. In the last decade and a half, an increasing number of global financial reporting standards have been based upon fair values, a trend we would wish to see accelerate. If asset exchanges and financial decisions are based upon fair values, then market efficiency would be enhanced if the information upon which such decisions are made is reported at fair value. The implication is that items in the balance sheet should be reported at current fair value. Furthermore, changes in these values should be reported in the income statement as they occur. We recognize that historical cost or contractual amounts may be needed for some purposes, such as tax determinations and for assessing some contractual commitments and obligations. We would recommend that such information be provided in tabular form in the notes, along with the relevant fair values for the individual items. If, for example, a credit rating analyst were evaluating the creditworthiness of a particular debt security, the analyst may find it useful to understand the contractual obligation entered into by a company. However, we believe it would be useful as well for the analyst to have at hand the relevant fair value of the obligation. The fair value may provide the analyst with information useful in evaluating the probability of repayment because fair values are likely to reflect the most up-to-date market assessments of that probability. With respect to the measurement of fair value, we believe that managers should look first to the most objective sources of fair value, for example, observable prices for the same or similar assets or liabilities in liquid markets. In the absence of such market-determined measurements, managers must report the best estimate of fair value as determined by widely accepted and applied valuation methods and by using market-based inputs. Our views on fair value measurement are consistent with the principles laid out in FASB’s recently issued Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurement.13 Currently, financial statements include some items reported at historical cost while others are measured at fair value, the so-called mixed-attribute system. Consequently, investors who rely on fair values for decision making must expend considerable effort trying to restate to fair value those decision-relevant financial statement items that are measured at historical cost. Their success depends on the sufficiency of disclosure and on the relative reliability of the measurements in the disclosures. Most, if not all, of this effort would be eliminated if the 12 13
Financial Reporting in the 1990s and Beyond (Charlottesville, VA: AIMR, 1993), p. 39. The FASB released SFAS No. 157, Fair Value Measurement in 2006. The IASB is currently exposing these provisions through its own due process and public comment period. This standard defines fair value and provides guidance on its application in the form of a hierarchy that is intended to foster consistency in its application and improve fair value disclosures. The standard does not prescribe fair value for any assets or liabilities. Rather, it defines how fair value measurement should be applied when such measurement is required by other standards. 9
financial reporting standards were to require that companies record assets and liabilities at fair value at inception with periodic revaluation. Indeed, the managers of companies are likely to have the best knowledge of the values of the assets and liabilities and, presumably, base their own investment decisions on behalf of the company on such values. Opponents of fair value reporting argue that measuring and recognizing assets and liabilities at fair value in the financial statements introduces volatility into the financial statements. We argue to the contrary: If fair value measurement results in greater volatility, then the measurement has merely unmasked the true economic reality that was already there. One of the most important evaluations investors must make is to ascertain the degree of risk to which an investment is exposed: The greater the volatility, the greater the risk. The risk is then weighed against the investment’s expected returns. Reporting methods that mask true volatility do a great disservice to investors, impair their ability to make well-founded investment decisions, and can result in inefficient allocations of capital. If managers choose to hedge economic risks, then comprehensive fair value reporting will better reflect the extent to which those hedging activities have been successful. To achieve this, the reporting should provide full fair value disclosure of both (1) the economic risks hedged and (2) the results of the hedging activities. That is, the fair values for the hedged items and their related hedges must not be netted or deferred, concealing both the underlying risks and management’s activities to alter or manage those risks. We have called for standard setters to implement a requirement for companies to record financial instruments, both assets and liabilities, at fair value.14 We recommend that standard setters make this project a priority and move to adopt and implement the standard. As a first step, we recommend that standard setters require that those financial instruments for which fair values are currently required to be disclosed in the footnotes be recognized at fair value in the balance sheet with changes in the fair values reported in the income statement as incurred. We would then propose that standard setters move to establish agenda projects for all other classes of financial assets and liabilities, including those that are off balance sheet. The projects should include the establishment of standards for footnote disclosures that provide the information investors need to understand the financial instruments and their reported measures. For example, the disclosures should explain the degree of uncertainty in a particular measurement. Similarly, investors need to know whether observed market prices or pricing models and assumptions were used to estimate the fair value and the extent to which management used judgment rather than market inputs to determine the measurement.15 For such measurements, sensitivity analysis is critical, especially when the effects of changes in market or other economic conditions on the fair value are nonlinear. Investors understand that uncertainty is a characteristic of the measurement of every recognized asset and liability. What is important is that managers disclose the degree of measurement uncertainty and its sources.
4. Recognition and disclosure must be determined by the relevance of the information to investment decision making and not based upon measurement reliability alone. Relevance and reliability may seem simple concepts at first. When used in the context of financial reporting, however, they are actually quite complex. Information is relevant when it “influences the economic decisions of users by helping them evaluate past, present or future events or [when they are] confirming or correcting their past evaluations.”16 Letter from the Corporate Disclosure Policy Committee of the CFA Institute Centre for Financial Market Integrity to the FASB (31 October 2006). 15 SFAS No. 157 currently requires some but not all of this information. 16 Framework for the Preparation and Presentation of Financial Statements, International Accounting Standards Committee, paragraph 26. ©2007, CFA Institute A Comprehensive Business Reporting Model: Financial Reporting for Investors 14
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Consequently, investors, who must rely on financial statement information, need to receive all relevant information. Moreover, the information required may differ depending upon the requirements and focus of investors’ decisions and the analysis necessary to support those decisions. Timeliness is also an important attribute of relevance. Indeed, information that is not timely may no longer be relevant. While we recognize that the benefits of providing some items of minor relevance may not be justified when compared with the costs associated with measuring and reporting the items, we find altogether too often that these constraints serve as excuses for relevant information to be withheld from shareowners. Reliability has been much misunderstood and misused in the financial markets. Indeed, reliability has in some quarters been taken to mean certainty of occurrence and measurement. Such an interpretation was never intended by standard setters. Rather, reliable information is that which faithfully represents the events that it “purports to represent or could reasonably be expected to represent.”17 We think this aspect of reliability is essential in the debate over the trade-off between relevance and reliability. In fact, we believe that faithful representation is an essential attribute of relevant information. Even more problematic from our perspective is the role that a misunderstanding of the concept of reliability has come to play in debates regarding whether certain financial information should be required to be recognized in the primary financial statements, held off the balance sheet and disclosed only in the footnotes, or eliminated altogether. We cite as examples the U.S. debate on the treatment of pension obligations two decades ago and fair value reporting of derivatives in the European Union recently.ISYS 111 Fundamentals of Information Systems
5. All transactions and events must be recognized as they occur in the financial statements. We have already discussed the importance of the recognition of events in the financial statements as they occur. This issue is so fundamental to reporting, however, that we believe it must serve as a separate concept and benchmark criterion. Completeness requires the financial statement recognition and measurement of economic events that can affect investors’ wealth, including changes in fair value, as they occur. Thus, no accounting standard should permit assets or liabilities, and changes in them that can affect shareowners’ wealth, to escape recognition at the time they occur in the financial statements. For example, where assets are jointly owned or obligations are shared with one or more entities, then the amounts to be recognized should be based upon the company’s and, therefore, the shareowners’ potential risk exposures in those activities and their expected rewards for bearing the risks. Such recognition and measurement are entirely consistent with fair value reporting. This means, of course, that all activities that currently are off balance sheet as a result of accounting standards or other conventions must be recognized, including executory contracts. Executory contracts, arrangements for which performance by the various parties is still in progress, represent commitments entered into by the parties. These commitments will affect shareowners’ wealth and should be recognized as any other obligation would be.
