This chapter discusses the information needs of users based on the Committee's study. As discussed in chapter 2, the Committee's study, and therefore the following summary, applies to certain types of users ; specifically, professional investors and creditors, and their advisors, that follow fundamental approaches and that cannot compel a company to produce the information needed for analysis. Users' differ in their needs for information. A short term trade creditor may need far less information than a longterm equity investor.
The study sought to understand the extent of and reasons behind that diversity. The following discussion focuses on the information needs of users that have extensive needs for information and that look to business reporting as a major source for that information. Predictably, the study indicated that users have a wide spectrum of opinion on many issues and insatiable appetites for information. When asked, users frequently say they want all possible information. Although that request is impractical, it reflects a willingness of users to wade through volumes of information to differentiate that which is useful from that which is not. As discussed in chapter 2, the study focused on views that are generally representative of users and it distinguished between information needs and less important information. The following summarizes users' needs for information, not the Committee's recommendations to improve business reporting.
Because of costs and other factors, business reporting cannot ; and should not ; meet all users' needs for information. Costs of business reporting are discussed in chapter 4, and the Committee's recommendations are discussed in subsequent chapters. This chapter is divided into six sections: (1) objectives and approaches of users, (2) diversity of users' needs for information, (3) concepts underlying users' needs for information, (4) types of information that users need, (5) sources of information, and (6) qualitative aspects of information in business reporting.
The objective of business reporting is to provide users with information that is helpful in deciding whether and at what price to commit, or continue to commit, resources to a particular company. The objectives and approaches differ depending on several factors, including whether users are evaluating equity securities (investors) or debt securities (creditors).
An investor's primary objective is to form opinions about the absolute and relative value of companies and their equity securities. In meeting that objective, investors use a variety of approaches to value companies and equity securities, including the following:
The approaches may be performed individually or their results may be combined. They may be performed on a companywide basis or separately for individual segments.
A creditor's primary objective is to assess the ability of a company to meet its obligations related to current or future debt, or other financial instruments, through timely payment of principal and interest or, as a last resort, through transfer of a collateralized asset. In meeting that objective, creditors use a variety of approaches, including the following:
The approaches may be performed individually or their results may be combined. They may be performed on a companywide basis or separately for individual segments.
Users have diverse needs for information. The information an individual user needs depends on the approach followed, the instrument being evaluated, the company's various businesses and circumstances, and the user's personal preferences. The following discusses how those factors affect the information users need.
The approach used by users sometimes affects their needs for information. For example, contrast the information needs of investors that follow the earnings momentum approach as a means of predicting shortterm stock price changes with those of investors that follow the fundamental approach as a means of determining the longer term value of a company's stock. Earnings momentum investors probably have extensive needs for information that helps predict nearterm earnings and yet they probably need little information about the expected longterm impact of key trends. In contrast, investors following the fundamental approach probably are less concerned with nearterm earnings but need far more information about the longterm impact of key trends.
The nature of the financial instrument under analysis often affects users' needs for information. For example, contrast the information needs of a bank credit officer who is evaluating a potential loan for an excellent credit risk and a bank trust department evaluating the same company's stock. If it is widely accepted that the company's cash flows are more than sufficient to pay its debts when due, then the credit officer may require no more information than the most recent audited financial statements and may use those statements only to verify certain key financial ratios.
Further, the credit officer may need little information about risks if those risks are judged to be minimal in relation to the excess cash flows. Finally, the credit officer may need no information about the company's opportunities. In contrast, the trust department may need more extensive information. It may need sufficient information to forecast the company's earnings and detailed information about its opportunities and risks to judge the uncertainties of those earnings.
A company's businesses and circumstances can affect users' needs for information ; for example, a company's circumstances can affect the extent to which investors need historical information. In most cases, historical financial and nonfinancial or operating business information over a tenyear period provides a foundation on which users can evaluate the future. However, for some companies, recent circumstances may have changed so that historical information is not as helpful in predicting the future. Those situations are typical of startup companies; cases in which changes in technology have redefined the market, product, or production process; and of companies emerging from dramatic restructuring, such as bankruptcy.
