Based on the information needs of users and the costs and benefits of suggested improvements, the Committee recommends changes in four areas: improving the types of information in business reporting, improving financial statements, improving auditors' involvement with business reporting, and facilitating change. This chapter addresses the Committee's recommendations in the first area.
Business reporting cannot and should not meet all users' needs for information. It would be too costly to do so and, as discussed in chapter 3, users want information from multiple sources. However, business reporting should include all information that meets the broad range of users' needs for information but be restricted by two conditions:
(1) the information should be within management's expertise (that is, management should be the best source for the information) and
(2) the information should be provided at acceptable cost. Within those constraints, however, it is important that the information provided by business reporting be as complete as possible ; it must address the broad range of users' needs for information. Because of dramatic changes in the environment affecting business, users may require new types of information.
At the same time, companies may develop, for management purposes, new types of information that users would find useful, and some information traditionally provided no longer may be necessary. Because of those changes, standard setters and regulators constantly must update their understanding of users' needs for information and the information management has available for internal purposes that could assist users to ensure that business reporting is as complete as possible considering the costs of providing the information .
This chapter discusses the Committee's recommendation to develop a comprehensive model of business reporting and describes the model developed by the Committee. It also discusses the Committee's recommendation for further study of benefits and costs to improve decisions about the types of information that business reporting should provide.
Standard setters should develop a comprehensive model of business reporting indicating the types and timing of information that users need to value and assess the risk of their investments. In business reporting, standard setters have recognized the usefulness of models or frameworks. For example, the FASB has developed its conceptual framework, which sets forth the fundamentals on which financial accounting and reporting standards should be based, including the nature of information that should be included in financial statements. Other standard setters also have established frameworks for financial statements that guide the direction of future standards.
Unfortunately, existing reporting models focus narrowly on financial statements rather than on the broad range of users' information needs. Users would benefit from business reporting based on a comprehensive model that prescribes all the types and timing of information that could be made available to them. Such a comprehensive model also would help standard setters and regulators provide guidance on the information content within business reporting. A comprehensive model would:
The comprehensive model should be based on general concepts that guide reporting under the model. The Committee recommends the following concepts that it learned from its study of users' needs:
The first seven concepts are based on concepts of users' needs for information discussed in chapter 3. The remaining three, which also are consistent with users' needs for information, are discussed in the following section.
To assess the feasibility of its ideas, the Committee designed and illustrated a comprehensive model based on the above concepts, its understanding of users' needs for information, and information about costs of reporting. Much of the information in the model would replace, not be in addition to, information currently contained in filings by U.S. public companies with the SEC. In addition to the discussion of the Committee's business reporting model in this chapter, the details of the model, listing specific types of information within broad categories of information, are outlined in appendix II and the model is illustrated, using a fictitious company, FauxCom, in appendix III.
The model divides reporting into elements (general types of information) that address the broad range of users' needs for information. As financial statements provide a useful structure for financial information, so would the elements of the model provide a useful structure in the broader arena of business reporting. The model includes ten elements within five broad categories of information that are designed to fit the decision processes of most users and are consistent with the types of information the Committee's study indicated users find useful (see exhibit 1, p. 52). Nine of those elements result directly from the Committee's study of the types of information that users find useful, as discussed in chapter 3.
The tenth ; the comparison of actual business performance to previously disclosed opportunities, risks, and management's plans ; was added by the Committee to improve the reliability and credibility of information and to help users assess the relative reliability of information. The model is consistent with the ten concepts of users' needs for information listed above. Chapter 3 discusses how the types of information in the model meet the first seven of those concepts. The remaining three concepts and how the model meets those concepts are discussed below.
As discussed in chapter 3, users have different needs for information depending on the circumstances. For example, a shortterm trade creditor may need far less information than a longterm equity investor. Further, the costs of reporting information also differ depending on the circumstances. Because needs for information and costs of reporting differ, not all companies should report all types of information with the same frequency and in the same time frame. Identical reporting by all companies would result in excessive costs and, in many cases, provide more information than is needed. Rather, the types and timing of information in business reporting should be customized to meet users' needs and cost constraints in the particular circumstances.