6. Investors’ information requirements must determine the materiality threshold. Materiality must be evaluated from the perspective of whether the information under consideration would make a difference to an existing common shareowner’s assessment and valuation of the investment. The use of arbitrary quantitative thresholds, such as 5 percent of some income statement number, to assess materiality does not serve investor interests. We believe that if there is doubt about materiality, the item should receive separate recognition and measurement, accompanied by sufficient disaggregated disclosure.
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7. Financial reporting must be neutral.
It has long been established that an accounting treatment must be based solely on what method best captures the economic substance of an item or most faithfully represents the transaction or event and not on the form of the transaction or the consequences of the reporting. Therefore, decisions about the appropriate treatment to be applied must not be influenced by a company’s size, its geographic location, a manager’s intent, or any other attribute unrelated to the economic substance of the transaction. As we stated in The FASB Report: The purpose of financial reporting is to tell a company’s economic story, its financial position and the results of its operations, as completely, clearly, and faithfully as possible. In other words, its job is to tell the story as it is. The role of fiction is to tell the story as it isn’t now, and perhaps never was or ever can be, but rather as the author would like the story to be told. A writer of fiction may well have some other objective than merely spinning a good yarn, including possibly a desire to influence some outcome. To the extent that financial information is manipulated to achieve a particular outcome rather than to faithfully report economic events and activity, the resulting information is biased. Neutral information is free from bias. For information to have value to investors and other users, it is critical that it be neutral. Investors depend on financial information for their investment decision-making. For example, investors routinely use financial disclosures in evaluating a company’s growth prospects, its riskiness, and the long-term success of the company’s business model. These analyses also provide the inputs investors need to price individual securities and to make portfolio decisions. Taken altogether, the quality of investors’ pricing and capital allocation decisions affects the relative efficiency and effectiveness of financial markets.18
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Simply put, when financial disclosures do not tell the economic story as it really is, the prices of securities, and even the amounts of capital allocated to a company, are less likely to reflect the company’s actual economic position. Some standards currently permit wide flexibility in financial reporting choices and have led to earnings manipulation and abuse, which have further diminished net income’s usefulness in making economic decisions. This flexibility allows managers to report similar transactions in very different ways, producing widely different financial statement effects. As we have observed, the method chosen is frequently driven not by what best reflects the economic substance but by the outcome or consequences preferred by managers in order to position the company in the best light—a clear violation of neutrality. More importantly, what managers may deem to be the best light does not always mean the most unbiased and objective light. It is essential that economic transactions and events with similar economic substance be accounted for in the same way. We do not see the logic in permitting issuers choices in either recognition, measurement, or display based on attributes other than economic substance. Some investors believe that managers have an inherent bias toward overstating earnings and equity and that the financial reporting concept of conservatism does much to rein in management optimism. These investors prefer that management use caution when selecting from the unbiased range of accounting results for a particular measurement. With respect to insurance reserves, for example, they prefer that managers be conservative when selecting the point estimate to be reported from the acceptable range. Conservatism would push managers toward the high end rather than the low end of the likely range of losses. Conversely, fair value reporting demands that managers determine the unbiased expected value by forecasting the possible outcomes and by applying probabilities to each of the outcomes. The concerns of some investors about conservatism, on the one hand, and the concerns of others about the degree of bias (positive or negative) in a measure, on the other, can both be met if the standards require that the range be disclosed when the range about a 18
Rebecca McEnally and Patricia Walters, “The Critical Nature of Neutral Financial Reporting,” The FASB Report, Constituents’ Commentary (29 August 2003). A Comprehensive Business Reporting Model: Financial Reporting for Investors
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point estimate is large relative to the estimate: The wider the range, the more important the disclosure. A circumstance where disclosure of the range is critical is when managers decide that the point estimate should be zero, for example, when lawsuits have been filed against a company. Sensitivity analysis is particularly useful in such circumstances because the point estimate does not provide the necessary context in which to understand the reported amount.
8. All changes in net assets, including changes in fair values, must be recorded in a single financial statement, the Statement of Changes in Net Assets Available to Common Shareowners. As we have stated, all events and transactions that can affect assets, liabilities, and equities, and thus the wealth of an investor in a company, must be recognized in the financial statements. Changes in those items also must be recorded in a single, highly transparent, and comprehensive financial statement. That is, there should be no category of items, such as those currently recorded as other comprehensive income, that escapes recognition in the primary changes in net assets statement. One implication of this principle is that so-called recycling of gains and losses will be eliminated. That is, there will be no deferral of fair value changes by recording such changes in equity, with recognition contingent upon future events. An example of such delayed recognition is the current treatment of available-for-sale securities. Although these securities are marked to fair value in the balance sheet, the resulting period-to-period changes in fair values do not flow to the income statement for immediate recognition but rather bypass the income statement and are deferred in other comprehensive income in equity until they are sold. Under the current model, accrual net income or earnings is an accounting construct, not an economic measure. Net income is the result of the recognition of some revenues and gains on accounting transactions less some expenses and losses. As long as a single summary statistic— the net income number—is reported and reporting standards allow managers flexibility in reporting choices, we believe some managers will continue to manipulate the number to suit their needs rather than those of shareowners. Therefore, we are proposing a financial reporting model that does not focus on a single earnings number.19 This change would require investors to analyze the individual reported items and the financial statements as a whole to determine which information is relevant to their financial decision making. We would observe that investors routinely make these assessments in evaluating their investment opportunities. Currently, although financial statements must of necessity articulate (that is, how individual items flow from one to another of the statements; for example, for credit sales, receivables in the balance sheet, cash collections in the cash flow statement, and revenues in the income statement), that articulation is opaque to investors. The reason is that the various statements do not follow a consistent structure or the same pattern of aggregation. Only when all of the changes to individual items are made clear and the measurement characteristics of items are fully disclosed will investors be able to understand a company’s process of wealth generation and the prospects for their investments. We develop the Statement of Changes in Net Assets Available to Common Shareowners in Chapter 3.
19 D.
Eric Hirst and Patrick E. Hopkins in Earnings: Measurement, Disclosure, and the Impact of Valuation (Charlottesville, VA: Research Foundation of AIMR, 2000), pp. 13–14, state: . . . [A]nalysis of historical earnings is usually an important precursor to forecasting relevant inputs, [but] what are the relevant historical earnings? Net income? Operating income? Income before extraordinary items? Comprehensive income? Of course, the definitive answer is: It depends.
