a company's
major or central operations and those of other activities or events
allows users to analyze trends affecting the business without
the potentially distortive effects of peripheral or incidental
activities.
Financial statements are at the center of business reporting. As discussed in chapter 3, the Committee's study confirmed the importance of financial statements ; they generally provide users with essential information that heavily influences their decisions. Despite the general vote of confidence, however, users were strongly critical about certain aspects of financial statements and they offered or supported many substantive ideas for improvement. Those involved in business reporting long have appreciated the importance of financial statements and the need to keep them relevant. Standard setters, regulators, and many others devote considerable resources to maintaining and improving them.
The FASB includes seven fulltime board members, with a supporting staff of about forty. The AICPA establishes standards through parttime boards and supporting subcommittees and task forces, with fulltime staff support. The SEC also sets standards for financial statements. Each of these organizations receives considerable help from companies, auditors, academics and, to a lesser extent, users through advisory boards, task forces, meetings, comment letters, public hearings, and field tests. Despite the continuing effort to enhance financial reporting, changes in the environment constantly threaten the relevance of financial statements.
For example, new reporting issues surface regularly because of changes in business transactions, new types of relationships between companies, new laws, and changes in the political, social, technological, and economic environments. Standard setters struggle to keep pace with changes to ensure that financial statements reflect the underlying economics of transactions and events and that reporting is comparable among companies. Despite the backlog of new issues, standard setters spend much of their time reconsidering controversial provisions in existing accounting standards. Critics frequently assert that existing standards do not result in proper reporting, that practice has resulted in diverse reporting by companies, or that standards conflict with each other.
The Committee's focus on users should help, for at least three reasons. First, a user focus can help identify highpriority areas for improving business reporting, which, in turn, can help standard setters develop their agendas. A related but less apparent benefit is the insight a user focus provides into areas that are less important. Obviously, because standardsetting time is scarce, standard setters should defer considering lowpriority issues. Third, a user focus can help identify specific ideas to improve financial statements and evaluate the pros and cons of possible improvements. This chapter is organized in three sections.
The first discusses the Committee's recommendations to improve financial statements. The second identifies issues the Committee believes standard setters should defer considering because they have low priority. The third section identifies changes suggested by users that the Committee rejected because it judged the costs would exceed the benefits.
The Committee's recommendations are based on both user criticism of current financial statements and the Committee's understanding of users' needs for information and ideas to better align financial reporting with those needs. The discussion identifies each recommendation, discusses why it is consistent with users' needs for information, and explains why the information can be provided at acceptable cost.
The Committee's recommendations necessarily are broader and less detailed than are accounting standards. Although the Committee believes it has sufficient basis to recommend its ideas to standard setters, the Committee has not followed a full due process approach, and further study of benefits and costs is necessary to convert the recommendations into specific accounting standards.
Improve disclosure of business segment information. As discussed in chapter 3, for users analyzing a company involved in diverse businesses, financial information about business segments often is as important as information about the company as a whole. Users suggest that standard setters assign the highest priority to improving segment reporting because of its importance to their work and the perceived problems with current reporting of segment information.
The Committee considered three issues related to segment reporting: the basis of segmentation, that is, the kinds of segments that companies should report; the kinds of financial information companies should report about each segment; and the frequency of reporting that information. This section discusses the first two issues as well as investments in unconsolidated entities since users' criticism of the reporting of these is similar to their criticism of segment reporting. Frequency of reporting is discussed later in the chapter under recommendation 6 on improving interim reporting.
The goal of segment reporting is to provide additional insight into the opportunities and risks a company faces. Thus, in concept, companies should determine the segments to be reported based on opportunities and risks: those activities having similar opportunities and risks should be aggregated while those having diverse opportunities and risks should be reported as separate segments. A company whose activities face similar opportunities and risks is not a multisegment company and would not report segment information. There are many bases on which a company's activities may be segmented.
They include industry; product lines; individual products; legal entities within the company; geographic based on where the company produces products or delivers services; geographic based on where the company sells its products or services; and others. The Committee's study of users' needs indicated 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. Both bases of segmentation are widely accepted by users in practice. Other segments are useful in fewer circumstances or with fewer types of users, and the Committee believes the costs exceed the benefits of providing the information on those bases in generalpurpose business reporting.
FASB Statement No. 14, Financial Reporting for Segments of a Business Enterprise, as amended, requires disclosures by industry segment. An industry segment under Statement 14 is defined as a grouping of similar types of products or services a company offers to outsiders. Users appear to be comfortable with that concept and definition of an industry segment. Although they are comfortable with the concept of industry segments, users are troubled by its application in practice today. They believe that 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.