Exhibit 1 THE TEN ELEMENTS OF THE COMMITTEE'S MODEL OF BUSINESS REPORTING Financial and non-financial data Financial statements and related disclosures High-level operating data and performance measurements that management uses to manage the business Management's analysis of the financial and non-financial data Reasons for changes in the financial, operating, and performance-related data and the identity and past effect of key trends Forward-looking information Opportunities and risks, including those resulting from key trends Management's plans, including critical success factors Comparison of actual business performance to previously disclosed opportunities, risks, and management's plans Information about management and shareholders Directors, management, compensation, major shareholders, and transactions and relationships among related parties Background about the company Broad objectives and strategies Scope and description of business and properties Impact of industry structure on the company
The elements of the model provide a menu of choices that allows flexible reporting. More specifically, companies and users should negotiate and agree on several aspects of reporting:
As a practical matter, reporting flexibility based on negotiation mostly would be applicable to private companies and the users of their business reporting. Private companies generally deal with a limited number of users. Further, private companies and users already negotiate over the content, frequency, time frame, timeliness, and extent and nature of auditor association of business reporting. The Committee believes the flexible reporting feature of the model is a logical extension of a process of negotiation that already works well in practice. It helps ensure that only information truly needed and that can be provided at acceptable cost is included in business reporting.
The model assists the parties to the negotiation process with a menu of mutually understood elements of information from which to choose in defining the features of business reporting that are best in the particular circumstances. It is likely that standardized subsets of the menu of elements would emerge as particularly useful for lenders to privately held companies. Those standardized subsets would reflect, among other things, the nature, duration, and risk of the lending. Users of public company business reports differ from users of private company reports in three respects. First, the users of a public company's reports are usually numerous and diverse, and they frequently change. Thus, few have sufficient bargaining power or resources to negotiate with specific companies over the content of business reporting.
Second, relatively few users of public company reports have ready access to management or are willing to devote the resources to contact management. Thus, they must rely to a greater degree on business reporting for companyspecific information. Finally, users of public company reports often are subject to insidertrading restrictions, which restricts them to a company's publicly available information. As a result of those differences, business reporting by public companies must meet a broad range of users' needs for companyspecific information.
Further, the content and timing of reporting by public companies must be determined differently from the decentralized negotiation with users that works for private companies. For public companies, regulators, such as the SEC, historically have represented users' interests. Since business reporting by public companies must meet a broad range of users' needs, regulators may choose to receive from public companies most, if not all, of the model's elements. Thus, the Committee considered practical constraints, as discussed below, to reduce the costs of reporting under the model.
Information should be communicated to users in an organized fashion that allows users to locate different types of information quickly. Information also should be provided in an integrated manner that eliminates redundancy, streamlines reporting, and provides only the information that users need. The information should be supplemented with charts and graphs to improve management's presentation and users' comprehension of the information. The information should be provided in either printed or electronic form, depending on which is more useful for users and after considering the costs involved. The model tries to improve the effectiveness and efficiency of communication in those ways.
Standard setters and regulators should continue to be sensitive to the costs of business reporting and search for ways to limit costs while still providing more useful information. As discussed in chapter 4, weighing the costs and benefits of possible improvements to business reporting is difficult and complex. It is impossible to measure many of the costs and benefits of improved disclosure, such as the cost of disclosing competitively harmful information or the benefits to the economy of another piece of useful information. In addition, the costs and benefits affect people and groups in different degrees. While difficult, cost and benefit decisions must be made.
On the one hand, business reporting must be enhanced to maintain its relevance, while on the other hand, undisciplined expansion of mandated reporting could result in large and needless costs. Faced with this dichotomy, the Committee adopted a cautious and practical approach, proposing ideas supported by users that would result in truly useful information while recommending constraints on disclosure when costs could be significant. Thus, the model includes constraints to limit the costs of reporting, which are discussed below.
Improving the reliability and credibility of business reporting is a goal of the Committee's work. The Committee's recommendations in areas of improving the reporting model, auditor association, and facilitating change in business reporting each play a role in meeting that goal. The model would improve the reliability and credibility of business reporting by including elements that help ensure balanced, neutral reporting. The elements include (1) the reporting of risks as well as opportunities, (2) the focus on measurements in addition to qualitative discussion, (3) the comparison of actual business performance with previously disclosed forwardlooking information, and (4) reporting about the uncertainty of reported measurements.
The Committee developed its model of business reporting subject to six constraints to reduce costs in areas where the costs of reporting under the model could be significant. Financial executives are very concerned about the costs to their companies of reporting under the Committee's comprehensive model. As discussed in chapter 4, those costs fall into three categories: the cost of developing and presenting information, the litigation risk attributable to disclosure, and the competitive disadvantage from additional disclosure. The Committee believes the practical constraints discussed below significantly reduce costs in each of those areas.
