Making a Financial Statement
After years of debate, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) have published a joint discussion paper entitled, ‘Preliminary Views on Financial Statement Presentation’. The discussion paper (DP) proposes a revolutionary change to the decades-old presentation of basic financial statements – i.e. the balance sheet and the income and cash flow statements – without changing the underlying accounting requirements. However, in the opinion of Standard & Poor’s Ratings Services (S&P), if the proposals set out in the DP are implemented, they would have equally significant implications for the analysis of financial statement information. The question S&P asks, therefore, is whether a complete replacement of the format of company financial statements is necessary when enhancements could be made to the existing format that might better resolve current concerns.
The two boards propose that the balance sheet is completely redesigned so that all assets and liabilities are categorised as relating to either operating, investing, financing, income tax, or discontinued operations. Furthermore, the income statement and the statement of cash flows would show earnings and cash items classified using these same categories corresponding to the assets or liabilities they relate to, thereby cohesively linking classification of items across the three statements.
The DP also proposes to replace the cash flow statement presentation that currently uses an ‘indirect method’ derivation of cash flows from operations – showing adjustments to an earnings measure (such as net income or operating income) needed to derive operating cash flows – with one that shows all cash flow amounts directly, listing amounts paid and received on a line-by-line basis that coincides with lines on the income statement.
S&P welcomes the wide debate that the DP has instigated on this important, far-ranging topic. Indeed, we believe it is critical for the boards to revisit the manner in which financial information is presented. In order to enable analysts better to estimate how a company may perform in the future, reporting should both explain the past well and provide a basis for understanding how the company responded to existing conditions.
However, while the DP proposes many major changes, we are not convinced that it does as much as it could to address issues that are relevant to the credit analysis that we undertake. We hope that these comments in gtnews may prove useful to companies that want to improve the transparency of their disclosure in advance of any new requirements.
The DP is intended, at least in part, to respond to requests for greater transparency of financial information by the investment and analytical community. For example, some of the issues S&P Ratings Services has commented on in the past relate to the clarity of what is driving movements in the value of assets and liabilities; greater disaggregation of revenues and expenses; and better information that would explain differences between accrual-based items of income and expense and related cash flows, including the results of changes in working capital.
Furthermore, no less important is the fundamental need to improve the basic reporting of underlying business transactions, linking them to the accounting policies applied and showing how they translate to financial statement amounts that track through lines of each of the separate financial statements. Although changing the financial statement presentation in and of itself will not necessarily solve this issue, it will clearly highlight areas and differences between companies that we expect could be expanded upon in more comprehensive disclosures. This would aid analysts and other users of financial statements in conducting more meaningful analysis based on better insights on the drivers of earnings and cash flows.
A prime example of the analytical difficulties faced when scrutinising current financial reports is the frequent lack of clear information on derivative activities of a company. This includes information on the terms of derivative instruments and their risk management or other business purpose, the method of hedge accounting applied (or not), the location of related amounts in assets, liabilities and equity, and the amounts included in earnings, cash flows, or being charged or credited to equity directly. Currently, disclosures are often lacking, utilise boilerplate language, or are incomplete.
As we have commented before to the boards, notably in our submission to their round table discussion in November 2008, we have significant concerns over disclosure that can for some companies be rather ambiguous and disconnected. These are concerns that we feel could be addressed by a basic disclosure framework, by requiring clear explanation of what the company’s underlying transactions are, how they have been accounted for, what the related amounts in the various financial statements are (and on which line items they are included), information on estimation (and why they have changed during the accounting period), and by their sensitivities to future changes.
Indeed, there are many ways that companies can communicate financial statement information to investors and analysts. They include financial statement presentation and narrative footnote disclosure, incorporating financial data tables and reconciliations. In our view, the financial statements and footnotes need to be considered as a package, rather than individually, and therefore the project on financial statement presentation should focus on identifying an optimal package of financial statement information that improves the quality of information and as such enables better analytical assessment.