Econ 1101 Microeconomics 1
9. The cash flow statement provides information essential to the analysis of a company and should be prepared using the direct method only. The IASB, in International Accounting Standard (IAS) 7, describes some of the benefits of cash flow information: A cash flow statement, when used in conjunction with the rest of the financial statements, provides information that enables users to evaluate the changes in net assets of an enterprise, its financial structure (including liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities. Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash equivalents and enables users to develop models to assess and compare the present value of the future cash flows of different enterprises. It also enhances the comparability of the reporting of operating performance by different enterprises because it eliminates the effects of using different accounting treatments for the same transactions and events.20
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In order for users of the statements to be able to make these assessments, the information provided in the cash flow statement must be fully transparent. That is, the individual categories of cash inflows and outflows must be disclosed clearly and unambiguously. Current standards generally permit companies to choose between the indirect and the direct methods. The indirect method chosen by the vast majority of companies fails to provide adequate information for analysis. Instead of providing the essential information on cash inflows and outflows, the indirect method begins with net income and “patches” the income number, purging noncash elements and adjusting for changes in cash flows not reflected in currentperiod income. Put simply, the only pure cash flow number in the operating cash flow section of an indirect method cash flow statement is the total, Cash Flows from Operations. CFA Institute, reflecting on users’ experience with cash flow statements prepared under current accounting standards, observed in 1993: . . . Cash flow statements that have appeared in published financial reports have been much less useful in analysis than we might have expected. First, almost no public company presents its cash flows from operations using the direct format; virtually all use the indirect format. We have learned . . . that it is extremely difficult or impossible in most cases for financial statement users to calculate reasonable estimates of gross operating cash flows (direct method) using only the data provided in financial reports in the indirect format.21
If cash flow information is essential to investors when they are forecasting future cash flows, and the indirect method does not provide the needed information or enable investors to generate it from the data, then companies must be required to use the direct method.
10. Changes affecting each of the financial statements should be reported and explained on a disaggregated basis. For investors to be able to understand the changes that have occurred in financial statements and, consequently, to their wealth, it is essential that they be able to analyze the individual forces at work that affect the company’s performance. Accounting standards currently permit assets and related liabilities, revenues, and expenses, as well as investing and financing cash inflows and outflows, to be reported on a highly aggregated or netted basis, causing much important information to be obscured or lost altogether. The information loss can result in misleading analyses, distorted conclusions, and suboptimal investment decisions. Such aggregation and netting should not be permitted. Similarly, we do not believe that netting should be permitted for individual line items. For example, changes in the property, plant, and equipment account can arise as a result of (1) purchases and exchanges, (2) sales and abandonment, (3) self-construction, (4) mergers and divestitures, (5) leases, (6) foreign currency changes, (7) depreciation, and (8) impairment 20 21
IAS 7, Cash Flow Statements, effective 1 January 1994, paragraph 4. Financial Reporting in the 1990s and Beyond (1993), p. 65. A Comprehensive Business Reporting Model: Financial Reporting for Investors
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write-downs. Clearly, information as to the precise source of the change is essential if investors and other users are to evaluate managers’ investments in productive capital, the effectiveness of managers’ decisions to invest scarce capital, and the value of the company’s capital. It is important to note that IAS 16 requires a full reconciliation of the change in gross fixed assets and accumulated depreciation.22
11. Individual line items should be reported based upon the nature of the items rather than by the function for which they are used. By “nature,” we mean that items should be reported by the type of resource consumed, such as labor or raw materials, rather than by the function or purpose for which it is used, such as cost of goods sold or selling, general, and administrative expense. Categorization according to nature can greatly enhance comparability across companies and consistency within the statements of a single company. Currently, users of the statements cannot determine from the statements or related disclosures where individual items, such as pension expense and depreciation, are recorded in the income statement. The statistical distribution properties of the various resources consumed in operations behave very differently over time. Consequently, aggregation by function, the current practice, merges items with different properties, reducing the information content of the items and significantly reducing their value as decision-making factors. We believe that functional disclosure is best reserved for segment reporting where the categories are most likely to be more nearly homogeneous and, therefore, more meaningful for assessing the profitability of individual units.
12. Disclosures must provide the additional information investors require to understand the items recognized in the financial statements, their measurement properties, and their risk exposures. Although disclosures are not a substitute for recognition and measurement in the financial statements, they are essential if investors are to understand the statements. The role of disclosure is to provide a comprehensive explanation of events or transactions that have been recognized, including (1) the models, estimates, assumptions, and principles that were applied to measure the effects (2) and the sensitivity of the reported information to changes in those principles and assumptions. To the extent that financial statement line items present aggregated information, disclosures must enable investors to disaggregate. The same qualitative characteristics of financial reporting (including understandability, completeness, relevance, and comparability) apply equally to the written disclosures that supplement the financial statements. The information and measurements contained in such disclosures should not be any less reliable than those recognized in the financial statements and should be subjected to the same level of audit scrutiny that the numerical items in the statements receive. To the greatest extent possible, these written disclosures should pertain to the individual characteristics and circumstances of the company involved and avoid routine, legal boilerplate. Finally, until financial statements are of sufficient quality that they no longer require investors to make substantial fair value and other adjustments, disclosures must provide the essential information investors need to make these adjustments. As we have made clear, however, fair value recognition will not remove the need for disclosures about the fair value measurement process. When standard setters consider new or amended recognition and measurement criteria, disclosures must be developed concurrently, not after recognition and measurement decisions are made. Disclosures must be treated as essential and indispensable commentary to the financial statements, rather than as a mere postscript. 22 For a good example of IAS 16, Property, Plant, and Equipment, see footnote 15 of the 2006 financial statements of Roche, a Swiss multinational that reports using International Financial Reporting Standards (IFRS). This footnote shows the effects on the net book value of each class of fixed assets of acquisitions, divestitures, currency translation, depreciation, and impairment.
C. Definitions
The proposed amendments to the conceptual framework have important implications for the definitions of assets, liabilities, and equity. No single definition of assets, liabilities, or equity can answer all questions or address all recognition issues. Nonetheless, we believe that the definitions proposed by the staffs of the FASB and IASB for assets and liabilities, which are currently under consideration by the two boards, provide a sound starting point for addressing recognition.
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1.
Assets
The proposed asset definition is:
An asset is a present economic resource to which the entity has a present right or other privileged access. a. b. Present means that both the economic resource and the right or other privileged access to it exist on the date of the financial statements. An economic resource is something that has positive economic value. It is scarce and capable of being used to carry out economic activities such as production and exchange. An economic resource can contribute to producing cash inflows or reducing cash outflows, directly or indirectly, alone or together with other economic resources. Economic resources include non-conditional contractual promises that others make to the entity, such as promises to pay cash, deliver goods, or render services. Rendering services includes standing ready to perform or refraining from engaging in activities that the entity could otherwise undertake. A right or other privileged access enables the entity to use the present economic resource directly or indirectly and precludes or limits its use by others. Rights are legally enforceable or enforceable by equivalent means (such as by a professional association). Other privileged access is not enforceable but is otherwise protected by secrecy or other barriers to access.
c.
We believe that as a practical matter, assets should be identifiable and separable, capable of being transferred to others. We do not believe that hard to identify, vaguely defined, or ambiguous items, such as goodwill, should be recognized in the balance sheet.