A company's circumstances also can affect the extent to which users need information about the value of certain assets. In many cases, the historical cost of assets provides useful information, and users have little need for fair value information. However, in some cases, the value of a company is based on the fair value of a few key assets or classes of assets. Examples include some natural resource companies for which the value of proved reserves or deposits determines a company's value. In those cases, users will need information that helps them value the key assets.
Another factor that affects users' needs for information is users' preferences. Two users may evaluate the same security, use the same approach, and yet have different needs for information because they assess facts differently, emphasize different matters, or have different time frames for their analyses.
Even users with the same needs for information may have diverse needs for business reporting because of alternative sources for information. For example, users that have easy access to management may need less information from business reporting because they can satisfy their needs for certain information through discussions with management. In contrast, other users with little access to management may need more information from business reporting to satisfy their needs for companyspecific information.
Regardless of the diversity just described, users, particularly those with extensive needs for companyspecific information, share much in common in analyzing information in business reporting. The Committee's study identified seven concepts underlying users' needs for information, which are described below.
For users analyzing a company involved in diverse businesses, information about business segments often is as important as information about the company as a whole. Segment reporting provides a proven and powerful tool to identify and analyze opportunities and risks that diverse companies face. Understanding opportunities and risks is key to determining whether to invest or extend credit and, if so, how to price that investment or credit. Further, for a diverse company, users find it more effective to project earnings or cash flows on a segmentbysegment basis than on the basis of the company as a whole. Also, when valuing companies, users often apply a different multiple or discount rate to a segment's earnings or cash flows, reflecting the diverse opportunities and risks of each segment.
Segment data thus provide for a more refined valuation than otherwise would be possible. There are many bases on which to segment a company's activities. They include industry, product lines, individual products, legal entities within a company, geographic based on where a company produces products or delivers services, geographic based on where a company sells its products or services, and others. Depending on the circumstances, any of those bases could provide useful information. However, the study indicates that industry segment information most frequently provides the greatest insight into the opportunities and risks a company faces. Segmentation based on geographic location also provides insight, although it often is of less interest to users than is industry segment information. Some users, particularly creditors, prefer segmentation based on legal entities. (See exhibit 1.)
Information about industry segments is particularly useful because industry structure is a key driver of opportunities and risks in nearly all businesses. Industry structure ; the relationships among competitors in an industry, the bargaining power of suppliers and customers relative to other companies in the industry, the threat of new competitors and of substitute products or services ; is a key determinant of future profitability and cash flows. Management, auditors, regulators, rating agencies, and users themselves frequently adopt an industry focus, in part because of the insight that focus brings in managing, auditing, or evaluating companies in an industry.
For many users, the industry segment in a multisegment company is the unit of analysis ; the unit users seek to understand in assessing the opportunities and risks a company faces. Although they are comfortable with the concept of industry segments, users are troubled by its application in practice today. They believe many companies define industry segments too broadly for business reporting and thus report on too few industry segments. As a result, users say, they are unable to evaluate opportunities and risks at a sufficient level of detail.
Exhibit 1
Key trends (for example, political, sociological, regulatory, economic, and technological) vary widely from location to location. Thus, information based on the geographic areas where a company does business often provides important insight into a company's opportunities and risks resulting from those trends. For example, a company in a geographic region with a rapidly growing demand for its products is obviously in a better position than a competitor in regions where demand is not as favorable. Information about geographic segments can help distinguish between companies well positioned to take advantage of market opportunities and those that are not or those that are exposed to certain risks and those that are not, thereby providing important information about the opportunities and risks companies face. Two categories of geographic information may be helpful in assessing opportunities and risks. The first is based on where a company sells its products or services (market locations).