The Committee does not propose changes to the concept or definition of industry segment. Rather, in response to the users' complaint, the Committee suggests that standard setters consider practical devices that will help companies better define their product and service groupings and, if appropriate, disclose information about more industry segments. The Committee believes the primary means to improving industry segment reporting should be to align business reporting with internal reporting. That is, to the extent possible, companies should define industry segments for business reporting in a manner consistent with their definitions for internal reporting to senior management or the board of directors.
The fact that a company defines industry segments more narrowly for internal reporting to senior management than it does for business reporting strongly suggests that it should expand the number of segments reported externally. Many, if not most, companies manage their businesses and develop internal financial reports along industry lines. In devising internal reporting systems, diverse companies define business segments to provide management and board members with insight into the company and its various businesses. On the one hand, information about every product or service within a diverse company is usually too detailed to provide much insight at the senior policymaking level. On the other hand, information about a diverse company as a whole is too aggregated.
Inbetween those extremes is information about groups of related products and services on which senior management or board members choose to focus in analyzing a company's performance and managing and overseeing a company's operations. Users also would benefit from reporting on those segments because of the insight it would provide into a company's opportunities and risks. Aligning business with internal reporting also is consistent with the objective of many users to understand management's perspective about the company it manages; this same theme is central to the Committee's model of business reporting. Users complain that companies too frequently cannot answer questions about segment data in business reporting because it is classified inconsistent with the segment data used internally.
Users also complain that companies too often discuss business segments in MD&A that are not reported as separate business segments in the segment note in the financial statements. Aligning business with internal reporting would solve both problems. It also would provide users with insight into how management defines its businesses, which can indicate the direction in which management intends to take the company, provide insight into opportunities and risks, and reduce costs of preparing disclosures. Some multiindustry companies choose to manage and report internally along a basis other than by industry.
For example, some companies manage and report solely on a geographic basis. However, the fact that a multiindustry company chooses to manage itself geographically does not override the fact that it operates in multiple industries or that its activities in those industries are subject to different opportunities and risks. Thus, multisegment companies should report information about their industry segments even if they manage their businesses on a different basis. In addition to aligning business with internal reporting, standard setters should consider the following practical devices that may help companies define their industry segments consistently with users' needs for information. In deciding on industry segments, companies should:
It is important to distinguish between industry segments and product line segments. Industry is a broader concept than product line and a far broader concept than individual products. With one exception, diverse companies should report information about industry segments and not about product lines or individual products. The exception is the unusual case in which a single product line or individual product is a critical cause of a company's opportunities and risks. In that case, a company should provide segment information for that product line or individual product.
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. Two bases of geographic information may be helpful in assessing opportunities and risks. The first is where a company sells its products or services (market locations) and the second is where a company produces products or services (operating locations). As discussed in chapter 3, the usefulness of geographic information depends on the company and its circumstances. The basis of geographic information, and the regions to be reported, can differ among companies and over time for the same company. Because the usefulness of geographic segment information varies, the Committee recommends flexible standards. Those standards should:
The Committee's recommendations differ from the geographic segment requirements in Statement 14 in two respects. First, the Committee suggests that companies consider disclosing geographic information on two bases: operating locations and market locations. In contrast, Statement 14 requires geographic information based on operating locations and export sales from the company's home country. As discussed above, segment information based on market locations often can provide considerable insight and should be disclosed when important. The Committee rejects disclosures about export sales because the information overlaps and is not as complete as segment information based on market locations. Second, the Committee suggests that information about geographic regions within countries occasionally can provide particular insight and should be disclosed when important. In contrast, Statement 14 does not require disclosures for areas smaller than countries.
The Committee's recommendations regarding financial disclosures about segments are discussed under four headings: key statistics; limitation on the statistics to be reported; limitations on the types of companies reporting segment information; and other matters related to the types of segment information to be provided.
In concept, users would like complete financial statements for each industry and geographic segment. However, as a practical matter, for the reasons discussed below under "The Costs of Reporting Segment Information," companies should be allowed to limit segment disclosures to key financial statistics. The FASB adopted the key statistic approach. For example, for industry segments, Statement 14 requires that multisegment companies report revenues, operating profit, identifiable assets, depreciation and amortization, capital expenditures, and equity income of investees.
It also requires that for foreign operations, companies report revenues, a measure of profitability, and identifiable assets. The Committee recommends that standard setters reconsider the key statistics to be reported for segments, including whether the statistics should vary by industry or sector. For example, it may be appropriate for financial institutions to report statistics that differ from those reported by manufacturing companies. In addition, standard setters should consider whether the key statistics should be expanded beyond those now required to include:
In specifying the computation of the key statistics, standard setters should not require arbitrary allocations of revenues, expenses, assets, or liabilities. Rather, they should allow companies to report a statistic on the same basis it is reported for internal purposes, if the statistic is reported internally. The usefulness of information prepared only for business reporting is questionable. Users want to understand management's perspective on the company and the implications of key statistics. Management will be in the best position to address questions about the statistics if they are consistent with the information reported and used internally.