2. Liabilities
The proposed liability definition is:
A liability is a present economic obligation of (or claim against) an entity. a. b. c. The entity is obligated to act or perform in a certain way (or refrain from acting or performing). The obligation exists at the financial statement date. The obligation is economic—it is an obligation to provide economic resources to others or to stand ready to do so.
3. Equity Interests
We believe that the definition should be narrowly defined to include only those components of equity that are associated with the common shareowner’s interest—that is, common stock, additional paid-in capital, and retained earnings. All other obligations, including those that are currently classified as liabilities, would be classified as “Claims.” This classification is consistent with Principle 2, “In financial reporting standard-setting as well as statement preparation, the company must be viewed from the perspective of an investor in the company’s common equity.” The position is also consistent with our view that all financial instruments other than common equity should be recorded at fair value in the balance sheet with changes in fair value recognized as they occur in the income statement. Common shareowners’ equity is the interest of the current owners of common equity, the last residual claimants, in the net assets (assets minus claims) of the enterprise. Hence, all other interests, including all remaining classes of shareowners whose interests precede and are preferential to those of the residual common shareowners, should be recognized as senior ©2007, CFA Institute A Comprehensive Business Reporting Model: Financial Reporting for Investors
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claims to the common equity and accounted for consistently. These interests would include shares representing ownership in a specific division or subsidiary of the company (i.e., minority interest) as well as the various forms of preferred stock. In general, financial instruments masquerading as equity instruments whose terms provide the holders with prior or preferential access (relative to the residual interest of common shareowners) to company cash flows or other assets should be classified as claims. Similarly, instruments, such as stock options, that require the future transfer of a portion of the net assets of current common shareowners to the holders of the instruments must also be classified as claims. Depending upon the terms of the instruments, they should be classified as Short-Term Claims, Long-Term Claims—Definite Maturities, or Long-Term Claims—Indefinite Maturities. In this context, our call for all financial instruments other than the residual common interest to be valued at fair value in the balance sheet with changes in the fair value recognized currently in the income statement would apply to other equity interests as well. That is, claims against the net assets that are senior to the residual common shareowners’ interest should be reflected at fair value. We would reiterate that we believe that the historical cost or contractual amounts of such interests should be disclosed in the footnotes to the statements when appropriate. These disclosures are consistent with our general view that financial statements should be presented from the point of view of the ultimate risk bearer in the company, the current residual common shareowner. However, claims against the current residual net assets that are prior or senior to those of the residual common shareowner should be presented as just that, senior claims. In addition, sufficient information should be provided in the statements and footnotes about each class of senior claims to enable users of the statements to fully understand the nature of the claims, their settlement terms, the contractual commitments against the net assets that they represent, and their current fair values.
D. Specific Implications of the Conceptual Framework
These proposed amendments and changes to the conceptual framework and the proposed definitions of assets, liabilities, and equity have important implications for current financial reporting standards. We would like to discuss just a few of these implications here. Deferral of defined-benefit plan actuarial gains and losses is incompatible with fair value reporting. All changes in the fair values of the liabilities must be included in pension expense in the period in which they occur. The corridor approach is an unfortunate result of the improper objective of smoothing the accounting recognition of economic events, and it conflicts with several of the concepts mentioned previously. From the perspective of current common shareowners, the granting of stock options to employees creates an obligation that transfers wealth from current common shareowners to employees. Therefore, it is irrelevant whether the obligation will be settled with cash, or other assets, or settled with equity; the obligation must be classified as a liability. Special hedge accounting is an artifact of the mixed-attribute model, is based upon managers’ intent, and results in the selective recognition of only some fair value gains and losses. The fact that it exists only to permit managers to offset losses with gains, thereby reducing reported volatility, is arbitrary. Only when all transactions are fully and separately accounted for at fair value and on a disaggregated basis will investors have a clear picture of both the risks to be hedged and the effectiveness of any hedging instruments or strategies used. The objective of financial reporting is to describe in accounting conventions what the actual financial condition of a company is and not what managers would like it to be. Several of the concepts we propose are diametrically opposed to, and would help prevent, accounting as determined by intent. The rationale for managers’ engaging in particular transactions or business strategies is best included in the disclosures. These disclosures must also include quantitative information that clarifies managers’ effectiveness in achieving their objectives. A Comprehensive Business Reporting Model: Financial Reporting for Investors ©2007, CFA Institute
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When viewed from the perspective of current shareowners, a downward change in the company’s credit rating necessarily means that wealth is transferred from existing bondholders, who have already committed to an interest rate and thus bear the risk of changes in the interest rates, to shareowners. If bondholders had waited to purchase the obligations, they may well have received a higher interest rate. What is unsettling to many, however, is the fact that the fair value recognition of a negative credit change results in a gain to the company and an increase in shareowners’ wealth. Such an occurrence is not a fluke of fair value reporting but rather is the inevitable result of the differential contractual claims of the bondholders and shareowners. We should note, however, that the increase in shareowners’ wealth resulting from the credit downgrade is generally offset by asset impairment, operating losses, or other factors that reduce equity.
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Chapter 3.
The Comprehensive Business Reporting Model—Our Proposals for Revision
We believe that the current business reporting model requires a number of major changes so that it can fully and clearly communicate the operations of a 21st century company to its investors and better serve their needs for information. Briefly, we propose a set of revised financial statements and one new statement. As we have expressed in Chapter 2, we believe that because fair value is the most relevant basis for financial decision making, fair value should be the preferred measurement attribute used in the financial statements. We have a responsibility, however, to propose statements that can serve investors well with today’s mixed-attribute model and during the period of transition to the fair value model. Consequently, the statements that we propose accomplish this objective as well. One by-product of accommodating the mixed-attribute model during the transition is that our proposed model lays bare many of the infirmities of the current model. Investors are interested in a number of major questions, including: • • • • How companies create value; How sustainable is the value-generation process; How value is dispersed to the various senior stakeholders; and How value accrues to the last residual claimants, the ultimate risk bearers in the company, who are generally the common shareowners.
It is apparent from this list that investors cannot rely solely on a single earnings number to make their investment decisions. Rather, investors require information about a variety of different concerns, including: • • • • • Resources available to the company; Obligations to transfer resources to others; The ability of the company to generate long-term, sustainable net inflows of resources; The ability of the company to convert the new resource inflows to cash; and The risks to which these resource-generating activities and cash flows are exposed, both in the near term and in the long run.
