By Paul B.W. Miller and Paul R. Bahnson
Ever since we uncovered and articulated the paradigm that we call Quality Financial Reporting, we have been committed to advocating a new attitude among managers.
We have asserted that they will soon respond to tremendous economic incentives for moving beyond minimum compliance with politicized rules.
Instead of reporting only the least amount required under generally accepted accounting principles, a practice that common sense tells us (and research confirms) increases the markets’ uncertainty and reduces stock prices, we challenge them to apply QFR thinking to identify and meet the markets’ information needs.
It is true that Enron and the other scandals exposed cases of out-and-out fraud, but they also should have dispelled any notions that minimum technical compliance with GAAP is good enough. In response, a growing number of managers have begun to make QFR-compliant reporting initiatives. One prominent example is the voluntary decision of many companies to improve stock option reporting. What began with a handful has grown to more than 200 S&P 500 firms whose income statements will soon report options expense.
No doubt, at least some of these managers look at this decision as a one-time move to placate nervous investors Ñ as if this single change will fully align their financial statements with users’ needs. For those who understand QFR, this action is but a first baby step toward continuously improving reporting.
At present, another QFR-friendly change is gaining momentum: the decision to stop providing short-term earnings guidance. In the markets’ exuberant days, many managers actively guided analysts in their predictions of the next quarter’s earnings per share. Surpassing the analysts’ forecast, even by a penny or two, was reputed to send share prices skyward, while missing a target by a cent or two would supposedly send stock prices down sharply and forever.
In the words of Nanette Byrnes, writing in Business Week, (“Earnings Guidance: Silence Is Golden,” May 5, 2003), playing this game devolved into a short-term fixated “world of whisper numbers and CNBC-addicted day traders.” While some might argue that quarterly earnings guidance provides relevant information to the markets, their claim overlooks the negative impacts of its limited scope and its very narrow distribution.
Thus, we applaud the top management of Coca-Cola for leading the way among really large companies in making a clean break from the guidance habit. Since that move, many others have followed suit, including McDonald’s, PepsiCo and Mattel. For these managers, success in this second step toward QFR could lead them to try others.
What is the next logical step? We have a recommendation: reporting operating cash flows with the direct method. There is probably no better (or easier) way to serve financial statement users’ needs. Of course, our assertion begs the question: If the direct method is so user-friendly, why isn’t it more prevalent or even required? The answer is politically inspired resistance. (Much of what follows we described in “Quality Financial Reporting,” which was published last year by McGraw-Hill.)
From the beginning of the Financial Accounting Standards Board’s cash flow project 20 years ago, users expressed a strong preference for the direct method so that they could analyze the gross amounts of cash inflows and outflows. Managers resisted by claiming that their accounting systems were not designed to provide this information. Rather, they were configured to support the more familiar indirect, or “bassackwards,” method that starts with net income and works back to net operating cash flow.
Like all other FASB standards, SFAS 95 is a compromise that allows managers to put their own convenience above users’ needs. While the board’s concession to preparers’ concerns might be explained as politics, managers have no justification whatsoever for their essentially unanimous rejection of the recommended direct method. Statement users have strongly and persistently asked for the direct method.
Most significantly, the Association for Investment Management and Research said, in “Financial Reporting in the 1990s and Beyond,” “Despite overwhelming expressions of support for the direct method by virtually all professional users of financial statements in the U.S. and Canada, it is the indirect method that appears almost without exception in published financial statements.”
The AIMR really nailed managers: “Nothing other than inertia prevents progressive business enterprises that seek favor with analysts from adopting the direct method. We reiterate: Not only is the direct method permitted, users of financial statements prefer it.”
Some may presume that management’s insistence on using the indirect method is based on its ease of preparation. Ironically, it is much more difficult to produce than the direct method. Although it looks straightforward in textbook examples, real world complications (especially acquisitions) throw that simplicity right out the window because someone has to sort through all the transactions to produce the indirect reconciliation.
Back in the December 1996 issue of Accounting Horizons, we published a study of literally thousands of cash flow statements that shows that these complexities existed in more than 70 percent of them.
As to the argument that the direct method is more costly, we dismiss it as too narrow because it leaves out the costs incurred by users in preparing their own unreliable direct calculations. It also ignores the higher cost of capital produced by not serving users’ needs.
In addition, we published another article in the February 2002 issue of Strategic Finance showing that the direct method can be accomplished automatically with a new kind of accounting system that uses temporary cash flow accounts instead of throwing all debits and credits to cash into a single account. One temporary debit account would record cash collected from customers, another credit account would record cash paid to vendors, still another cash paid for income taxes and so forth, until there would be one account for each class of reportable operating, financing and investing activities. Preparing the statement simply involves presenting the balances of each temporary account, just like putting revenue and expense balances on the income statement.
We have another suggestion concerning the reconciliation of income to cash flows, whether in the body of the statement or as a supplement. The traditional format begins with net income and then reports the necessary adjustments to transform it into operating cash flow. We believe that this schedule makes much more sense if it is inverted to start with cash flow and then moves to net income. Even though the same reconciling items are presented, they are presented with more logical operations.
For example, instead of adding depreciation back to net income, this format deducts it from operating cash flow to get to net income. Likewise, non-operating gains are added instead of subtracted. Based on our experience in explaining it to others, the items on this inverted schedule are easily comprehended, in contrast to the convoluted addbacks and deductions in the conventional reconciliation.
Of course, if you do switch, don’t expect your auditors to like it. Chances are they have not seen, or, better yet, audited a direct method presentation. Insist that they enter the modern age and do what you ask.
As a final point, managers who switch to the direct method will not encounter any risk of recrimination for straying outside GAAP’s boundaries. After all, it is not only permissible but preferable. That makes us wonder why more have not already taken this sure step toward reaping the rewards of meeting users’ needs.
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