The second is based on where a company produces products or services (operating locations). Market locations affect the opportunities and risks for a company's revenues, and operating locations affect the opportunities and risks related to a company's costs. Both affect the opportunities and risks related to a company's assets. Although both perspectives may be useful, if forced to choose, users generally prefer information based on market locations because a company's success in the marketplace usually is the key driver of future earnings and cash flows. The configuration and extent of geographic areas that companies should report vary depending on the company and its circumstances. For some, major areas of the world ; such as the Americas, Europe, and Asia ; are the drivers of opportunities and risks. For others, individual countries, or regions within a country, provide the most insight.
For example, the different economic conditions in various regions within the United States may be important to the operations of a real estate company with nationwide operations. Although useful for many companies, geographic information may not provide much insight for some. For example, the technical performance of a new product may so dominate the opportunities and risks of a startup company that geographic segment information may not add much value. As another example, a company may sell its products to a handful of customers that, in turn, use it in products they distribute around the world. In that case, geographic information based on where the company ships products to its customers may not be useful.
Creditors often lend money to a particular legal entity within a consolidated group of companies. Thus, they have an interest in understanding the opportunities and risks of the particular legal entity and how its operations and financial affairs relate to those of other legal entities in the consolidated group. To meet their needs for information about legal entities, some creditors request financial statements by legal entity, in a consolidating format. Information about legal entities is less important or unimportant for users evaluating investments in a consolidated entity.
All users following fundamental approaches of analysis need to understand the nature of a company's businesses, including the linkage between events and activities and the financial effect on a company of those events and activities. The nature of a business refers to the types of products or services offered, the methods of producing or delivering those products or services, the number and types of suppliers and customers, the locations of facilities and markets, and other factors that describe the activities of a business.
Users cannot assess the risks and opportunities related to a company whose activities they do not understand. Understanding the linkage between events and activities and the financial effect on a company of those events and activities is a critical part of understanding a business. Users recognize that financial results are a consequence of a company's business activities and events. Thus, users analyze and predict both business activities and events and the financial consequences of those activities and events. That process requires users to translate into financial terms their predictions of activities and events. That translation, in turn, requires that users also understand the linkage between activities and events and the financial effect of those activities and events.
Users need a forwardlooking perspective because their goal is to predict a company's financial future. But how do they obtain a forwardlooking perspective? The study indicated that users use three methods:
Users seek management's perspective about the businesses it manages for three reasons. First, management is closest to the businesses and therefore often the best source for companyspecific information. Second, management influences a company's future direction. Thus, understanding management's vision for the company and its plans for the future provides users with a valuable leading indicator of where management will lead a company. Third, management's perspective provides users with valuable information to evaluate the quality of management, which also may be a leading indicator of the company's future performance.
The usefulness of information is a function of its relevance and its reliability. Users obviously need information that is most relevant for their purposes. They also need information to be as reliable as possible. A large portion of relevant information also is reliable. For example, a company's contractual debt obligation usually can be reported reliably. However, other relevant information is inherently less reliable. For example, management may be very uncertain about its estimate of a liability for warranty claims. Users need all information that is relevant for their purposes, including relevant information that is inherently less reliable.
However, users also need to be able to distinguish between information that is highly reliable and that which is less reliable; that is, they need to understand the measurement uncertainty of less reliable information. Understanding measurement uncertainty is important for at least two reasons. First, certain users may choose to reduce their reliance on information depending on the relative reliability of the information. Second, users consider information risk when valuing companies or evaluating credit risk. The reliability of information is discussed further under "Qualitative Aspects of Information in Business Reporting."
Users do not evaluate a company in a vacuum. Rather, they usually evaluate several companies at once. Users usually are deciding about which of a myriad of companies in which to invest ; their investment options rarely are restricted to a single company. Further, comparing companies, particularly competitors, is useful in assessing relative strengths and weaknesses. Comparing companies requires a basis for the comparison a yardstick against which to evaluate one company against others. Usually the basis for comparison involves measurements of various types.
Examples include financial measures about assets, liabilities, equity, revenues, expenses, gains, losses, and cash flow. To be comparable, measures must be computed in the same fashion. For example, it is not useful to compare financial measures denominated in U.S. dollars to measures denominated in Japanese yen. Enabling the comparison of information is a key reason for business reporting standards, which specify the types of measures to be reported and how they are computed. Comparability is discussed further in the section below, "Qualitative Aspects of Information in Business Reporting."