In order to answer the questions listed above, investors must understand (1) the economic activities reported in the financial statements and (2) the processes managers have used to produce the financial statements and disclosures. If investors are not able to distinguish the underlying economic activities from the effects of financial reporting, then they will not be able to address the larger questions. Their ability to do so depends directly on the business reporting model, its clarity, its completeness, the transparency of its articulation, and the quality of its measurements.23 The financial statements are all interrelated. To understand one statement, investors must have the means to understand them all. If investors are to better understand how companies are creating value, whether their activities are increasing or decreasing the value of their investors’ investments, and whether the value-generation process is sustainable, much greater attention must be paid to the balance sheet and cash flow statements, to the quality of measurement of items reported in them, and to the relationships among the items. With respect to the balance sheet, because value can be created or lost simply by holding assets and liabilities, we believe that the fair values of both recorded and currently unrecorded assets and liabilities must be reported. 23
Of course, distinguishing between the economics and the effects of GAAP application depends as well on the good faith of managers in applying the model fully and completely and striving for clarity and understandability whether the news is good or bad rather than obscuring any negative or undesirable outcomes. ©2007, CFA Institute
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At present, the balance sheet includes measurements of dubious relevance that are generated using a variety of different measurement bases, including historical cost, amortized cost, observed fair market values, and managers’ estimates of values. The different measurements are mixed together with, in some cases, insufficient information in the disclosures for investors to determine which bases have been used and whether the accounting processes have captured the underlying economics. An equally problematic issue is that changes in these measurements are not required to be recognized in one statement. Rather, they are dispersed between the income statement and, increasingly, Other Comprehensive Income, a category of equity that bypasses the income statement altogether. The ultimate objective of the wealth-generation process is to generate cash. Thus, it is critically important for investors to understand how companies generate cash and how they manage cash receipts and payments. Investors will achieve this understanding only when the business reporting model communicates the process clearly and completely. Investors need a reporting model that better communicates the risks and uncertainties implicit in the events and transactions and thus in the amounts recognized in the financial statements. This information should be reported in such a manner that it can directly support the development of forward-looking estimates of sustainable cash flows. Academic research confirms that “disaggregating earnings into cash flow and the components of accruals enhances earnings’ predictive ability relative to aggregate earnings.”24 It is not surprising that disaggregating the earnings series would improve predictive ability, a primary purpose of financial reporting, because information lost in the aggregation process is preserved in the separate series. In addition, separate reporting of cash flows and accruals permits investors with different analysis and investment objectives to apply different weights to the series in developing forecasts and valuations. This research supports our call for a new business reporting model, one that disaggregates the jumbled income statement and cash flow numbers and that clearly and completely communicates both cash flow information and accruals. Research by Eric Hirst and Patrick Hopkins, as well as work by Ann Tarca et al., shows that how and where reported information is displayed affects investors’ understanding of the reported information as well as their ability to incorporate all relevant information into their valuation models.25 Because of the difficulty inherent in assessing the relevance and persistence of the…[financial statement] amounts, users of financial accounting information often must sort through voluminous notes and nonfinancial information to effectively forecast the future earnings, cash flows, or intrinsic value of a company. This wide dispersion of value-relevant information increases the direct and indirect cost of valuation activities.26
Transparency and accessibility of information are as important as relevance and reliability if investors are to incorporate the data into their analyses and judgments. We believe that a complete cost–benefit analysis would show that it is more costly for many investors to independently engage in search-and-estimate missions than it is for companies to display information succinctly, clearly, consistently, and in accessible formats. Hence, to achieve this objective, we propose a set of new financial statements with revisions to the remaining old ones. The statements retain the most useful characteristics of the old statements but also: • • • Expand the information sets presented; Disaggregate cash flow and accrual information; Distinguish among the measurement bases for such items as cash flows, accruals, and fair value measurements;
Mary E. Barth, Donald P. Cram, Karen K. Nelson, “Accruals and the Prediction of Future Cash Flows,” Accounting Review, vol. 76, no. 1 (January 2001), pp. 28–58. 25 Ann Tarca, Philip Brown, Phil Hancock, David Woodliff, Michael Bradbury, and Tony van Zijl, “Identifying Decision Useful Information with the Matrix Format Income Statement,” working paper. 26 D. Eric Hirst and Patrick E. Hopkins, “Comprehensive Income Reporting and Analysts’ Valuation Judgments,” Journal of Accounting Research, vol. 36, Supplement (1998), pp. 47–75. ©2007, CFA Institute A Comprehensive Business Reporting Model: Financial Reporting for Investors
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• •
Disaggregate functional categories to provide disclosure by the nature of the item; and Reveal the articulation of the individual line items in the financial statements.
We propose that standard setters provide investors with a revised set of four financial statements. All statements are of equal importance. The first three statements provide information at a higher level of aggregation. The fourth statement provides a level of disaggregation that is missing today and that is critical to investors’ understanding of how the other statements, and the items in them, articulate. This set of financial statements comprises: 1. Comparative Balance Sheets—Minimum of three years (three balance sheets and two income and cash flow statements provide two full years of data), with accounts listed in order of decreasing liquidity within each category. Comparative Cash Flow Statements—Minimum of two years, prepared using the direct method, with a supplemental schedule of significant noncash financing and investing activities. (New) Comparative Statements of Changes in Net Assets Available to Common Shareowners—Minimum of two years, that: a. Identify and distinguish among: i. Current-period cash and accrual transactions; ii. Estimates; and iii. Changes in the fair values of balance sheet accounts. b. Provide information by nature of each resource consumed rather than the function for which it is consumed; and c. 4. Display transactions with owners that affect net assets, such as dividends and new share issuances. Reconciliation of Financial Position—Reconciles the comparative balance sheets by further disaggregating the amounts in the statements mentioned previously and by clearly showing how the statements articulate.
2.
3.
In the remainder of this chapter, we explain and illustrate the details of each of these four statements. We provide sample financial statements and the relevant journal entries for TransGlobal Exports, Ltd., a fictional small specialty manufacturer of tools. These statements are the (1) proposed balance sheet, (2) direct method cash flow statement, (3) statement of changes in net assets, and (4) reconciliation statement. In addition, consistent with our view that fair values should be used for the measurement of assets and liabilities, we believe it is important that we provide a more detailed example of the information than we would expect to see in actual practice in the proposed financial statements. Therefore, we provide an example of an interest rate swap in Table 6A,27 which is already measured at fair value under U.S. GAAP, illustrating how the initial and subsequent transactions would be reflected in the proposed statement of changes in net assets and in the reconciliation. The latter also shows the information that would appear in the balance sheet and cash flow statement. The journal entries are those that would be recorded under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities.
B. Classification: Business—Operating and Investing—and Financing Standard setters worldwide, working in a variety of contexts, have sought without success to define those activities that should be classed as operating and to provide a sharp distinction between such activities and other classifications, such as nonoperating, investing, and financing. Indeed, drawing the line between operating and investing activities is fraught with ambiguities, particularly in the case of financial institutions and manufacturing companies 27
Patricia A. McConnell, “Derivatives and Hedging: The FASB Solution,” Accounting Issues, Bear Stearns Equity Research (5 February 1998), pp. 24–29. ©2007, CFA Institute
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that provide long-term financing to their customers. As a result, many observers feel that sharp distinctions cannot always be clearly made between operating and financing activities. Some financing from such sources as suppliers, banks, and other investors is inextricably linked to operations and the level of a company’s business activity. Other third-party financing—for example, the issuance of long-term bonds—is of a much more general nature and is at best indirectly linked to operations. We believe that greater clarity may be achieved by classifying third-party financing separately as financing activities. All other financing arrangements arising from relationships with customers, vendors, or other related parties should be classified as business—that is, operating and investing activities. We also believe that classifying investing activities as a separate category of business activities would better reflect the actual economics of most modern companies, particularly those in which customer or vendor financing is an intrinsic part of the business model. It is important for consistency and comparability that all transactions and events related to these various activities be similarly classified, including their foreign exchange consequences. Income tax, however, cannot be disaggregated because it is a statutory charge against activities in a particular jurisdiction. Therefore, we believe that income tax expense, cash payments, and deferred assets and liabilities should not be classified.
