This is our third installment on the recent CFA Institute monograph, A Comprehensive Business Reporting Model: Financial Reporting for Investors. The work, authored by a committee of experienced analysts, updates the 1993 commentary called Financial Reporting in the 1990s and Beyond. Like its predecessor, this report speaks forthrightly about the highly limited usefulness of current generally accepted accounting principles financial statements. (It's available without cost at http://cfapubs.org/.)The report's centerpiece is 12 principles that serve as a manifesto for replacing the status quo. We covered other principles in two earlier columns, and we now tackle a couple more.
Before doing so, it's worth a reminder that what you're about to read is not coming from two aloof academics. While we generally agree with what it says, the report expresses the frustrations of expert statement users who have to re-engineer GAAP financial information to get at least some idea of what they need to know. As prime consumers of financial reports, their views deserve careful consideration.
Here are the four principles that we discussed before:
1. Putting the focus on equity investors;
2. The usefulness of fair value information;
3. Understanding that reliability means more than verifiability; and,
4. The need to define materiality from the users' perspective.
On the first point, the report argues that shaping financial statements to meet investors' needs would take care of everyone else too. The second principle goes directly to the heart of the information that these equity investors want - nothing short of complete fair value financial statements.
The third principle puts to rest common misperceptions about reliability by explaining that it involves more than authentication. While verifiability is important, it has long been misused in justifying historical costs. According to the monograph (and the Financial Accounting Standards Board), representational faithfulness is equally, if not more, essential. However, the committee observes that much of GAAP "reflect[s] more of a concern for practicality (what is easiest to do and most easily verified) rather than from consideration of what would constitute the most useful information." Not quite a ringing endorsement for our profession's core concepts.
The fourth principle challenges conventional practice by stating, "Materiality assessments should use the standard of whether the item would make a difference to an informed investor." The committee's ultimate plea calls for materiality judgments to be based on users' needs.
We now turn to two other objectives that both advocate significant changes in the format and content of financial statements.
Statement of changes in net assets
The CFAI committee proposes that a new "Statement of Changes in Net Assets" should replace today's statements of net income and comprehensive income. The goal is to "provide full recognition in a single statement of all the events and transactions that can affect investors' wealth." Said another way, the statement would report all wealth-changing events, "not just those thought of as performance indicators."
The premises behind this proposal are that the statement should help users assess performance, and that "performance assessment is the responsibility of investors, not managers." In effect, these analysts are announcing that they want the raw data, instead of filtered and predigested reports. To describe it another way, they want to do it themselves, instead of relying on accountants to tell them what to think. By having a single, comprehensive statement of all wealth changes, users will be able "to select those items that are pertinent to the investor's particular perspective, analytic requirements and objective."
The net asset statement would report all operating, investing and financing transactions and events with their respective tax effects. Further, separate columns would be provided within each section to distinguish current accruals, estimates, and changes in fair values. In addition, individual line items would be reported according to their origin (e.g., labor), not the function to which they were applied (e.g., cost of goods sold). The committee prefers this system to avoid aggregating disparate items, which it says "results in information loss ... [that] reduces predictive power and analytic value."
Perhaps stunningly, the new statement would not include bottom-line summary performance measures like net income or the ever-pliable earnings per share. Instead, individual users would determine for themselves which reported items have relevant implications for future periods. The committee hopes that the new format without summary measures would help overcome managers' present unhealthy and dysfunctional fixation on short-term earnings.
This radical proposal would undoubtedly provoke a tremendous backlash if FASB were to ever give it serious consideration. Nevertheless, nothing about it is infeasible. Furthermore, if a single comprehensive statement is what users want, on what basis (other than a misjudged self-interest) would preparers or auditors base their objections?
Direct method cash flows
The report also sums up years of frustration with current cash flow reporting practices. The committee's premise here is that, "Investors use cash flow information as an important reality check on the quality of reported earnings." It also observes that a direct method cash flow presentation gives investors ready access to information they need for this task.
Unfortunately for users (and the capital markets as a whole), virtually all managers obstinately use the non-preferred indirect method that begins with net income and then lists a dozen plus and minus noncash items to arrive at operating cash flow. When the smoke clears, the users get only a single net cash flow number without clear knowledge of how it came about.
Some defend this reporting practice as nothing more than an inconvenience, because surely users who want the direct method can back into it from an indirect reconciliation. According to the committee's substantial experience, "It is impossible for even the most skilled analyst to create a reliable direct method cash flow statement for most companies with existing [indirect] data."
This conclusion completely overturns FASB's somewhat glib claim in SFAS 95 that the conversion is easily accomplished. In fact, it can't be done at all!
It's worth noting that the Financial Reporting in the 1990s and Beyond monograph made an impassioned plea: "Although FASB has not seen fit to mandate the direct method, and neither has the IASC, both endorse it as the preferable method. 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."
We cannot understand why virtually all financial statement preparers have totally ignored this clearly articulated and reasonable demand from a key consumer group.
Supply vs. demand
Despite current and past pleas, few managers provide more informative financial reports to satisfy the expressed demands of analysts, investors and other users. We simply cannot fathom why managements who compete so keenly for customers in their product markets completely ignore these clearly expressed needs of their customers in the capital markets. Their indifference cannot be justified by the lack of consequences.
Once again, here are four axioms that explain the sure results of not addressing users' needs: Incomplete information creates uncertainty; uncertainty creates risk for investors and creditors; risk makes them demand a higher return; and this higher return constitutes a higher cost of capital to the firm. The ultimate outcome has to be lower security prices. If management does not meet the markets' need for useful information, they are assuredly achieving the opposite of the goal that they claim to pursue.
We aren't so naive as to believe that this monograph will single-handedly reverse the self-destructive course that financial reporting has been tracking for decades under the misguided concept that addressing the needs of those who supply information (managers and auditors) is better than satisfying the users' demands. However, the CFAI report does make another prominent proclamation that the collective emperors of GAAP are stark naked.
At some point, the weight of these claims will stimulate fundamental change. Our hope is that it is sooner rather than later. Let's all hope that the analyst community isn't left waiting another 13 years.
Paul B.W. Miller is a professor at the University of Colorado at Colorado Springs, and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.