The DP proposes a very detailed direct basis cash flow statement that enables a proposed reconciliation of cash flows to earnings. This particular aspect of the proposal has caused some controversy among preparers due to the perceived significant costs in generating detailed levels of cash payment and receipt information, and a lack of consensus among users of the need for information to be gathered in this manner. Indeed, much of the information that we believe would be useful for analysis could be provided through alternative means. In our view, the main drawback with the current indirect presentation of operating cash flows is not that it’s indirect, but that the items shown as differences between the earnings amount used and the amount of operating cash flows are often unclear. Indeed, we recommend that the indirect derivation of operating cash flow begins with operating income (not net income or another earnings measure). This limits the distance between the start point and operating cash flows by beginning with a more directly related earnings amount. This approach would also ensure a more consistent start point and a more consistent list of reconciling items. Adjustments to operating income should be described clearly in a manner that relates them to asset and liability descriptions on the statement of financial position. Discontinued operations should also be presented clearly on the statement itself or in the footnotes.
Comprehensive tables – such as the one proposed in the DP to reconcile all cash and earnings amounts – are useful if the totals shown are meaningful and/or the line-by-line detail is helpful. However, we find the Boards’ specific proposal in this regard lacking on both of these counts. In addition, many assets and liabilities seem likely to end up in the operating category, which in our view would not provide significant new insight.
We also note that, even with the proposed reconciliation of earnings to cash flows, the information provided in the DP still does not explain the full amount of change in balance sheet amounts, such as accounts receivable, during the year. In our view, more comprehensive information should be presented on the relationships between amounts on the financial statements. Reconciling the asset or liability amount from beginning to end of year could provide this link.
Furthermore, we would argue that such reconciliations should be provided for various lines on the statement of financial position. Indeed, many such reconciliations are already required by International Financial Reporting Standards (IFRS), including reconciliations of property, plant, and equipment (PP&E), intangibles, net postretirement benefit (PRB) asset or liability, and provisions.
Additional items for reconciliation could include debt (or each asset and liability included in financing, if a classification approach is used), working capital assets and liabilities, investments, derivatives, and taxes. The effects of business acquisitions, disposals, and foreign exchange translation on asset and liability values are very often not apparent, but should, in our view, also be identified in such reconciliations. Table 1 shows a sample structure for such a reconciliation table. Columns B to D would be described and potentially split into sub-columns to facilitate understanding of what the different components of change represent, and where they appear in the respective financial statements. Alternatively, the table could be rotated, with Columns A to F presented as rows, potentially allowing for greater disaggregation of the changes we have listed under columns B to E.
In our opinion, such reconciliation information is best presented in the footnotes, as this allows for a more meaningful description of the applicable changes than can be accommodated in a single table that includes all assets and liabilities. For example, developments such as transaction activity, amortisations, fair-value remeasurements, or impairments would, in our view, benefit from greater explanation in the form of separate footnote tables. Related assets and liabilities could be shown together in a single table, for example – one table listing various income tax assets and liabilities, one listing debt and interest components for related obligations, or one on derivatives and related assets and liabilities to help present the relationship between such items. Differences between cash and earnings amounts would be made apparent – shown as the amounts under column B versus column D in Table 1.
We believe that this package would provide clear information to support analysis, including the cash conversion cycle and the accounting cycle for underlying business activities, tracking through the statements of financial position, and cash and earnings flows. Although there is a lack of clarity in what is currently presented, we do not believe this necessitates a complete replacement of the format of company financial statements. Rather, we believe that more clarity could potentially be achieved with less radical changes than proposed by the boards and that changes could be introduced over time as enhancements to the current approach to presentation.
If the current indirect cash flow statement were to be removed, we do not believe that the set of statements and reconciliations proposed in the DP would generally provide enough information to work out the changes in working capital that are attributable to differences between related earnings and cash amounts. The cohesiveness approach advocated by the boards does not sufficiently extend to a reconciliation of a company’s assets and liabilities. Rather than introduce a detailed direct basis cash flow format, we consider that an improved indirect statement of cash flows would better provide the information desired by users, and would be particularly useful in our corporate ratings analysis.
We hope the two boards will consider retaining an improved version of the indirect derivation of operating cash flows and they will consider adding certain supplemental reconciliations of asset and liability balances. However, having received more that 200 letters commenting on the DP, it is uncertain whether this is the direction they will take. The current joint project plan calls for an Exposure Draft to be issued in the first half of 2010, and a final standard published in 2011. In the meantime, we continue to monitor the progress of this important project and participate in the ongoing discussion with the boards, issuers, investors, and other interested parties.
The themes explored in this article are covered in greater depth in a report posted on Ratings Direct, entitled “Standard & Poor’s Views On The IASB/FASB Financial Statement Presentation Proposal.”