One ingredient of relevant information is timeliness, which is important particularly for users of business reporting. Users need to understand promptly the important changes affecting a company. Important changes often affect users' decisions to commit or continue to commit capital to a company and, in extreme circumstances, may permit a user to effect change at a company in time to improve or protect the value of an investment. For example, an important positive development could cause a creditor to extend a loan commitment or to renew a commitment under more favorable terms to a company. Failure to understand promptly important changes increases the risk of mistakes in allocating and pricing capital. Companies use business reporting as one vehicle to report important changes. Thus, the frequency of that reporting determines whether such changes are communicated promptly.
Many users seek new information about the economy, an industry, and a company and based on that information, update their views about a company's prospects on a regular basis. Quarterly reporting from the company is consistent with users' needs for updated information, with the exception of critical transactions and events, which should be reported within a few days of the transaction or event. Users believe more frequent reporting, such as monthly reporting, is not necessary because it is too short a period to discern trends or changes in trends. However, for many users, annual information from a company is not sufficient. Quarterly reporting helps users identify, on a timely basis, trends and changes in trends affecting a company. Because users extrapolate trends, changes in users' perceptions about them often affect their judgments about a company's future.
Thus, users need information about changes affecting a company shortly after those changes occur, without the significant lag that often would result from annual reporting alone. Some believe, including some in management, that the importance of quarterly reporting is overemphasized. They believe that the securities market is too shortterm oriented and quarterly reporting reinforces that shortterm view. Thus, they suggest that quarterly reporting by public companies be abolished or, at a minimum, that improvements in quarterly reporting are unnecessary. They see little reason to accommodate the information needs of shortterm users that serve only to increase the volatility of stock prices. They argue that annual reporting is sufficient for users with longer term views. Users believe strongly that quarterly reporting by public companies should be retained. The Committee agrees with that belief for three reasons:
Quarterly reporting by public companies has been accepted for many years. Further, many private companies report on an interim basis at the request of users. However, interim reporting is not needed by all users. For example, a trade creditor of a wellestablished, profitable company may be comfortable with annual reporting by its customer. Users often do not need to have all private companies report quarterly; the need for interim reporting varies for private companies.
The study identified the types of information that users need, focusing on the information needs of users with extensive needs for information. The types of information are limited to what can be provided by business reporting. More specifically, they are limited to companyspecific information for which management is often the best source. Users need companyspecific information in five categories, which are consistent with the concepts underlying users' needs for information discussed above:
The following section discusses the types of information in each category and how that information helps users meet their objectives.
The data in this category are of two types: (1) financial statements and related disclosures and (2) highlevel operating data and performance measurements that management uses to manage the business. Each type is discussed below.
Financial statements are the center of business reporting. They represent the financial picture of a company, both at a point in time and over a period of time, translating into financial terms many, but not all, of the events and activities that affect it. Investors use financial statements for various purposes, such as an analytical tool, a management report card, an early warning device, a statement of collateral or security interest, and a device for control and accountability. Many investment decisions ; such as whether to lend money; whether to buy, hold, or sell securities; and how to price transactions ; are based, in large part, on the information in financial statements.
The Committee's study confirmed the importance of financial statements. Financial statements generally provide users with essential information that heavily influences their decisions. There is no evidence that users are abandoning analyses of financial statements because they believe the information is irrelevant or for other reasons. The study indicated that financial statements are an excellent model for capturing and organizing financial information. They package information in a structured fashion that permits analysis of a wide range of trends and relationships among the data. These trends and relationships, in turn, provide considerable insight into a company's opportunities and risks, including growth and market acceptance, costs, productivity, profitability, liquidity, collateral, and many others. No user suggested that financial statements should be scrapped and replaced with a fundamentally different means of organizing financial information.