The Committee recommends that key statistics to be reported be limited to statistics a company has available (with the exception of revenues and cost of revenues, as discussed below). This concept differs from Statement 14, which requires that companies report key statistics even if they have to develop new reporting to capture the information. A statistic is available to a company if it is used for internal reporting or if information already captured by the accounting system can be aggregated to develop the statistic. Limiting the statistics reported to those that are available serves several objectives. First, it reduces costs of gathering, auditing, and reporting information, particularly for smaller multisegment companies. Second, it is more likely that management can respond effectively to questions from users about information it uses to manage the segment.
Third, the fact that a company does not capture a particular statistic may suggest the statistic is not very relevant. All multisegment companies should report at least the revenues and cost of revenues (for the manufacturing industry, and surrogate measures for other industries) related to their segments. Revenues and costs of revenues are so important to evaluating segment performance that reporting them is justified even if the information is not readily available. The Committee suspects, however, that this requirement would not impose a burden on most companies since they already capture this information.
Creditors prefer segment reporting requirements to be the same for public and nonpublic entities. Regardless of company size or ownership, operating in different industries or over varied geographic areas causes a company to face diverse opportunities and risks; information about industry or geographic segments helps users assess those opportunities and risks. Thus, the Committee recommends that segment reporting apply to all multisegment companies. This recommendation differs from Statement 14, which requires segment reporting only for multisegment public companies.
Statement 14 requires companies to report segment information in a format that reconciles each key statistic to the applicable consolidated total in the financial statements. Often, that reconciliation requires an "other" segment that includes businesses or geographic regions that individually do not meet the criteria for disclosure as separate segments. That requirement has provided users with useful information and should be continued. The Statement also requires that companies restate previously reported segment information to reflect changes in definitions of industry or geographic segments. Segment information should be restated if the restatement can be reasonably assembled and is necessary for a better and more complete understanding of the business. Otherwise, restatement or reclassification should not be required.
The Committee is sensitive to the costs of segment reporting and has attempted to develop recommendations that could be met without inflicting significant costs on companies. Companies are concerned about the costs of accumulating, preparing, and auditing segment information and about the potential competitive costs of segment reporting. These costs are discussed below.
Defining segments consistently for internal and business reporting, limiting the reported statistics to those available, not requiring arbitrary allocations, and reporting on geographic segments only when it provides insight about opportunities and risks reduce significantly the costs of accumulating, preparing, and auditing segment information. Because smaller companies currently are exempt from reporting segment information, they are particularly concerned about the additional costs engendered by that reporting. The Committee believes that the vast majority of smaller companies operate in single industries or in narrow geographic regions and would not be subject to segment disclosure requirements. For smaller companies operating in diverse businesses or geographic locations, segment reporting would be limited to revenues, costs of revenues, and other key statistics available. That information could be provided at minimal cost. The Committee's recommendations would result in some public companies reporting more industry segments than they report currently. However, the incremental costs to accumulate and prepare information about those segments should not be significant if business reporting is aligned with internal reporting as the Committee recommends.
Companies, particularly public companies, are concerned about the potential competitive costs of improved reporting of segment information. They are concerned that competitors will gain new insight from segment information and use that insight to the company's competitive disadvantage. To a lesser extent, companies are concerned that suppliers and customers also will gain new insights from better segment reporting, thereby enhancing their relative bargaining positions in price negotiations. Three factors mitigate the competitive costs of segment reporting. First, companies already receive useful information about competitors from competitors' former employees, mutual suppliers and customers, market research, and the marketplace.
The competitive cost of disclosing segment information depends on the incremental insight that information brings to competitors relative to their other information sources. Second, competitive costs are mitigated by the broad nature of segment reporting. The concept of an industry segment is broader than that of a line of business and far broader than that of individual products. Thus, industry segment reporting provides information that is not as useful to competitors as information about lines of business and individual products would be. Third, the insight competitors gain is at least partially offset by the insight a company gains from its competitors' segment information. Many public companies are concerned about the unfair advantage of foreign competitors that raise capital in their local markets and, under their local reporting requirements, do not disclose segment information.
Some U.S. companies argue for leveling the playing field by allowing U.S. companies to report fewer segments or less segment information. That solution, however, would itself tilt the playing field in favor of U.S. multisegment companies, which still would have access to the complete reporting of their singlesegment, public company competitors. The Committee does not recommend eliminating segment reporting because of its usefulness and because of the unlevel playing field it would create for U.S. companies. The playing field with foreign competitors should be leveled by harmonizing reporting standards in a manner that meets users' needs for information, not by reducing the quality of U.S. reporting.