C. Balance Sheet
The balance sheet provides investors with information about a company’s assets and the claims against those assets: 1. 2. 3. 4. The resources available to it; The relative liquidity of the resources; Recognized and contingent claims against those resources; and The relative time to maturity of these claims.
The importance of the balance sheet to investment decision making has diminished in recent decades. Arguably, this is a result of such factors as: • • • Models that focus on reported earnings and cash flows rather than accounting net worth; The reduced relevance of historical cost–based numbers for decision making given both general inflation and price changes for specific assets and liabilities; The omission from the balance sheet of major classes of resources and obligations (for example, intangible assets and operating leases and other off-balance-sheet financing arrangements); and Accounting choices that limit comparability.
•
We believe that it is time to refocus attention on the balance sheet, to correct its deficiencies, and to restore its usefulness as a communicator of essential information about companies. In Chapter 2, we made clear that we believe that: 1. 2. 3. 4. 5. 6. 7. All assets available to the company and all obligations and commitments that can consume the net assets available to investors should be recorded in the balance sheet; All balance sheet assets and liabilities should be reported at fair value, starting with all financial instruments as soon as possible; All balance sheet items should be disaggregated; Assets and liabilities should not be netted; Income statement components and related balance sheet items should be reported by nature rather than function; Related assets and liabilities should be classified together by category; and All assets and liabilities should be ordered by liquidity, specifically by decreasing liquidity, within their respective categories. A Comprehensive Business Reporting Model: Financial Reporting for Investors
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These principles are not routinely followed in the current balance sheet process, reducing its transparency and usefulness to investors. An investor should be able to readily determine the company’s true net assets at the balance sheet date and, in conjunction with the cash flow statement, be able to evaluate the company’s ability to liquidate claims and obligations from the balance sheet. See Table 1 for an example of a balance sheet constructed using these principles.
D. Cash Flow Statement
In 1986, when the FASB issued its exposure draft for SFAS No. 95, Statement of Cash Flows, to replace the funds flow statement, we urged the board . . . to require a cash flow statement that clearly discloses flows of cash (and cash equivalents) through the entity. The cash flow statement itself should focus only on cash flows and not have its utility and relevance diluted by unwarranted injection of accrual accounting concepts.28 [Emphasis added.]
At that time, we requested that a single format for the statement be prescribed, and we requested that “as long as net income was considered to be of primary importance, the objective of the statement of cash flows should be to facilitate an understanding and analysis of the income statement.”29 By 1990, four short years later, when the International Accounting Standards Committee (IASC) issued a similar exposure draft, we had reconsidered our views. In our 27 July 1990 comment letter, we explained that our . . . support [for the indirect method] was based, in part, on the need of financial statement users to understand how reported net income differs from cash from operations and to be able to reconcile the two. We also believed that users who wished to prepare a direct method statement would be able to do so using the data provided in the indirect method reconciliation.30 [Emphasis added.]
Our experience since then confirms our view that it is impossible for even the most skilled analyst to create a reliable direct method cash flow statement for most companies from existing reported data. The analysis required to even approximate a direct method cash flow statement from the available data is difficult and time consuming. The real challenge, however, is not the enormous effort required but rather the fact that the articulation between the balance sheet and the income statement is almost always obscured. For example, most companies provide insufficient information to permit a skilled analyst to cleanly decompose the entries affecting accounts receivable and to determine cash inflows from sales, the amounts of cash collected from customers. Cash collected from customers is perhaps the single most important direct cash flow number and is a primary indicator of the company’s cash-generating ability. Gross estimates must be made, greatly reducing the reliability and usefulness of the information generated by the exercise. The same is true to a greater or lesser extent for all of the other numbers in a direct method statement. In addition, it is often impossible to align the adjustments in the indirect method cash flow statement with any single income statement line item.
28
Patricia McConnell and Gerald I. White, “Comment Letter of the Financial Accounting Policy Committee of the Financial Analysts Federation to Financial Accounting Standards Board” (15 October 1986), p. 1. 29 Ibid, p. 3. 30 Patricia McConnell and Gerald I. White, “Comment Letter of the Financial Accounting Policy Committee of the Association for Investment Management and Research to the International Accounting Standards Committee” (27 July 1990), pp. 1–2. A Comprehensive Business Reporting Model: Financial Reporting for Investors ©2007, CFA Institute
Table 1. Trans-Global Exports, Ltd., Comparative Balance Sheets at 31 December 20X3 and 20X4 31 December 20X3
Assets
23
20X4 € 5,918,411 196,100 845,000 (70,500) 774,500 619,694 25,756 722,250 4,260,000 (275,000) € 3,985,000 €12,241,711
Cash Marketable securities Accounts receivable Less: Allowance for bad debts Net accounts receivable Inventory Leased asset Investment in affiliate Building Less: Accumulated depreciation Net building Total assets Claims and Common Shareowners’ Equity
€4,000,000 0 595,000 (20,000)* 575,000 850,000 0 0 3,600,000 (100,000) €3,500,000 €8,925,000
Accounts payable Accrued liabilities Advances from customers Interest payable Income taxes payable Dividends payable Current portion of lease liability Short-term debt Accrued stock compensation Lease liability Deferred income tax liability Accrued pension liability Bonds payable Minority interest Perpetual preferred stock Total claims Common stock Additional paid-in capital Treasury stock Retained net assets Total common shareowners’ equity Total claims and common shareowners’ equity *Parentheses indicate negative numbers.
€ 850,000 28,000 15,000 0 54,639 0 0 0 6,000 0 23,699 2,400 0 100,000 300,000 € 1,379,738 € 600,000 4,000,000 (100,000) 3,045,262 € 7,545,262 € 8,925,000
€
375,000 78,000 190,000 125,000 75,451 35,000 9,208 500,000 13,500 24,870 56,819 4,800 2,500,000 100,000 300,000
€ 4,387,648 € 600,000 4,000,000 (100,000) 3,354,063 € 7,854,063 €12,241,711
©2007, CFA Institute
A Comprehensive Business Reporting Model: Financial Reporting for Investors
24
There is an additional issue that is critical for investors’ use of cash flow information. As our 1990 letter explained, academic research provides evidence that the individual components of cash flow from operating activities have explanatory power that is superior to that of the currently reported total cash flow from operations.31 That is, information useful for forecasting cash flows is lost in the aggregated single number, cash flow from operations, the only cash flow amount in an indirect method cash flow statement. The most useful and revealing cash flow components are only available in a direct method cash flow statement. In the 1993 Financial Reporting in the 1990s and Beyond and again in a 1996 comment letter to the Canadian Accounting Standards Board, we repeated our request for a statement of cash receipts and disbursements (that is, a direct method cash flow statement). We repeated our belief that such a statement is more useful than the indirect method of adjusting net income to remove noncash items and to patch for cash flow items not recognized in the income statement. We believe that the cost required to develop even an approximation of a direct method cash flow statement clearly overrides any cost–benefit objections issuers might have for providing it. Investors use cash flow information as an important reality check on the quality of reported earnings. To the extent that cash flows and earnings diverge, a result of noncash accruals changing at a faster rate than the related cash flow number, investors are put on warning that the reported accrual numbers may be less than reliable indicators of the company’s performance and thus of its value-generating ability. The divergence may also signal cash flow difficulties at some time in the future. Information about significant noncash operating, investing, and financing transactions is also important. Therefore, to provide transparency for transactions that are not disclosed in the cash flow statement, a supplementary schedule of these transactions must be required. See Table 2 for an example of such a direct method cash flow statement. (In Table 5, we provide the supporting journal entries for the items reported in the cash flow statement.) Note that these entries include the accruals for the period and fair value adjustments as well, which are not relevant for the cash flow statement.
