It’s been called the most dramatic overhaul of financial statements since the cash flow statement was introduced more than two decades ago. But when the comment period closed last week on the ideas for radically changing financial statements, the proposed design from the world’s accounting standard setters had been called a few other things too: “poorly defined,” “confusing,” cluttered, “information overload,” “inconsistent with management’s internal reporting,” and, frequently, “costly.”
In October 2008, the Financial Accounting Standards Board and the International Accounting Standards Board jointly issued a discussion paper laying out their preliminary ideas for changes to financial statements that would fundamentally alter the way information is presented on the financial statements. Comments were due last week.
The two boards said their goal was to tie the different financial statements more closely together, provide deeper dives into financial numbers that are often aggregated at a very high level, and also provide a heavy emphasis on cash and liquidity. A key feature of the proposal is that managers would separate a company’s actual business activities from its financing or funding activities. As a result, each of the three statements — balance sheet, income statement, and cash-flow statement — will be divided into two major sections: business and financing.
The financing section will include those activities that fund a company’s business. For nonfinancial institutions, that would primarily include cash, bank loans, bonds, and other items that arise from general capital-raising efforts.
The business section — which would be further subdivided into operating and investing categories — would focus on what a company does to produce goods and provide services. The operating category will include primary or “core” revenue and expense-generating activities, and the investing category will include activities that generate a return but are not “core.”
Many preparers, particularly banks, commented that FASB and IASB needed to do more to clearly define ‘operating’ and ‘investing’ activities. “They’re using the same terminology that we use in FAS 95 for cash flows,” Grant Thornton partner John Hepp told CFO.com, “But they have completely different meanings from what they meant [in FAS 95].” Indeed, Hepp’s sentiments are echoed in Grant Thornton’s official comment letter, which notes not only that the distinction between the operating and investing sections is “very confusing,” but also that “the [discussion paper] itself uses three different descriptions.”
“I don’t think FASB or IASB is real clear on what these terms mean, so I don’t know how management would apply them,” Hepp added.
Some of the debate, of course, may come down to FASB’s and IASB’s desire to have management itself define what activities it considers to be part of their company’s business model for adding to shareholder value, versus simple investment returns.
“Users of financial statements analyze how a company creates value separately from how it funds that value creation,” said FASB senior project manager Kim Petrone in a webcast at the beginning of this year. “So we want to separate the creating activities from the financing activities.” Petrone explained that companies will begin by classifying assets and liabilities based on how they are used by management. “That management approach is going to be very important because it allows [the accounting] to apply to many different entities. It’s been asked if this will apply to banks, and it will apply to banks.”
But banks themselves were less than thrilled with that portion of the proposal. While conceding that it might be useful for investors of non-bank institutions to see financing activities separated from business activities, the American Bankers Association said “this kind of breakout will have little or no value to users of financial statements of banking institutions. . . . In essence, both investing activities and financing activities normally are operating activities at a bank.”
“The nature of the banking industry would lead, in our opinion, to the vast majority of activities being presented within the business activities (operating category),” concurred the British Bankers Association, adding that, for financial institutions, “we do not believe that the separation of business activities from financing activities will provide users with information that is more decision-useful than the current presentation method.”
While banks might find it impossible to distinguish between financing and operating activities, it is interesting to think that some of the distinctions proposed might have helped banks highlight the difference between actual losses and the writedowns that many were forced to take as a result of changes in fair value. Indeed, that’s what at least one analyst, not speaking specifically about the banking industry, suggested just over a year ago. “As we see more fair value coming through the financial statements, those statements need to do a better job of showing where the changes are coming from; this would help a lot,” Janet Pegg, a senior managing director and an accounting analyst at Bear Stearns, told CFO magazine in Feb 2008.
By far the single greatest concern of preparers, however, and one that was shared by companies of all types, was the suggestion that businesses be required to use the direct cash flow method. Among companies, there was near-universal agreement that their financial systems were not set up to capture such information and that doing so would be costly. “We strongly object” to the proposal to use the direct cash flow method, wrote FirstEnergy controller and chief accounting officer Harvey L. Wagner, who added that the costs to his company would “far outweigh” any benefit to investors.
Shell’s vice president of accounting and reporting, Paul Morshuis, agreed, noting he had not heard of any significant demand among financial statement users for the little-used direct method, “and therefore cannot see that this requirement could possibly survive cost/benefit analysis.”
Likewise, the Institute of Management Accountants devoted three full pages of its comment letter to explaining why most corporate computing systems are not set up to provide the sort of data the direct cash flow method would require. That complaint was repeated by Intel controller James Campbell, who said the information would be “extremely difficult” to obtain “without a complete system solution or at a minimum a partial system solution with extensive manual process enhancements.” He said the making the necessary modifications at Intel would “cost us in excess of $5 million in implementation costs and $2 million a year on an ongoing basis.”
In essence, the direct method of accounting tracks cash changes from the bottom up to arrive at net income, rather than starting with net income and making adjustments. (Currently, most companies use the latter, indirect method.)
“The feedback I’m hearing is mainly about the direct method,” says Grant Thornton’s Hepp, whose firm recently surveyed 511 CFOs about the financial statement presentation. A large majority of CFOs — 63% — said they were not even familiar with the project, a surprising result given the changes that it would require of publicly traded companies.
Of the 188 CFOs who were familiar with the project, a quarter of them said the proposed format would not be beneficial to users of their financial statements, while another 36% said that the proposed format would be beneficial, but that the benefits to users still would not justify the company’s cost of implementing it.
Another issue raised in the comment letters was whether such a substantial change should be rolled out at a time of economic crisis, particularly when FASB and IASB themselves are planning to accelerate the roll-out of several significant accounting changes by 2011. If American companies are required to adopt IFRS at the same time that new financial statements are implemented, wrote Intel’s Campbell, “it will create a tremendous amount of avoidable stress on our systems and reporting infrastructure.”
To be sure, most of the complaints came from preparers rather than financial statement users. In his comments, Kurt Schact of the CFA Institute, an advocate for analysts and investors, noted “We believe that the proposals . . . would address major shortcomings with current financial statement presentation . . . including the limited transparency of the cash flow from operations in financial statements.”
During a FASB webcast at the beginning of this year, Moody’s managing director Greg Jonas also seemed to contradict corporate claims that analysts typically don’t ask for a direct method cash flow statement, saying that he and other analysts have used the indirect method to analyze cash flows “because that’s all they have.” Both he and panelist Joe Joseph of Putnam Investments said they thought the direct method was superior for predicting future cash flows, though they admitted it would take time even for analysts to adjust to the change.
Still, preparers were skeptical. IBM “is aware that limited academic research supports the hypothesis that the direct method of cash flow provides better predictive value to future operating cash flows than either the indirect method or the income statement,” wrote Gregg L. Nelson, the company’s vice president of accounting policy and financial reporting. But if that were true, he argued, companies themselves would use that information for internal reporting, something IBM and many other companies insist they do not do. “To state the obvious,” added Nelson, “future cash flow is largely driven by future transactions. Historical data is of limited predictive value.” IBM, he wrote, believes that revenue, days sales outstanding, changes in accrual balances and company information should be sufficient for investors to make their decisions.