Financial statements also are popular because they are adaptable to the diverse information needs of various users. As discussed above, users differ in their sophistication, the types of securities they analyze, the objectives and approaches to their work, and their personal preferences in performing their duties. As a result of those differences, users focus on different types of financial data as well as trends and relationships among that data. Fortunately, financial statements provide a broad array of financial information that allows many users to focus on the particular trends and relationships they find most useful. Financial statements assist with five of the key concepts underlying users' needs for information discussed in the previous section. Disclosure of segment financial data helps users analyze separately a company's business segments.
Financial statements also help users understand the nature of a company's business by indicating the types of its assets, the need for working capital, the types of its revenues, the general nature of its expenses, the sources and uses of its cash flows, and other aspects of its business. Financial statements help users understand the linkage between business activities and events and the financial effects of those events. For example, analysis of financial statements over time can help users understand the relationship between cost, volume, and profit. Further, analysis of financial statements can help users obtain a forwardlooking perspective by, for example, surfacing trends affecting the business. Because financial statements are comparable among companies, they help users understand performance relative to that of competitors and other companies.
Finally, financial statements can help communicate important changes affecting a company. Despite the general vote of confidence, however, users were strongly critical of certain aspects of financial reporting, and they offered or supported many substantive ideas for its improvement. Understanding the reasons for the criticism has been instructive as it helped the Committee identify highpriority issues and develop recommendations. Users' views and the Committee's recommendations related to financial statements are discussed in chapter 6.
Operating data are statistics about a company's business activities, excluding data reported in financial statements and related disclosures, which the Committee considers to be financial data. Operating data may be denominated in terms of a currency or in terms of units of product or service, number of employees, units of time, and others. Performance measurements are data about a company's key business processes. For example, they relate to the quality of products or services, the relative cost of activities, and the time required to perform key activities, such as new product development. The distinction between operating data and performance measurements is unimportant and some measures may fall in both categories. For example, productivity measures, such as the ratio of outputs to inputs, are both an operating statistic and a performance measure.
Although the results of users' analyses often are expressed in financial terms, such as the value of a security or the amount of cash flow available for debt service, users' analyses rarely are confined to financial measures. Many users will model company revenues and costs both in operating terms ; such as units sold, key resources consumed, and number of employees ; and financial terms ; such as revenues, cost of revenues, and operating profit.
The practice of modeling both business activities and financial results helps users understand, for example, the relationship between cost, volume, and profit. It also helps users answer questions such as: What would profit be if unit volume declined 10 percent? What will happen to profits if a company restructures and terminates 10 percent of its work force? The Committee's discussions with users and study of analysts' reports provided many examples of forecasts based on both financial and operating terms. To illustrate a common example, assume a user wishes to predict a widget company's revenues over the next few years. One method is to extrapolate the trend in historical revenues from the company's financial statements. A second method is to predict future revenues based on estimates of the number of widgets the company may sell and the widgets' future selling price.
The number of widgets could be predicted, for example, based on industry estimates of the total market for widgets and the user's estimate of the company's share of that market. The market share could be based on recent trends in that share and the user's judgment about the quality of the company's widget compared to that of competitors. The user could estimate future price based on recent trends in that price and estimates about whether the widget industry would be operating at or near capacity in future years. In practice, users are likely to use both methods to predict future revenues and to compare the results of the two. The first method requires only historical financial statements. In contrast, the second method requires a variety of information, none of which comes from financial statements, and also that users understand and predict the linkage between number of widgets sold and future revenues ; in this case, the future selling price for a widget.