As discussed in chapter 5, the Committee recommends that management should not be required to report information that would harm a company's competitive position significantly. That constraint should apply to reporting segment information. However, if competitive costs are significant, a company should not report fewer segments. For example, a multisegment company should not suggest that it is in one industry. Rather, it should omit only the particular types of information that are competitively harmful, while disclosing the remainder.
Companies did not raise litigation costs as a significant factor in improving segment reporting. Segment information usually is derived from the same accounting records as those used to prepare the company's financial statements. Thus, management should be comfortable with the source and reliability of the information, particularly if it is aligned with internal reporting, as the Committee suggests. Further, unlike other types of data such as forwardlooking information, segment information does not appear to be a troublesome source of litigation.
Users want to understand and analyze significant investments in unconsolidated entities (investees) for the same reasons they want to analyze segments: separate analysis of an investee provides insight into opportunities and risks that aggregated reporting cannot achieve. Investees include noncontrolling investments by one company in another company, partnership, or joint venture. The frequency and magnitude of those investments are increasing as companies seek to take advantage of new technology or market opportunities while sharing risks with others. Many investments in investees are accounted for by the equity method. Under that method, the investment is reported in the balance sheet of the investor as a single amount.
Likewise, an investor's share of earnings or losses from its investment usually is reported in the income statement as a single amount. In most cases, additional information about an investee's results of operations and financial position is provided in notes to the investor's financial statements. There are two alternatives to the equity method of accounting for recognizing investments in investees: proportionate consolidation and expanded equity methods. Under the proportionate consolidation method, an investor would record its proportionate interest in the investee's assets, liabilities, revenues, and expenses on a linebyline basis and combine the amounts with its own assets, liabilities, revenues, and expenses.
For example, if an investor owns 30 percent of an incorporated joint venture, 30 percent of the joint venture's cash balance would be added to the investor's cash balance; 30 percent of the investee's other assets, liabilities, revenues, and expenses would be handled similarly. Under the expanded equity method, an investor's share in the total current and noncurrent assets and liabilities and in the total revenues and expenses would be displayed separately from the investor's other assets, liabilities, revenues, and expenses in the investor's financial statements and labeled descriptively, such as, "current assets of investee." Total assets of the investor would include the combined total of investee's and investor's financial items. This reporting method is a compromise between the oneline display under the equity method and the combined display of an investor's and investee's assets, liabilities, revenues, and expenses required under the proportionate consolidation method.
Users reject the proportionate consolidation method for accounting for investees because it combines amounts users seek to disaggregate. Users want to understand the opportunities and risks of significant investees as separate entities, much as they want to evaluate business segments separately. Combining amounts related to investors and investees reduces users' ability to focus on investees' operations. Worse, amounts related to investees can distort trends and relationships related to the investors' operations. Thus, users fear the proportionate consolidation method would result in a loss of important information. Users prefer either the equity or expanded equity methods, with no strong preference, provided there is adequate disclosure of information about significant investees. Disclosure is key. Users complain that companies too often do not report enough information about investees.
Consistent with their views on segment information, they recommend more disclosure about individual investees, particularly if those entities are important to the reporting company's earnings, cash flows, opportunities, or risks. Many users would prefer to receive full financial statements for all investees or, at least, each significant investee, and would define significant using a 10 percent criterion rather than the SEC's 20 percent criterion (rule 309 of regulation SX). Some users support full financial statements for significant investees using the 20 percent criterion in deference to costbenefit considerations.
Users believe that it is more important to get more information about each significant investee than aggregate information for insignificant investees. They are concerned that aggregated information for investees is not helpful because it combines entities having diverse opportunities and risks. The Committee recommends the following concerning the accounting and disclosure of information about unconsolidated investees:
The FASB currently is reconsidering the requirements of Statement 14 in a major project on disaggregated disclosures. Two aspects of this project are particularly positive: a user focus and involvement of other standard setters. The project began with Reporting Disaggregated Information, a research report issued in February 1993, which, among other matters, summarized research about users' needs for segment information. The board also is studying the Committee's work on users' needs for segment information and has held several meetings with analysts and companies on the issue of how industry segments should be defined.
The board intends to seek additional user input in the future. The board is conducting the project jointly with the Accounting Standards Board of the Canadian Institute of Chartered Accountants (CICA) in an unprecedented effort to develop a parallel standard. Further, the International Accounting Standards Committee's (IASC's) agenda also includes a project on segment reporting, and the FASB, the CICA, and the IASC are exchanging information as their respective projects progress. The Committee is pleased that the FASB has recognized the importance of improving segment reporting, is basing its decisions on research with users, and is coordinating its work with other standard setters.