The Committee's comprehensive model differs from current reporting by U.S. public companies to the SEC in six areas: (1) business segment perspective, (2) financial statements, (3) highlevel operating data and performance measurements, (4) management's analysis, (5) forwardlooking information, and (6) background information. Differences in each of those areas are discussed below.
Reporting information about business segments is a key feature of the model and applies to most of the model's elements. As discussed in chapter 3, for users analyzing a company involved in diverse businesses, information about each business segment often is as important as information about the company as a whole. For many users, the business segment is the unit of analysis. Thus, companies should report information about their business segments in addition to information about the company as a whole. At a minimum, multisegment companies should report business segments on an industry basis, for the reasons discussed in chapter 3. Companies also should report segment information on a geographic basis if that information is useful to users in understanding opportunities and risks that a segment faces. In general, multisegment companies would report on more industry segments under the model than they report on in current practice.
Determining which industry and geographic segments, if any, on which to report is discussed in chapter 6. For a company with more than one industry segment, most types of information specified by the model will apply to the industry segment level. The goal of the segment breakdown of information is to permit the user, to the extent practicable, to analyze how the different opportunities and risks of business segments are being managed by the company. The FauxCom example in appendix III illustrates the model's concept of segment reporting.
FauxCom consists of two industry segments: the PC Segment and the Integration Segment. In that illustration, most of the types of information in the model are provided for each of the two segments, as shown in exhibit 2. The only information not provided at the segment level is information about management and shareholders, which applies to the company as a whole. The Committee's model focuses more on reporting at the segment level than does reporting in current practice. For example, private companies are exempt from disclosing segment data in financial statements. Public companies must report at the segment level in financial statements and in the description of the business and properties section of form 10K. However, in MD&A, discussing operations at the segment level is up to management's judgment, and many companies do not clearly segregate their discussions on a segment basis.
The Committee's study of users' needs confirmed the importance of financial statements and related disclosures. There is little evidence that users are abandoning their analyses of financial statements because they believe the information is becoming irrelevant. No user suggested that financial statements should be scrapped and replaced with a fundamentally different means of organizing financial information. Thus, the model generally retains the form and content of today's financial statements and related disclosures. Despite the general vote of confidence about financial statements, however, users were strongly critical about certain aspects of financial reporting, and they offered or supported many substantive ideas for its improvement. The Committee developed recommendations to improve financial statements and related disclosures based on both user criticism of financial statements in current practice and the Committee's understanding of users' needs for information and ideas to better align business reporting with those needs. Those recommendations are discussed in chapter 6 and are reflected in the model in appendix II.
The Committee's model includes highlevel operating data and performance measurements that management uses to manage the business. With certain exceptions, U.S. public companies currently are not required to report that type of information, although many voluntarily provide substantial information of this type.
Exhibit 2
SEGMENT PERSPECTIVE IN FauxCom ILLUSTRATION
The Ten Elements of the Committee's
Perspectiv
e
` Model of Business Reporting Segment Company
Financial and non-financial data
Financial statements and related disclosures X X
High-level operating data and performance
measurements that management uses to manage X
the business
Management's analysis of the financial and
non-financial data
Reasons for changes in the financial,
operating, and performance-related data and X X
the identity and past effect of key trends
Forward-looking information X X
Opportunities and risks, including those X
resulting from key trends
Management's plans, including critical X
success factors
Comparison of actual business performance to
previously disclosed opportunities, risks, and
management's plans
X
Information about management and shareholders
Directors, management, compensation, major
shareholders, and transactions and X X
relationships among related parties X X
X X
Background about the company
Broad objectives and strategies
Scope and description of business and
properties
Impact of industry structure on the company
As discussed in chapter 3, highlevel operating data would help users understand the business, and in particular, the linkage between events and activities and the financial effects on a company of those events and activities. Performance measurements also would be useful. There is nothing new about corporate executives' use of performance measurements to manage their businesses. Manufacturing companies, for example, have been using the reject rate on goods produced and sales order backlog for many years. Performance measurements sometimes are published. For example, the findings of J.D. Power & Associates, a consulting group that conducts auto industry surveys of vehicle quality and customer satisfaction, are cited, as are Neilson ratings for the broadcast industry.