The Committee's study indicated users are as interested in a company's business activities, business processes, and events affecting a company as they are in financial measures about a company. The Committee's study of analysts' reports indicated analysts write as extensively about business activities and events affecting a company as they do about financial results or predictions. For example, they frequently write about the trends in units sold and selling prices, the number of employees, trends in wages, and trends in costs of purchased materials. The study of materials voluntarily supplied by companies indicated that many large public companies supply users with "fact books" containing data about a company's business activities and processes. The Committee also found users as likely to discuss business activities and processes as financial performance. The users' goal may be to project a company's financial future, but that goal requires information about a company's activities, processes, and events that affect it and the translation of those activities and events into financial terms. Users do not rely on financial results alone (see exhibit 2, p. 28). Companies manage their businesses using a myriad of operating data and performance measures, much of which relate to detailed and specific operations, such as that of a single machine, production line, or even an operating location. What users find useful, however, is
Exhibit 2
highlevel
operating data and performance measures relating to the business
segment level of operations. Highlevel operating data and performance
measures help with five of the key concepts underlying users'
needs for information. Operating data and performance measures
that relate to the business segment level help users analyze separately
a company's business segments. They also help users understand
the nature of a company's businesses. In particular, operating
data and performance measures are useful in helping users understand
the linkage between events and activities and the financial impact
of those events on a company. They also may help users identify
trends affecting a business and thereby provide users with a forwardlooking
perspective. Further, operating data and performance measures
can help users understand management's perspective by noting the
types of data that management is using to manage the business.
Users find management's analysis is important to understand the business reasons for changes in data about a company. Management is closest to the business and often has analyzed data about its company for purposes of managing the business. Thus, management is often the best source for analytical information. Management's analysis includes two elements. The first includes reasons for changes in the financial, operating, and performancerelated data. Users want to know about changes relating to market acceptance, productivity, costs of key resources, profitability, innovation, changes in financial position, liquidity, and the identity and effect of unusual or nonrecurring transactions and events. The second category identifies key trends and discusses the past effect of those trends.
Management's analysis is consistent with several of the concepts underlying users' needs for information discussed in the previous section. Management's analysis of each business segment helps users analyze a company's business segments separately. The analysis also helps users understand a company's business and, in particular, the linkage between events and activities and the financial impact of those events and activities. Further, it helps users with a forwardlooking perspective by identifying and discussing the past effect of trends and performance measures ; both useful leading indicators of future performance.
Finally, it helps users understand management's perspective. Public company disclosures include management's discussion and analysis of financial condition and results of operations (MD&A). Current MD&A disclosures focus on explaining changes in amounts in financial statements. In contrast, users would find helpful an expanded analysis that includes analysis of changes in operating data and performance measures as well as changes in amounts in financial statements. Although users have found practice under current requirements to be useful, they are critical of current practice for the following reasons:
In addition to explaining changes in financial data, MD&A requires management to provide a forwardlooking perspective by discussing events and uncertainties that would cause reported financial information not to be indicative of future operating results or financial condition. Users' interest in forwardlooking information is discussed in the following section.
The study found that users find useful management's perspective on two types of forwardlooking information. The first is about opportunities and risks and the second is about management's plans for the future. Although users are interested in forecasted financial and operating data, they generally believe that management should not include those forecasts in business reporting.
Opportunities and risks result from changes in a company's industry conditions, such as a threat from substitute products or services, changes in the bargaining power of customers or suppliers, including employees, and changes in the nature of competition with competitors. Opportunities and risks also result from concentrations in a company's assets, customers, or suppliers. Users also are concerned about illiquidity risks and contingent gains and losses related to a company's rights and obligations. Understanding the opportunities and risks a company faces is critical to users and is common to most of their analytical approaches. Assessments about opportunities and risks directly affect a users' valuation of a company or judgments about credit risk. For example, information about opportunities and risks determines the multiple or discount rate that investors use in valuing companies.
Users learn about and assess opportunities and risks from many sources of information, including industry and trade publications, financial statements, operating data, discussions with other users, and others. However, information from a company's management is particularly useful. Management often is an excellent source for information about opportunities and risks because it is closest to the business and usually has considered opportunities and risks in planning for the future and managing the business. Also, understanding what management thinks about opportunities and risks helps users understand where management plans to lead a company.
Understanding management's plans is important for users. Management is the best source of information about the direction it intends to lead the company and its plans are an important leading indicator of the company's future. Even though a company may not achieve its plans, understanding the general direction of the company is helpful. Also, management's plans are an important driver of the opportunities and risks a company will face. Plans usually depend on key assumptions about factors or conditions that must be present for the plans to be successful (critical success factors). For example, a computer maker's plan to be first to market with innovative and technologically superior products may be based on an assumption that key suppliers will continue to work with the company to incorporate leading technology into its products. If suppliers choose to treat all computer makers equally, then the company's plan will fail. Users find information about critical success factors useful because they provide insights about the opportunities and risks a company faces.
The approaches used by many users to value companies or assess credit risks require forecasted data, particularly financial data. Usually, those forecasted data are the results of considerable work by the forecaster after analyzing the types of information discussed in this chapter. Despite the relevance of forecasted data, except in the circumstances described below, users generally do not need forecasted data from management in business reporting, for the following reasons:
Although users generally do not need forecasted data from management, some users, particularly lenders to smaller companies, seek management's forecast, for the following reasons:
Users of public company reports emphasized the importance to their analysis of information in annual proxy statements furnished to shareholders. More specifically, they find information in the following categories useful:
Users also need background information about a company which provides users with a mental image of a company's businesses ; the business engines that generate cash flows and earnings. Users need the information for each business segment. More specifically, users find background information useful in the following categories, for the reasons indicated:
Users need and use information from multiple sources for two reasons. First, users need information from the best sources, which differ depending on the type of information and other factors. For example, users obtain information about the economy from economic studies and reports by economists and other sources. They obtain information about industry conditions from industry trade publications, government statistics, and others. Although a company's management is often the best source for a large portion of companyspecific information, it is not the only source, nor always the best source. For example, users learn about a company's stock price and trading volume from a stock exchange. Second, obtaining the same type of information from multiple sources allows users to compare views and assess the relative reliability of the information. For example, users may learn about a company's strengths and weaknesses from its management, competitors, customers, and other users, each of which may offer a different perspective. Users can judge for themselves about which view is the most reliable. Despite its usefulness, users do not want business reporting to become the only source for their information.
Users are increasingly using databases and will continue to use them mostly for screening purposes and to gain rapid access to aggregate industry information. Databases are useful to users because they provide easy access to considerable financial information for a large number of companies.
However, their use is restricted mostly to screening purposes and to accessing aggregate information because (1) the information is not timely; (2) the information is not comprehensive (for example, notes to the financial statements normally are not included in the databases, which makes it more difficult to identify differences in accounting practices among companies); and (3) adjustments are made in the databases that are not easily identifiable and understandable. Users are willing to use databases in the future to assist them with their analytical work on specific companies as the information provided in databases becomes more comprehensive, consistent, reliable, and comparable. Some believe that further advances on database technology (for example, the SEC's EDGAR system), combined with improvements in financial reporting practices, inevitably will lead to an increase in the uses of databases.
Users are deeply concerned about the relevance, reliability, and comparability of information ; the qualitative aspects of business reporting. Most of the Committee's study of users concerned the relevance of information. The Committee identified the types of information that users find most relevant and the appropriate timeliness of that information, which are discussed elsewhere in this chapter. This section discusses the remaining issues of reliability and comparability of information.
The reliability of information depends on the faithfulness with which information represents what it purports to represent. It also depends on the degree to which information is verifiable. Users are very concerned about the reliability of information in business reporting. They believe that many companies' managements are not forthright in reporting problems and poor company performance, that much of the information they disseminate is too promotional, and that troubled companies take great pains to convey the impression that they are not seriously troubled.
Although they have confidence in management integrity, users say managers commonly procrastinate about disclosing problems and many managers express a more optimistic view of their companies' situations than seems warranted by the users' own analyses. Users believe, for example, that management emphasizes nonrecurring losses while burying nonrecurring gains in continuing earnings. They also believe that management tends to double up when reporting bad news by also recognizing other losses that have occurred earlier but whose recognition has been deferred or losses whose current recognition will avoid the need to recognize expenses or losses in the future. The confidence of the user community is shaken by a series of surprise adjustments or writeoffs.
