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We Need Better Financial Reporting


BY C. RICHARD ALDRIDGE, CPA,
AND JANET L. COLBERT, CPA


During the past few years, successful businesses have become more customer and service oriented rather than product oriented. Entities are concentrating on human resources, information and data, and research and development as they adapt to rapid changes in technology and increased competition. The new focus replaces the traditional objective of managing and controlling raw materials, direct labor, and overhead.

Financial reporting, however, has not kept up with these advances. The traditional financial reporting model is grounded in historical costs and the reporting of economic events, so it needs to be broadened to make it more informative and useful to investors, creditors, and their advisors.

For users of business information and for financial markets, the stakes in an informative model of reporting are high. Capital allocation decisions are made based on information received from management, and accurate, timely information facilitates the flow of capital to the most appropriate business opportunities. In turn, capital allocation decisions and the liquidity of capital markets affect the competitiveness of the nation as a whole. Thus, it is critical for a business reporting model to encompass information needed by users.

The current model of financial reporting requires fairly consistent accounting principles and disclosures-with some limited range of choices-regardless of the company's industry or the particulars of the business. A more flexible model that emphasizes the usefulness of company-specific information is more appropriate in addressing the needs of users of business information.

BUSINESS REPORTING RECOMMENDATIONS

In 1994, the AICPA's Special Committee on Financial Reporting1 issued a report titled Improving Business Reporting-A Customer Focus that called for significant changes to the current model of financial reporting. The recommendations are not binding on any standard-setting body or regulatory agency, but both the Financial Accounting Standards Board and the Securities & Exchange Commission continue to study the proposals and may choose to incorporate them into their own standards and releases. Because of the expanded focus, which includes not only financial reporting matters but also broader business issues in management's reports to users, it is important for management accountants and financial managers to understand the recommendations.

Business Reporting recommends changes in four areas:
  • Extending the business information model,
  • Enhancing financial statements,
  • Improving auditing, and
  • Facilitating change.


Extending the business information model. Business Reporting recommends improving the information provided to financial statement users by expanding the business information model to include nonfinancial as well as financial information and to provide forward-looking as well as historical information. These two elements are incorporated in the five categories of the extended business reporting model as shown in Table 1.

Traditionally, financial statements have been the primary means by which information about a company is communicated to users, yet they disclose financial information only. Today's users also demand nonfinancial or operating information. Nonfinancial information helps users understand the connections among ongoing events, the financial statements, and factors that produce long-term value and wealth for the company. Operating data can provide information to users before the effects of events are captured fully in the financial statements.

Although most of today's financial reporting focuses on the past, which may be useful when making predictions, users are more concerned with the future. Useful forward-looking information includes key trends and the disclosure of expected opportunities and risks resulting from those trends. Management's plans also should be disclosed along with factors critical to the plans' success. Finally, management should assess how actual business performance compares to previously disclosed opportunities, risks, and plans. To guard against unwarranted litigation risk, forward-looking information would be disclosed only with appropriate safe harbors. Safe harbors are specific requirements or standards that, when followed properly, preclude management from being held liable for its disclosure of forward-looking information.

Table 2 shows an annual report format a company might use in compliance with Business Reporting. Western Builders Supply, Inc., markets building materials to individual homeowners and small contractors. All stores house a retail unit as well as a contractor sales area. The annual report contains background and historical information on the company and both segments, management's analyses, information about management and shareholders, forward-looking information, and the auditor's report.

Enhancing financial statements. In addition to enlarging the reporting model, the Special Committee also recommends improving the financial statements within the model. Financial statement users say they are satisfied with the general framework of financial statements, but several areas could be enhanced. Here are some of the suggestions:
  • Improved disclosure of segment information,
  • Improved disclosure and accounting for innovative financial instruments,
  • Improved disclosures of the opportunities and risks of off-balance-sheet financing,
  • A clear separation of the effects of core and noncore activities and events,
  • Improved disclosures about the uncertainty in measurements of certain assets and liabilities, and
  • Improved quarterly reporting.


Segment data. Users note that multisegment companies often do not report enough segment information in their financial statements. In some cases, information is presented for too few or no segments, while, in other cases, insufficient detail about segments is provided. Because proper analysis of companies involved in diverse businesses is important, segment information is as significant as information about the company as a whole.