Comparisons of patents obtained per year sometimes are published to demonstrate technological leadership. Companies may advertise their performance through nonfinancial measures to create competitive advantage (for example, airline ontime data), suggesting a link between the measure and potential revenue. Increased competition and rapid advances in technology are driving dramatic changes. In response to changes in their businesses, companies also are changing their information systems and the types of information they use to manage their businesses. A host of new types of performance measures have become more widely used by management, some in connection with the movement to total quality management (TQM), which emphasizes the benefits of measuring the performance of key processes and the primacy of customer satisfaction.
Benchmarking is both a feature of TQM and a management tool in its own right. Performance measurement has taken on a role in today's managerial practices far greater than before, and it is growing. Major initiatives around the world are considering what additional performance measures are needed. For example, the Financial Executives Research Foundation is considering the use of performance measures in its project on Economic Reality in Financial Reporting. The Conference Board has announced an international study evaluating nontraditional measures of corporate performance. A new body based in London, the Performance Measurement Foundation, was set up in 1992 to extend the scope of performance measurement beyond the conventional focus on internal, historical, financial, numeric, and shortterm information.
In addition, many private entities, including accounting firms, are helping companies rethink performance measurement. Can effective business reporting exclude new performance measures on which management is focusing to manage the business? Managerial use of nonfinancial measures in running a business suggests users would benefit from access to the measures. Users share with management a vital interest in a company's future cash flows and earning capacity. Further, the Committee's study indicates users believe they would benefit from greater access to the highlevel performance measures management is using to manage the business. The Committee believes that disclosure of performance measures would:
Highlevel operating data and performance measures will vary by industry and by company. Management should identify measures it believes are significant and meaningful to its businesses and that are leading indicators of a company's future. Management need not report operating data or performance measures it does not already have or need to manage the business. Operating data and performance measurements should be presented for the same periods as the financial statements. Companies should consider disclosing operating data and performance measurements in the categories listed in exhibit 3 (p. 62).
Both the Committee's model and current practice by public companies include management's analysis. However, the notion of management's analysis in the model differs in important respects from management's analysis in current practice. The Committee has rethought the concept and role of management's analysis within its notion of a comprehensive model of business reporting. It also has tried to respond to users' concerns about current practice, as listed in chapter 3. The following summarizes the major differences between the Committee's concept of management's analysis and current practice:
As used in this report, forwardlooking information is in three categories:
Forecasted financial statements are not part of forwardlooking information, as defined above, nor are those financial statements suggested by the Committee's model, for reasons discussed above under practical constraints. Opportunities and risks are characterized as material trends, demands, commitments, concentrations, or events, including legal proceedings, known to management that would cause
Exhibit 3
OPERATING DATA AND PERFORMANCE
MEASUREMENTS
Category Examples Used in FauxCom
Illustration
1. Statistics related to Number of design and
activities that produce revenues, installation contracts in
market acceptance, and quality, Integration Segment
such as units and prices of Percentage of contracts awarded
product or services sold, growth to number of proposals
or shrinkage in market share, Percentage of contracts renewed
measures about customer Market share in PC Segment
satisfaction, percentage of
defects or rejections, and
backlog
2. Statistics related to Average number of employees in
activities that result in costs, each segment by function
such as the number of employees Average compensation per
and average compensation per employee
employee and the volume and Value of purchased components
prices of materials consumed and materials as a percentage of
cost of sales
3. Statistics related to Number of PCs produced per
productivity, such as the ratio employee
of outputs to inputs Gross margin per employee in
Integration Segment
4. Statistics related to the time Product-development lead time in
required to perform key PC Segment
activities, such as developing
new products or services
5. Statistics related to the Employee turnover in Integration
amount and quality of key Segment
resources, including human
resources, such as the average
age of key assets or the quantity
of proven reserves of natural
resources
6. Measures related to Expected growth in new
innovation, such as the consulting services contracts in
percentage of units produced in Integration Segment
the current year that were
designed in the last three years
or the number of suggestions to
improve business processes
received from employees in the
last year
7. Measures of employee Employee turnover in Integration
involvement and fulfillment, such Segment
as employee satisfaction and the
rate of change in that measure
8. Measures of strength in vendor None used to manage the business
relationships, such as vendor
satisfaction
reported financial information not to be indicative of future core earnings, net income, cash flows, or future financial condition. Opportunities and risks fall into the following classes:
The importance to users of understanding management's perspective on opportunities and risks was discussed in chapter 3. The SEC already requires, in MD&A, disclosures about opportunities and risks. For example, regulation SK, item 303, paragraph 303(a) instruction 3, states: The discussion and analysis shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.