Those events seem to occur in periods of economic stress. Frequent writedowns of assets and recurring restructuring charges have led users to believe that companies' asset amounts have been overstated in the past, resulting in loss of confidence in the accuracy and reliability of amounts that are reported currently. Users need audited financial information because it provides independent assurance of the reliability of amounts reported and disclosed in financial statements that are not otherwise verifiable by thirdparty users. In their analyses, most users rely heavily on information that has been verified by auditors independent of management.
Auditor involvement in financial reporting provides a discipline for management to adhere to established requirements. Most users would be unwilling to lose the comfort of an independent audit function. Independence gives users assurance that confirmation and verification procedures have been performed by those not subject to management influence.
Neutrality means that in formulating and implementing standards, the primary concern should be the relevance and reliability of information, not the effect the new standard may have on a particular interest. Users wholeheartedly support the precept that standards setters ensure, insofar as possible, the neutrality of information. Any other approach would undermine the usefulness of information in business reporting. Users believe that business reporting should help users in making rational investment, credit, and similar decisions but should not try to determine or influence the outcomes of those decisions. The role of business reporting requires it to provide evenhanded, neutral, and unbiased information.
For users, conservatism in reporting means the uncertainties that are inherent in many transactions should be recognized by exercising prudence in reporting. Conservatism should mean prudence in evaluating uncertain outcomes and amounts, not the creation of arbitrary reserves. Another widely expressed view is that conservatism makes it likely that possible errors in measurement will be in the direction of understatement rather than overstatement of net income and net assets. Thus, future surprises likely will be pleasant. In both views users emphasize prudence, but reject the notion of deliberate understatement of assets, overstatement of liabilities, or smoothing of income.
Users believe businesses that are volatile should report that volatility faithfully and should not smooth earnings to appear less volatile than the underlying business. Some preparers believe stable results tend to lower the cost of capital. Users need to be apprised of the true volatility to make correct judgments in allocating capital. Companies that report significant swings in earnings are more difficult to analyze. However, if that is the nature of their business or industry and, therefore, a risk that needs to be understood, a user needs to understand that fact.
Analysis for both investment and credit decisions relies on three types of comparisons:
Comparability and consistency in financial reporting over a long time, generally five to ten years, is very important to users in comparing a company's performance and financial position within its industry and across industry lines, and in identifying trends. Many users believe they can handle differences in accounting among companies, even in the same business, if they can obtain information that enables them to understand the differences and interpret them as clearly as possible. Differences in the way companies apply accounting rules should be allowed as long as there is disclosure of the application methods.
Many users value information that is consistent over time more highly than information that is comparable among companies because they consider themselves capable of adjusting information to compensate for noncomparabilities resulting from use of alternative accounting procedures and the many differences in companies. However, they usually are unable to adjust for inconsistent information resulting from business combinations accounted for by the purchase method, changes in accounting principles, and the like.
A change in accounting principles destroys the interperiod consistency of data before and after the change. Even if standards setters require restatement of priorperiod data, public companies provide only three comparable income statements and two comparable balance sheets. Users sometimes have sufficient information to estimate the effect of the change on earlier years and are able to restate the results themselves, and some companies take the time to assist users in understanding the pre and postchange data.
Generally, however, the ability to analyze trends over a long period is destroyed. New accounting standards that do not preserve the consistency of information result in significant costs for users. Effective date and transition provisions that permit a new reporting standard to be adopted in any of several years and that allow a choice of how to adopt, such as retroactive application, prospective application, and the like, are particularly troublesome for users. Users do not suggest that standard setters issue fewer standards. However, they suggest that standard setters should simplify the procedure for adopting new pronouncements by making them effective for everyone in a single year and prescribing only one method of adoption.
In addition to the general understanding of users' needs for information discussed in this chapter, the Committee's study considered users' needs for information in more specific areas, many related to financial statements. Chapter 6 includes information about users' needs for information in the following categories:
In addition to the above, user views on auditor association with business reporting are discussed in chapter 7 and user views on international harmonization of accounting standards are summarized in chapter 8.