Business Reporting recommends defining segments consistently as companies do frequently when reporting internally to senior management. Geographic segment data also should be disclosed when they provide insight into the company's opportunities and risks. In addition, better information should be provided about unconsolidated investments and other affiliations.

Innovative financial instruments. The proliferation of complex innovative financial instruments such as swaps, compound options, and collars has not been followed by changes in financial reporting requirements. Disclosures are needed to address user questions such as: What risks have been transferred or taken on? What are management's objectives? What effects do these instruments have on the company's financial statements?

Off-balance-sheet items. Long-term leases, special purpose entities, joint ventures, long-term purchase agreements, and other similar transactions and events are not understood easily by users because they generally are not reflected in the financial statements. Disclosures and accounting requirements are needed to ensure that the risks, opportunities, resources, and obligations that result from these special arrangements are represented fairly in business reporting.

Core activities. Predictions of future earnings and cash flows can be made by examining historical data that exclude unusual and nonrecurring activities or events (noncore effects). Consequently, Business Reporting recommends that management should quantify and display separately the effects of core (usual and recurring) and noncore activities and events on the face of the income statement, balance sheet, and cash flow statement. Noncore events and activities and their effects also should be described clearly in notes to the statements. The Committee recommends that noncore assets and liabilities be measured at fair value because these assets and liabilities are not part of the ongoing business.

Measurement uncertainties. Some assets and liabilities can be measured with great precision, while others require considerable estimation. For example, there should be no question about the cash balance at the balance sheet date. The accrued liability for environmental cleanup is much less certain. So users can understand the uncertainties inherent in some measurements, companies should identify in notes to the financial statements the specific types of assets and liabilities subject to significant measurement uncertainties. Management should disclose how these amounts were derived and explain the estimates, judgments, and assumptions used in making the measurement.

Quarterly reporting. Quarterly reports often give users the first indication of important trends or changes in a company's business. But some companies that report quarterly often do not report on the fourth quarter separately. Although users can derive fourth quarter data from the annual and prior quarterly reports, they would benefit from separate fourth quarter reporting including an analysis by management of fourth quarter activities and events. Business Reporting also recommends including more segment information in quarterly reports.

Improving auditing. The third component for better overall business reporting is improved auditing. At present, auditors report only on information derived from the accounting records. Under the expanded model, auditors will be called on to provide assurance on additional, more subjective information. Providing this assurance would require new skills and new auditing standards.

An auditor's involvement will vary from company to company and should be determined by the company and the users of the business reports. Some users might demand an audit, the highest level of assurance. Other users might find a review, which provides a much lower level of assurance, to be sufficient. The auditor's report must be tailored to meet a variety of assurance needs.

Facilitating change. The final recommendation in Business Reporting involves facilitating change. Business reporting must be responsive to changes in the business and economic climate, especially advances in technology and the rush toward a global marketplace.

To facilitate change, standard setters must focus more on users' needs by asking for users' direct involvement in the evaluation reporting process. Users also are encouraged to increase their direct involvement in the standard-setting process through participation on standard-setting boards, advisory councils, and task forces. Finally, if business reports are expanded to include forward-looking information, measures need to be implemented to discourage unwarranted litigation. Such measures could involve safe harbors and specific provisions relative to forward-looking information that enable companies to demonstrate their compliance with requirements.

OUT WITH THE OLD-IN WITH THE NEW

The present financial reporting model has not been altered significantly for decades. Concerns about the deteriorating relevance of financial reporting have been expressed for some time. When surveyed by the Special Committee on Financial Reporting, users indicated that not all their needs were met by traditional financial reporting. Although financial statements provide crucial information for investment and credit decisions, users have developed other sources for additional important information. But this information is less reliable than information prepared under GAAP and audited by CPAs. To meet users' needs, all relevant information should be included in a comprehensive, integrated business reporting format.

The recommendations offered by the Special Committee on Financial Reporting differ from current financial reporting in three ways. First, high-level operating data and performance measures would become an integral component of the reporting process. Current financial reporting requirements require no disclosure of operating information, yet performance measures used by management are important to users. The inclusion of operating data and other performance measures would allow users to understand management's perspective and the connection among ongoing events, the financial statements, and factors that create long-term value and wealth for the company.