This would include descriptions and amounts of (a) matters that would have an impact on future operations and have not had an impact in the past, and (b) matters that have had an impact in reported operations and are not expected to have an impact upon future operations. Despite the current disclosure requirement, users believe disclosures about opportunities and risks should be improved. Including the disclosures in a separate section of a business report and providing a framework for identifying and disclosing information about opportunities and risks would improve the usefulness of the disclosure. The model does not require management to discuss all opportunities and risks. Rather, it limits disclosures to opportunities and risks that meet five criteria:
Disclosures about opportunities and risks that meet the above criteria should include (1) the nature of the opportunity and risk and the identity of the trend, demand, commitment, or event that gives rise to it and (2) the effects, if any, on the company's future earnings and cash flows. The model suggests, in section III(A)3, specific disclosures related to liquidity. The model also includes disclosures of management's plans, including critical success factors. As discussed in chapter 3, users find management's plans important in understanding where management intends to lead a company, which, in turn, is important in understanding a company's opportunities and risks. The model suggests the following as a framework for disclosure about management's plans:
Companies are concerned that disclosures about management's plans could harm a company's competitive position significantly. However, as discussed under practical constraints, several factors mitigate the competitive costs of reporting management's plans. Further, the information often can be provided in a form that provides insight to users while not significantly harming competitive position. Further, companies need not disclose plans that would harm their competitive positions significantly.
The model divides information in the background category into three elements: (1) broad objectives and strategies, (2) scope and description of business and properties, and (3) impact of industry structure on a company. Current practice already requires disclosures in the scope and description of business and properties category. The Committee's model for that type of information is substantially consistent with that practice. Current practice does not require information for the two remaining elements, although public companies often voluntarily discuss their objectives and strategies in business reporting.
Reporting under the model would include information about a company's broad objectives and business strategy. This information also could have been classified as forwardlooking information, since objectives and strategy are, by their nature, forwardlooking. However, the Committee included objectives and strategy in the background category because it is helpful to evaluate historical data in the context of what management was trying to achieve. The model suggests that companies identify their broad objectives and the business strategies used to achieve each broad objective. The disclosures about business strategy should also discuss the consistency or inconsistency of the strategy with key trends affecting the business. That information helps users evaluate the degree to which a company's business strategy is aligned with the broader business environment.
The importance of an industry perspective in analyzing a business was discussed in chapter 3. Management is not necessarily the best source for information about the industry in which a company operates. However, management is the best source for information about how industry structure affects the business it manages. That impact should be the focus of the reporting. The model provides a framework for reporting information about industry structure, which the Committee borrowed from the industry framework suggested by Michael Porter in his book, Competitive Advantage. More specifically, the model divides the discussion into four categories, listed in section IV© of the model:
Improve understanding of costs and benefits of business reporting, recognizing that definitive quantification of costs and benefits is not possible. Improving the types of information in business reporting inevitably means facing difficult cost benefit decisions. Unfortunately, despite the importance of those decisions, much of what is written is speculative, in part because definitive quantification of costs and benefits is impossible. But progress can be made, through additional research and discussions with users and companies, in identifying the different types of costs and benefits, as well as their range and relationships. Progress in this area would facilitate deliberations and improve decision making about the types of information that should be included in business reporting.
The limitations of additional costbenefit research should be borne in mind. First, important areas do not lend themselves to empirical research. Second, no amount of research is going to yield reliable dollar figures for the public and many of the private benefits and costs of disclosure. Third, because of the nature of social decision making, even assuming, for the sake of argument, that research could produce such dollar figures, the results could never relieve those who make recommendations on disclosure or those who set standards of the obligation to exercise judgment, make tradeoffs, consider the interests of all participants, and determine the public interest. Kenneth J. Arrow, a Nobel laureate, demonstrated that ideal outcomes from collective decision making could never be a direct aggregation of constituent preferences. Therefore, even if every constituent's preferences were backed by indisputable costbenefit figures, no decision for the group could directly reflect the rank ordering of the diverse preferences
. The FASB was rightly constituted to consider all points of view but to leave the decision to the deliberations of those selected for their expertise, ideals, and temperament. No group that considers informative disclosure can avoid the hard task of seeking the public interest. Costbenefit research should never hide the responsibilities of those charged to improve business reporting. Thus, with awareness of its limitations, the Committee encourages additional research and hopes that its analysis of the generic benefits and costs of disclosure, discussed in chapter 4, will help to stimulate it. Below are examples of the types of research subjects that could improve understanding of the range and relationships of various types of costs and benefits: