Published: January 01, 2010
Following the recent proposals published by the International and U.S. Financial Accounting Standards Boards for the presentation of financial statements, Sue Harding, European Chief Accountant for Standard & Poor’s Ratings Services, discusses how helpful the proposed changes would be for credit analysis.
Having debated this issue for a number of years, the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) have now published a joint discussion paper entitled ‘Preliminary Views on Financial Statement Presentation’. The discussion paper (DP) advocates a radical change to the decades-old presentation of basic financial statements – the balance sheet and the income and cash flow statements - without changing any of the underlying accounting requirements. However, in the opinion of Standard & Poor’s Ratings Services, if the proposals described in the DP are introduced, the implications for the analysis of financial statement information would be no less significant. The question S&P would raise, therefore, is whether simple enhancements could be made to the current format of company financial statements that might better resolve concerns than a complete replacement of the format.
The proposal from the two boards aims to cohesively link classification of items across the balance sheet, income statement and statement of cash flows. This entails a complete redesign of the three statements so that all assets, liabilities, earnings and cash items are categorised as relating to either operating, investing, financing, income tax, or discontinued operations.
On the cash flow statement, the boards also propose to replace the ‘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 a method that shows all cash flow amounts directly, listing amounts paid and received on a line-by-line basis that corresponds with lines on the income statement.
We believe it is crucial for the boards to examine how financial information is presented and as such Standard & Poor’s welcomes the wide debate that this DP has triggered on this important, far-ranging topic. Our firm belief is that in order to enable analysts to better 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.[[[PAGE]]]
However, while the DP proposes many major changes, we are not certain that it does as much as it should to address issues that are relevant to this form of credit analysis. We hope that these comments in Treasury Management International may also prove useful to companies that want to improve the transparency of their disclosure, even in advance of any new requirements.
One of the intentions of the DP, at least in part, is to respond to requests from the investment and analytical community for greater transparency of financial information. 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.
No less important is the fundamental need to improve the basic reporting of underlying business transactions. Financial reporting should link underlying transactions to the accounting policies applied and show how they translate to amounts that track through lines of each of the separate financial statements. Although this issue will not be fully resolved simply by changing the financial statement presentation in and of itself, the proposed changes will clearly highlight areas and differences between companies that we expect could be expanded upon in more comprehensive disclosures.
Under the current format, reports can often lack clear information, for example, on derivative activities of a company, including 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, such disclosures are often lacking, utilise boilerplate language, or are incomplete and clearly present analytical difficulties for analysts scrutinising current financial reports.
We have significant concerns over current disclosure that can for some companies be rather ambiguous and disconnected, as we have commented before to the boards, notably in our submission to their roundtable discussion in November 2008. These are concerns that we feel could be addressed by a basic disclosure framework that requires clear explanation of what the company’s underlying transactions are, and links this to 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.
The boards should focus on identifying an optimal package of financial statement information that improves the quality of information and as such enables better analytical assessment. Indeed, there are many ways that companies can communicate financial statement information to investors and analysts, including 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 an entire package, rather than individually.
In order to enable reconciliation of cash flows to earnings, the DP controversially proposes a very detailed direct basis cash flow statement. Indeed, preparers perceive significant costs in generating detailed levels of cash payment and receipt information, and there is a lack of consensus among users of the need for information to be gathered in this manner. In fact, 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 it is often unclear which items shown represent differences between the earnings amount used and the amount of operating cash flows. We recommend that the indirect derivation of operating cash flow begins with operating income (not net income or another earnings measure). By beginning with a more directly related earnings amount the distance between the start point and operating cash flows is limited. This approach would also ensure a more consistent start point and a more consistent list of reconciling items. Discontinued operations should be presented clearly on the statement itself or in the footnotes and 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.
Comprehensive tables are useful if the totals shown are meaningful and/or the line-by-line detail is helpful. However, we find the table proposed in the DP to reconcile all cash and earnings amounts to be lacking on both of these counts. Furthermore, 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 would not explain the full amount of change in balance sheet amounts, such as accounts receivable during the year. In our view, not only should more comprehensive information be presented on the relationships between amounts on the financial statements, but we would also argue that reconciliations of asset or liability amounts from the beginning to the end of year 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 post retirement benefit (PRB) asset or liability, and provisions. Additional items for reconciliation could include debt (or under the classification approach, each asset and liability included in financing), working capital assets and liabilities, investments, derivatives and taxes.[[[PAGE]]]
Elements that are very often not apparent, but should, in our view, also be identified in such reconciliations include the effects of business acquisitions, disposals, and foreign exchange translation on asset and liability values. 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.
Certain developments in assets and liabilities, such as transaction activity, amortisations, fair-value re-measurements and impairments would, in our view, benefit from more specific explanation in the context of the specific assets and liabilities to which they relate. As such, in our opinion, reconciliation information is best presented in the footnotes to allow for a more meaningful description of the applicable changes than can be accommodated in a single table that reconciles all assets and liabilities. However, several related assets and liabilities could be shown together in a single table – for example a table listing various income tax assets and liabilities, one listing debt and interest components of related obligations, or one for derivatives and related assets and liabilities – in order to help present the relationship between such items. Differences between cash and earnings amounts would also be made apparent without the need for the reconciliation table proposed in the DP – shown as the amounts under column B versus column D in table 1.
We believe that this more comprehensive approach would provide clearer information to support analysis, including the cash conversion cycle and the accounting cycle for underlying business activities, tracking through all the statements - connecting financial position, and cash and earnings flows. We do not believe that the lack of clarity in what is presented in reports at present 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 those currently proposed by the Boards and that changes could be introduced over time as enhancements to the current approach to presentation.
We do not believe that the set of statements and reconciliations proposed in the DP – if the current indirect cash flow statement were to be removed – 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, together with certain additional asset and liability reconciliations, would better provide the information desired by users, and would be particularly useful in our corporate ratings analysis.
We understand that the boards are now considering a range of approaches, including steps we have advocated to retain an improved version of the indirect derivation of operating cash flows. They will also consider adding certain supplemental reconciliations of asset and liability balances that could vary between companies to focus on information most relevant to an understanding of their activities. The current joint project plan calls for an Exposure Draft to be issued in April 2010, and a final standard published in June 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.
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