Second, forward-looking information would be included in the reporting process because it would give users insight into management's vision and the opportunities and risks associated with an investment or a loan.

Third, segment reporting would be expanded and improved. Although under current financial reporting requirements some segment data must be disclosed, under the suggested recommendations segments would be defined in a manner that is consistent with internal reporting to senior management. Geographic segment data also would be required as companies with multiple segments operate diverse businesses that are subject to different opportunities and risks. Improved segment reporting provides additional insight about the opportunities and risks of each business activity and sharpens predictions.

BENEFITS VS. COSTS

Increased competition and advances in technology have changed the way companies are organized and managed. The companies that are successful in today's marketplace focus on customer needs. Similarly, to foster efficient capital allocation among companies, financial reporting must focus on the needs of the customer-the user. As usual, there are both benefits and costs associated with supplying additional information.

Benefits. First, improved reporting should result in lower capital cost as investors' information risks are reduced. Second, more efficient trading should result in highly liquid markets as investors and creditors become better informed. Third, the new reporting model should meet the increased demand for more information by institutional investors and financial analysts and result in better relations with all users.

A fourth benefit to companies is the reduced cost of not having to maintain two sets of accounting records. The new reporting format would present information to external users in a manner that is consistent with the information management uses in making decisions. This uniformity of information for external and internal users also could reduce "window dressing" and suboptimal behavior by management. Fifth, an expanded, comprehensive business report reduces the potential for litigation when companies divulge information to some users (financial analysts) that has not been disseminated to all users. Finally, a comprehensive business report would reduce the cost and the potential for inconsistency of preparing the many reports that are required by various user groups.

Costs. Users may become "information junkies" because they do not bear the direct cost for the information they demand. But information contained in financial and business reports does have a cost. First, companies incur costs in preparing and disseminating information, which include the costs of collecting and processing data, the costs of refining the data to a quality level necessary for public disclosure, and the costs of auditing the data (if audited). Second, companies incur liability and litigation costs to defend against claims that the information is misleading. These costs are especially relevant given the recommendation that companies report forward-looking and other "soft" information. Third, in providing information to users, companies incur competitive costs. That is, Company A may provide information that Company B, a competitor, may find useful. If disclosure of the information is required by GAAP, no unfair advantage would result as Company A would have access to the same information about Company B. Competitive costs could be significant if the competitor is not subject to U.S. GAAP.

The Special Committee on Financial Reporting attempted to evaluate the benefits and costs of the proposed reporting model before making its recommendations. Although its analysis was more qualitative than quantitative, the Committee concluded that the benefits of the proposed general recommendations exceeded the costs. As standard setters attempt to implement the recommendations, however, they should assess the costs and benefits of specific standards.

THE CHANGE IS NECESSARY

Because businesses have changed so dramatically since traditional financial statements were developed, a corresponding change is needed in the way businesses report to investors and creditors. A broad reporting model that encompasses not only financial information, but also operating data, management's analyses, forward-looking information, facts concerning management and shareholders, and company background, is beneficial to users. Such company-specific information helps investors, creditors, and their advisors make appropriate capital allocation decisions. Although companies will incur costs to disseminate a wider spectrum of information to users, the benefits of lower costs of capital, more liquid markets, better investor relations, decreased preparation cost, reduced potential for litigation, and consistent information provide significant advantages to users. 


C. Richard Aldridge, CPA, is professor of accounting at Western Kentucky University in Bowling Green, Ky. He is a member of IMA's South Central Kentucky Chapter and can be reached at (502) 745-3099.

Janet L. Colbert, CPA, CIA, is the Meany-Holland Professor of Accounting at Western Kentucky University. She can be reached at (502) 745-2971.


1 American Institute of Certified Public Accountants, 1994. The Committee sometimes is referred to as the Jenkins Committee after its chair, Edmund Jenkins.


Recent Developments

The AICPA continues to campaign for an expanded business reporting model. Earlier this year, its Special Committee on Assurance Services released a report detailing the results of research and recommendations related to the future of assurance services. The document strongly supports the Business Reporting model and urges the FASB to adopt its recommendations. The report also encourages the SEC to view positively the accounting profession's efforts to expand the business reporting model because enhanced decision-making information benefits decision makers and the economy.


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