Coordinated efforts that focus on the information needs of users offer the best chance for harmonizing standards in a useful way. The FASB's project on unconsolidated entities is not currently active, although the board plans to resume work on it in the future. The project will address presentation in the investor's financial statements of investments in noncontrolled entities, including joint ventures and undivided interests. The Committee recommends that the project's scope include disclosures about investments in unconsolidated entities as well as the accounting for those investments.
Those disclosures should focus on financial information about each significant unconsolidated entity. The FASB also should consider disclosures of qualitative information, such as the business reason for the investment and the nature of dealings between the investee and investor. In addition to considering investments in equity securities, the scope of the project should include all significant interentity affiliations resulting from contractual arrangements or other such situations.
Address the disclosures and accounting for innovative financial instruments. In recent years, there has been an explosion of innovative financial instruments such as swaps, swaptions, embedded options, compound options, caps, floors, collars, and many others. That explosion is likely to continue because the underlying causes ; increased volatility and the need to manage risks related to that volatility, increased competition, and advances in techniques for analysis and information technology ; are likely to continue .
Accounting standards have not kept pace with the proliferation of innovative instruments. As a result, users are confused. They complain that business reporting is not answering important questions, such as: What is the company's goal in using innovative financial instruments, and how is the company going about achieving that goal? What instruments has the company entered into, and what are their terms? How has the company accounted for those instruments, and how has that accounting affected the financial statements?
What risks has the company transferred or taken on? If the company has hedged certain risks, what are the related transactions or events hedged and when are they expected to occur? Many of the above questions can be addressed through improved disclosure. However, users also are concerned about whether the accounting for innovative financial instruments reflects the underlying economics of those instruments. Those concerns raise fundamental accounting questions, such as: When should financial instruments be recognized in financial statements, and when should financial assets or liabilities be considered sold or settled?
In what circumstances should financial instruments be measured at historical cost, market value, lower of cost or market, or some other basis? How should financial instruments that consist of both liability and equity elements be treated? What special accounting, if any, is appropriate for hedging activities? To date, accounting guidance has focused on specific innovative financial instruments and conditions. For example, the FASB Emerging Issues Task Force (EITF) has dealt with sixtyone issues on financial instruments, many involving innovative instruments, the largest category of issues the EITF has addressed.
Although the EITF's work has been important and has filled a void in guidance, an instrumentbyinstrument approach offers little hope of addressing the fundamental questions that need to be addressed. Further, it always will lag behind the pace of innovation in financial instruments. What is needed is broader guidance that addresses fundamental issues. That guidance would provide a framework for addressing the accounting for future innovations in financial instruments, thereby leading rather than lagging behind the pace of change. The FASB appreciates the need for broader guidance. Since 1986 the board's agenda has included major projects on financial instruments, with the ambitious goal of creating a broad framework that addresses fundamental issues.
To date, standards have focused on disclosures, which, as indicated by the first set of questions, are important. It also has issued documents addressing recognition and measurement issues, including three statements, an interpretation, two discussion memoranda, and various research reports. Several projects on financial instruments currently are active and more projects are waiting in the wings for a spot on the agenda. A considerable portion of the board's staff is devoted to projects involving financial instruments. The Committee's work with users affirmed the critical importance of improving disclosures and accounting for innovative financial instruments, thereby confirming that the FASB is addressing the appropriate issues and is right in giving that work the highest priority.
Improve disclosures about the identity, opportunities, and risks of offbalancesheet financing arrangements and reconsider the accounting for those arrangements. Users are concerned that they do not understand the risks resulting from certain transactions and arrangements that, under current accounting rules, are not reflected on the balance sheet. Those transactions and arrangements sometimes involve longterm leases, unconsolidated and special purpose entities, and securitizations, to cite a few examples. The following discussion describes those transactions or arrangements, reasons for the users' concern, the FASB's projects addressing offbalancesheet financing arrangements, and the Committee's recommendations.
Some users believe all leases convey both property rights and obligations that should be recognized as assets and liabilities on the lessee's balance sheet. Thus, they would eliminate the distinction between operating and capital leases and capitalize all leases. The AIMR holds that view and would extend the concept to recognize in financial statements the rights and obligations in all executory contracts. Other users see a fundamental distinction between leases that convey the rights and obligations of property ownership and those that are executory, representing the rental of property.
They argue that the distinction between operating and capital leases should be retained. Some users within this group generally are pleased with the current criteria used to distinguish operating and capital leases. Others would change the criteria in one manner or another to, for example, classify more leases as capital leases. Regardless of their views on the accounting for leases, most users would expand disclosures related to operating leases. Current disclosures, they believe, are not adequate to allow users to understand the opportunities, risks, and obligations that result from the company's leasing contracts. To provide more insight they suggest, for example, that companies:
Companies maintain significant but noncontrolling ownership interests in other entities (unconsolidated entities) for many reasons. For example, a company may want to share financial and market risks with others in joint ventures, access new technology, or enter foreign markets that require local company control. Some companies also are motivated to structure investments in unconsolidated entities to finance assets or operations without recognizing the associated debt on their balance sheets. Because companies do not control unconsolidated entities, they recognize their net investment as a single asset and do not record the entities' separate assets and liabilities.
Companies that structure investments in unconsolidated entities primarily to achieve off balancesheet treatment often want to retain as many benefits of complete ownership of the entities as possible without triggering consolidation. For example, a company may manage the unconsolidated entity or agree to purchase a large portion of the products or services the entity provides. At the same time, the parties providing the financing for the entity may want the company to retain as much of the risk as possible concerning the entity's debt and may require, for example, that the company guarantee the debt. One popular structure involves the use of special purpose entities (SPE) whereby a company (the sponsor) forms a new company (the SPE) that will operate primarily for the benefit of its sponsor. Usually the SPE is highly leveraged and capitalized with minimal equity.
The sponsor retains most of the opportunities and risks related to the SPE even though it may own little or none of the SPE's equity. Retaining most but not all of the risks and rewards of ownership over the unconsolidated entity raises fundamental questions about the circumstances in which one company should consolidate another. Users are concerned that current rules may permit companies to exclude from their balance sheets rights and obligations that make companies appear to be less risky than they are.
Other users do not propose changes to the criteria for consolidation but suggest the need for expanded disclosures about unconsolidated entities ; disclosures that allow users to understand the opportunities and risks resulting from a company's investment in an unconsolidated entity and its contractual ties to that entity. Some users would like enough information to judge whether the unconsolidated entity should be consolidated for purposes of their analysis and, if so, to prepare approximate pro forma statements to reflect that consolidation.
Securitizations involve the sale of assets, usually financial assets such as receivables, to a trust that then issues securities to investors. The cash flows to the security holders are determined by the cash inflows from the assets in the trust. Securitizations have become popular in recent years and have expanded both in terms of value and in the types of financial assets that are securitized. They have opened new ways for companies to sell financial assets and have offered investors a diverse range of securities tied to various portions of the cash flows from the trust. Companies that sell financial assets to be securitized and that have no continuing involvement with them raise few accounting issues.
However, in some cases, companies retain risks and rewards associated with ownership of the assets. For example, companies may continue to service the financial assets in the trust or guarantee that the credit losses related to the assets will not exceed a certain amount. A company's continuing involvement with the assets in the trust raises fundamental questions about the substance of the securitization transaction. Did the company sell assets or did it obtain financing secured by the assets? Current rules usually allow companies to record the transfer of assets in a securitization as a sale. Some users are concerned that some forms of continuing involvement with the assets are inconsistent with recording sales.
Other users are not concerned about the current accounting for securitizations. However, most users would prefer more disclosure about the continuing involvement of companies with assets that have been securitized and risks related to that involvement.
The FASB's agenda includes projects addressing unconsolidated entities, special purpose entities, and securitization transactions. The scope of those projects includes both accounting and disclosures. The Committee's research with users affirmed the importance of providing accounting guidance for commonly used offbalancesheet financing arrangements. However, due to time and resource limitations, the Committee did not develop recommendations related to accounting for unconsolidated entities, special purpose entities, and securitizations. Users emphasized the importance of improving disclosures related to offbalancesheet financing arrangements.
Better disclosure would provide insight into the opportunities and risks of those arrangements that accounting alone cannot provide. Better disclosure also would permit users to calculate pro forma adjustments to the financial statements to reflect their own views about accounting for offbalancesheet financing arrangements. The Committee encourages the FASB to emphasize disclosures in its projects on unconsolidated entities, special purpose entities, and securitizations. The Committee does not recommend that the FASB reconsider the accounting for leases at this time. Users are divided about the best accounting and for users that choose to do so, improved disclosures could provide enough information to determine the effect of capitalizing all leases. Because of the importance of disclosures, the Committee recommends that the FASB add a limitedscope project to its agenda to improve disclosures by lessees of operating leases.
Report separately the effects of core and noncore activities and events, and measure at fair value noncore assets and liabilities. The display of information on the face of financial statements offers a powerful tool in assisting users with their analysis. Financial statements do not display only net income, total assets, total liabilities, or net cash provided by operations. Rather, each statement includes key components within those totals designed to:
Exhibit 1
a company's
major or central operations and those of other activities or events
allows users to analyze trends affecting the business without
the potentially distortive effects of peripheral or incidental
activities.
Users believe that financial statements and related disclosures do not contain sufficient information about unusual or nonrecurring items to meet users' needs for information. The information is insufficient because the statements do not identify a sufficiently broad range of unusual or nonrecurring items. Further, the descriptions and details of items labeled as unusual or nonrecurring are sometimes insufficient to permit users to evaluate whether, for analytical purposes, to exclude the effects of the items from recurring operations.
Without adequate information about the effects of unusual or nonrecurring items, users fear they will develop misleading impressions about key trends in the financial data (see exhibit 1). For example, the revenues and gross margin resulting from a onetime unusually large sale, if not separately disclosed, could create a misleading impression about the trends in market share, revenue, and income. Because users often apply a multiple to their estimates of a company's earnings or cash flows in valuing companies, misleading impressions about a key trend, or the sustainability of a company's earnings, can magnify an error in valuation. The Committee believes that information about unusual or nonrecurring transactions and events should be improved.
Although there are various ways to provide improved information, the Committee believes that improved display of information on the financial statements, coupled with improved disclosure, offers a powerful tool to improve users' understanding of unusual or nonrecurring transactions or events. More specifically, the financial statements should distinguish between the effects of core and noncore activities and events, and the related footnotes should include disclosures about the effects of noncore items.
The goal of distinguishing, on the financial statements, between the effects of core and non core activities is to present the best possible information with which to discern trends in a company's business. A company's core activities are usual or recurring activities, transactions, and events. Usual means the activity is ordinary and typical for a particular company. Recurring means the activity, transaction, or event is expected to occur again after an interval. Core activities include usual or recurring operations and recurring nonoperating gains and losses. Conversely, noncore activities, transactions, and events are unusual (not typical for a particular company) or nonrecurring (not expected to occur again in the forseeable future or before a specified interval). Examples include:
It can be presumed that all operations of a company are core activities unless considered otherwise by management. Current practice already distinguishes between the effects of continuing operations, discontinued operations, and changes in accounting principles. Further, the concept of separately displaying unusual or nonrecurring transactions or events (termed extraordinary items) is also in authoritative guidance. However, that concept has been interpreted so narrowly in practice that few transactions or events qualify as extraordinary. Users would be served better by broadening the concept of unusual or nonrecurring transactions or events.
The term core activities sometimes is used in the business community to mean major, critical, or central operations as opposed to peripheral or incidental operations. However, based on discussions with users, the Committee uses the term core differently, as described above. The Committee believes that insight into different business activities, such as a company's main business and its emerging business, is best provided through segment reporting and not through display of information on the face of the financial statements. The Committee considered whether disclosures about unusual or nonrecurring items should be part of the financial statements or part of another element of the Committee's model, such as the management's analysis element. The Committee decided they should be in the financial statement element for the following reasons:
Distinguishing between the effects of core and noncore activities would affect display on the income statement, statement of cash flows, and balance sheet, as described below.
Core earnings are not a prediction of future earnings. Rather, they are historical earnings adjusted to exclude the effects of historical unusual or nonrecurring items. The goal of presenting core earnings is not to present an estimate of normal income or recurring income. Neither should core earnings be averaged or smoothed artificially. The core earnings of a business that is inherently cyclical or volatile should appear cyclical or volatile ; not smooth. Exhibit 2 illustrates the changes that would be required in current practice to distinguish between core and noncore earnings:
Nearly all users were intrigued with the concept of core earnings. Users agreed with the importance of providing more information about unusual or nonrecurring items. Further, many
Exhibit 2
INCOME STATEMENT DISPLAY
MANUFACTURING COMPANY
Current Practice With Core/Non-Core Concept
Revenue* Revenue*
Cost of revenue* Cost of revenue
Gross margin
Selling, general, and Gross margin
administrative expenses* Selling and marketing
Research and development
General and administrative
Other operating costs and Other operating costs and expenses
expenses*
Operating income
Interest expense Recurring non-operating gains and
Non-operating gains* losses
Non-operating losses*
Pre-tax income from continuing Pre-tax core earnings
operations Income taxes related to core
Income tax expense earnings
Income from continuing Core earnings
operations before extraordinary
item and change in accounting
principle
Non-core items and financing
costs:
Financing costs (e.g., interest
income and
expense and gains and losses
from settlement of debt)
Income (loss) from discontinued Income (loss) from unusual or
segment of non-recurring transactions and
the business events
Income before extraordinary item Income (loss) from discontinued
and cumulative effect of change operations
in accounting principle
Extraordinary item
Effect of change in accounting
principle
Effect of change in accounting
principle
Pre-tax non-core income and
financing costs
Net income Income taxes related to non-core
items and
Share data: financing costs
Income from continuing Non-core income and financing
operations costs
Income before extraordinary item Net income
and
change in accounting Share data:
Net income Core earnings
Non-core income and financing
Weighted average shares costs
outstanding
Net income
Weighted average shares
outstanding
* May include unusual or
non-recurring items.