E. Statement of Changes in Net Assets Available to Common Shareowners Our proposed Statement of Changes in Net Assets replaces both the Income Statement and the Statement of Comprehensive Income. This statement is designed to: • • • Provide the information investors need to understand a company’s operations and the events and transactions affecting those operations; Require full recognition in a single statement of all events and transactions that affect common shareowners’ equity; Increase the transparency and understandability of the behavior of individual items and the effects these have on a company’s operations by requiring that items be reported by nature rather than function; Provide information on all investing and financing activities; Provide information on the company’s transactions with investors, the company’s common shareowners; and Deemphasize the focus on accounting net income, a single arbitrary performance indicator.
• • •
This statement fully reflects our views on the necessity of providing shareowners with complete and understandable information on all activities, events, and transactions that can affect investors’ wealth. As we made clear in Chapter 2, no transactions affecting investor wealth should be allowed to escape recognition in the primary financial statements. Rather, all transactions and events that change net assets must be recognized in a timely fashion in this single statement, not merely those that are generally considered to be performance indicators. This requirement means that financial reporting standards would no longer permit either selective disclosure of activities or deferral or allocation of other items to other periods. 31
Ibid, p. 2. ©2007, CFA Institute
Table 2. Trans-Global Exports, Ltd., Cash Flow Statement and Significant Noncash Financing and Investing Activities for the Year Ended 31 December 20X4 Cash Flow Statement
Business Activities Collections from customers Payments for inventory purchases Payment for labor Payment for rent Payment for other services Pension contribution Net operating cash flows Purchase of investment in affiliate Capital expenditure—building Purchase of marketable securities Dividends received Net investing cash flows Net cash flows from business activities Financing Activities Interest payment Dividend payment Issuance of short-term debt Issuance of bonds Net cash flows from financing activities Payment of income taxes Net change in cash
25
20X4
€ 2,700,000 (1,750,000)* (210,000) (120,000) (100,000) (1,200) € 518,800 (710,000) (500,000) (185,000) 9,250 €(1,385,750) € (866,950)
Supplemental Disclosures Collections from customers Cash sales Advances Collections on credit sales Total Payments for inventory purchases Cash purchases Payment for prior period purchases Credit purchases current period Total
€ 250,000 200,000 2,250,000 €2,700,000 € (300,000) (850,000) (600,000) €(1,750,000)
Noncash Financing and Investing Activities Investing Activity Leased building and land Financing Activity Lease obligation—building and land
€ 31,700 €(31,700)
(125,000) (35,000) 500,000 2,500,000 € 2,840,000 (54,639) € 1,918,411
*Parentheses indicate negative numbers.
We believe that performance assessment is the responsibility of the investor, not managers. The statement of net assets will allow the investor to select those performance measures that are pertinent to the investor’s particular perspective, analytical requirements, and objectives. Such a statement would continue to meet the needs of all users of financial statements and at the same time provide the richer dataset that long-term common equity investors need. We believe that investors will not be able to assess the values of their investments and their prospects unless they are able to understand the forces at work that can increase or decrease that value. This means that individual line items must be reported by the nature of the item (e.g., labor cost) and not by the function for which a resource is consumed (e.g., cost of goods sold). Aggregation of disparate items results in information loss, and as we have observed, that loss reduces predictive power and analytical value. This new statement also includes the effects of all investing and financing activities because they are integral to a company’s value generation. Indeed, it is frequently difficult to clearly distinguish among the categories, as we have observed. Investors’ understanding of a company’s operations will be greatly improved if investing and financing transactions and events are required to be recognized in this statement. At present, investors are left to guess at many such transactions, frequently involving highly material amounts. ©2007, CFA Institute A Comprehensive Business Reporting Model: Financial Reporting for Investors
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One direct implication of this comprehensive statement is that it may well have the effect of reducing what we believe to be the market’s unwarranted focus on earnings per share (EPS). We believe that this myopic focus on a single number, which is highly susceptible to manipulation, leads to exaggerated market reactions that serve to fuel unproductive and unwarranted market volatility and the “short-termism” of stock market speculators—a disservice to investors with a longer-term perspective. Indeed, long-term investors are concerned primarily with forecasting total return to the investment horizon. The richer dataset may also encourage analysts to develop better forecasting methods that could result in more efficient and effective capital allocation. Consistent with our view on the components of the statement of changes in net assets, we do not support the continued reporting of a single arbitrarily defined EPS number. As we have stated, the earnings used in the numerator of the ratio is an accounting artifact, an aggregate of some revenues and gains and some expenses and losses, rather than a transparent, economics-based measure of performance. Indeed, most professionally trained analysts today are forced to routinely adjust the earnings number to better reflect economic reality. Disclosure of the weighted-average number of shares outstanding would be used to create investor-specific per share metrics as inputs to valuation models. The benefits of these changes would ultimately accrue to the investing public. Finally, we see no logical reason why transactions with shareowners must be relegated to a separate statement or footnote disclosure. We believe that it is both more effective and cost efficient if such events are recorded in the statement of changes in net assets as a financing activity. Recording all events in a single statement will be particularly helpful in the current environment in which some financial instruments blur the distinction between liabilities and equities. We have designed the proposed format for the Statement of Changes in Net Assets so that it can be implemented for the current mixed-attribute accounting model. It is also intended, however, to be completely appropriate and adaptable to the full fair value model. As the accounting for particular assets and liabilities transitions to fair value measurement, we expect that most estimates will shift to the Changes in Fair Value column. See Table 3 for an example of a statement of changes in net assets and see Table 5 for some sample journal entries. Following are the top-level definitions of the different transactions and other economic events that would be reported: 1. Current-Period Transactions (Column 1): Exchange transactions that increase or decrease assets and liabilities in the current reporting period. The items recorded in Column 1 are the traditional accrual transactions—for example, sales revenue, use of labor and other operating services, purchase of raw materials or goods for resale, interest expense, and gains or losses on sales of fixed assets. These transactions must be measured at the gross amounts. Whether a transaction is recorded in this column is not affected by the measurement attribute of the balance sheet account in which they are recorded. Examples of transactions that are recorded in this column include: a. Sales: Sum of (1) the gross amounts recorded to accounts receivable (assumes cash sales are recorded as credit sales with immediate recording of cash collected) and (2) advances from customers. b. Interest: i. Gross increase in amount payable on debt securities. ii. Gross increase in amount receivable from investments in debt securities. c. Income tax: i. Gross increase in amount payable. ii. Gross increase in amount receivable. d. Gain on sale of fixed asset: Gross amount of difference between carrying amount of fixed assets and the cash or other assets received in exchange. ©2007, CFA Institute
Table 3. Trans-Global Exports, Ltd., Statement of Changes in Net Assets Available to Common Shareowners for the Year Ended 31 December 20X4 Current-Period Transactions Business Activities Sales Bad debt expense Purchases of inventory Ending inventory less beginning inventory Direct labor Other compensation expense Rent expense Pension expense Depreciation expense Amortization expense Other operating expense Net operating activities Revaluation of building to fair value Dividend income—marketable securities Marketable securities: revaluation to fair value Equity in earnings of affiliate Net investing activities Financing Activities Interest expense Net financing activities Income tax Net change in net assets before transactions with owners Dividends declared Change in net assets € 780,422 (70,000) € 710,422 €(572,721) €171,100 € € 2,775,000 € (50,500)* (1,275,000) (230,306) (110,000) (107,500) (120,000) (1,200) (1,505,306) (110,000) (107,500) (120,000) (3,600) (175,000) (5,944) (150,000) € 0 160,000 9,250 11,100 12,250 21,500 (252,378) € (252,378) € 0 € 0 €(108,571) €(572,721) €171,100 € 0 €171,100 € 547,150 160,000 9,250 11,100 12,250 € 192,600 (252,378) € (252,378) € (108,571) € 378,801 (70,000) € 308,801 €2,724,500 Change in Fair Value of Related Assets & Liabilities Change in Net Assets
27
Estimates
(2,400) (175,000) (5,944) €(464,150)
(150,000) € 1,011,300
*Parentheses indicate negative numbers.
2.
Estimates (Column 2): Noncash items that approximate price and other changes of assets and liabilities. Examples of items recorded in the current mixed-attribute model include the following: a. Bad debt expense, sales returns, and allowances b. Change in the balance of inventory (this estimate is required for calculating cost of goods sold when items are reported by nature rather than function) c. Deferred taxes d. Inventory lower-of-cost-or-market write-down e. Current-period stock compensation expense (a period allocation of the grant date fair value) f. Depreciation expense (an allocation, using any of a variety of methods, of the historical cost of a fixed asset over an assumed useful life)
©2007, CFA Institute
28
g. i. j. k. 3.
Overhead allocations Foreign currency translation effects for assets and liabilities not measured at fair value Amortization of bond discounts and premiums Interest capitalized
h. Pension accruals for defined-benefit pensions
Changes in Fair Value (Column 3): Currently in the mixed-attribute model— Nontransaction valuation adjustments derived from adjusting the carrying amount of an asset or liability (net of related accrual valuation accounts, such as Allowance for Bad Debts) to its fair value at the reporting date. Examples of such adjustments that would be recorded in the current mixed-attribute model: a. c. Change in market value of available-for-sale investments Interest rate swap fair value adjustment b. Foreign currency translation effects for assets and liabilities measured at fair value d. Fair value adjustment for securities held for trading
We believe that this new set of financial statements, which reflects our view that fair value is the most relevant measurement attribute, can serve investors well with the current mixedattribute model and during the period of transition to the fair value model. Moreover, we believe that the proposed Statement of Changes in Net Assets as described can enhance investment decision making throughout this process. As these adjustments reveal, during the period of transition from the current mixed-attribute model to the fair value model, Column 3, the fair value adjustments column, will include pure current-period fair value adjustments for those items currently carried at fair value in the balance sheet. However, for those items carried at adjusted historical cost—that is, historical cost plus or minus an estimate or allocation such as depreciation—the number recorded in Column 3 will be the amount necessary to adjust the current carrying value to fair value. As additional assets and liabilities are measured at fair value, the estimate and allocation events related to those assets and liabilities will no longer be needed. Consequently, the amount of the fair value adjustment recorded in Column 3 will be the gross amount of the revaluation. For example, we expect the following changes will occur: 1. Accounts Receivable: a. Estimates of uncollectible amounts will no longer be recorded (although full disclosure of the fair value estimation method and assumptions used will be required).
b. The amount recorded as the Change in Fair Value will be the total change in fair value from the beginning of the period. 2. Inventory: The inventory change due to price (rather than quantity) changes will be measured and recorded as a Change in Fair Value (Column 3) rather than an estimate (Column 2). Fixed Assets: a. Depreciation will no longer be recorded as an Estimates item (Column 2); rather, an estimate of the fair value of productive capacity used in the current period will be disclosed separately.
3.
b. The Change in Fair Value of Fixed Assets will be the total change in fair value from the beginning of the period. 4. Income Taxes: The change in the tax liability or asset will be recorded as a Change in Fair Value.
29
5.
Stock Compensation: a. The amount necessary to restate the obligation to fair value will be recorded as a Change in Fair Value.32
6.
b. The change in fair value from the services provided during this period must be disclosed separately. Foreign Currency Translation: Each effect would be recorded as a change in fair value for the assets and liabilities related to Operating, Investing, and Financing, respectively.
F. Reconciliation of Balance Sheet, Cash Flows, and Other Changes in Net Assets Financial statements articulate; that is, the items in the transactions and events statements (currently, the Statements of Income, Cash Flow, Comprehensive Income, and Shareowners’ Equity) flow from one to another of the statements, including the balance sheet, and should be traceable and directly observable by investors. Indeed, the knowledge gained from analyzing such flows is critical to an investor’s understanding of a company’s value-generation process. Currently, as we have described in the discussion of the Cash Flow Statement, this articulation is at best obscured, making it impossible for even the most skilled investor to dissect this articulation in order to perform a thorough analysis. The articulation is hidden by (1) the very different and inconsistent aggregation and netting processes in the various statements and (2) the impossibility of directly comparing the operating section of the indirect method cash flow statement with the income statement or the investing and financing sections with changes in the balance sheet. Therefore, we propose to add a completely new statement—the Reconciliation of Balance Sheet, Cash Flows, and Other Changes in Net Assets—to the set of statements shareowners and investors currently receive. We consider this to be essential to our goal of increasing the transparency and understandability of companies’ financial reporting and disclosures. Although our preference is for the reconciliation to be provided as a required statement, we fully understand that it may be lengthy and, therefore, better positioned as a required supplementary disclosure that would be fully audited. We should not, however, compromise on the presentation of the statement, which should make the disclosures most accessible to investors. The reconciliation must appear as a single disclosure and must not be disaggregated with separate sections appearing in multiple locations throughout the disclosures. Indeed, disaggregation would subvert the very purpose of the statement. This statement should not be costly to prepare. The cost is in the data production, all of which is currently available to managers, not the data display. Investors should not be forced to expend additional costs to put the puzzle back together. See Tables 4A and 4B.
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