Note: The notes would disclose a
company's accounting policies
used to distinguish between core
and non-core activities and the
details of the individual items
included in captions on the
income statement. For example,
the accounting policies note
would discuss a company's policy
for determining unusual or
non-recurring transactions and
events. The notes also would
identify, describe, and quantify
the effects of each individually
significant transaction or event
that is classified as unusual or
non-recurring.
adjust a company's reported income using a concept similar to core earnings to identify better trends in the business. Thus, the concept of core earnings appears to parallel the users' own thought processes. Nevertheless, some users are reluctant to support a separate display of core earnings. They believe that determining core earnings is the role of financial analysis and not financial accounting. Further, they are concerned that the concept is vaguely defined and will result in noncomparable reporting in practice.
The Committee agrees that the ultimate judge of core earnings is financial analysis. However, the Committee does not propose the display of core earnings to replace user judgment. Rather, it proposes the concept as a means of providing a framework and discipline to present data that are useful to users in forming their own judgments about a company's core earnings and about unusual or nonrecurring items. Note disclosures about the individual items in the noncore category should be designed to allow users to decide for themselves whether a particular item should be included in or excluded from core earnings. The Committee acknowledges that two people looking at the same facts may reach different conclusions about the best measure of core earnings. However, management is in the best position to identify unusual or nonrecurring items, and users would benefit from that insight.
Further, users will make judgments about the effects of unusual or nonrecurring items regardless of whether business reporting discloses information about those items. Better disclosures about unusual or nonrecurring items allow users to make better judgments. Many preparers with whom the Committee spoke also were concerned about distinguishing between core and noncore items. Although they generally were intrigued by the concept, many considered the concept to be impractical. They noted that managers within their companies have spent a lot of time discussing the best measure of core earnings, often without agreement. Some companies even have concluded that nothing that affects their business is unusual or nonrecurring.
The fact that many companies spend considerable time identifying core earnings underscores the analytical importance of identifying unusual or nonrecurring items that have affected the business. For public companies, the SEC already requires management to describe unusual or nonrecurring events or transactions and to quantify their effect in MD&A. The Committee's recommendations about core earnings provide a framework for thinking about and reporting disclosures that are already required.
Exhibit 3 illustrates the changes that would be required in current practice to distinguish between core and noncore cash flows:
In valuing companies, users convert many measures into per share amounts, including earnings per share and operating cash flow per share. No single measure is universally accepted
Exhibit 3
STATEMENT OF CASH FLOWS DISPLAY
CASH FLOWS FROM OPERATING
ACTIVITIES
MANUFACTURING COMPANY
Current Practice With Core/Non-Core Concept
Cash Flows From Operating Cash Flows From Operating
Activities Activities
Core:
Net income Core earnings
Adjustments to reconcile to net Adjustments to reconcile to net
cash provided cash
by core activities provided by core activities
Depreciation and amortization Depreciation and amortization
(other adjustments listed here) (other adjustments listed here)
Net cash provided by core
activities
Non-core and financing costs:
Non-core income and financing
costs
Adjustments to reconcile to net
cash
provided by non-core activities
and
Net cash provided by core financing costs (adjustments
activities listed here)
Net cash provided by non-core
activities and financing costs
Net cash provided by operating
activities
The investing and financing
portions of the cash flow
statement would be unchanged.
or sufficient. Consistent with various measures computed and used in practice, the Committee's model permits disclosure of cash flow per share data, including core cash flow per share. In contrast, current guidance prohibits reporting cash flow per share data in financial statements and discourages reporting the data outside of financial statements, such as in MD&A.
Exhibit 4 (p. 86) illustrates the changes that would be required in current practice to distinguish between core assets and liabilities and noncore assets and liabilities. The display would help users:
Core assets and liabilities result from a company's usual or recurring activities, transactions, and events. Conversely, noncore assets and liabilities result from unusual or nonrecurring activities, transactions, and events.
Exhibit 4
BALANCE SHEET DISPLAY
MANUFACTURING COMPANY
Current Practice With Core/Non-Core Concept
Current assets: Current assets:
Cash Cash
Accounts receivable, net Accounts receivable, net
Inventories, net Inventories, net
Deferred tax assets Deferred tax assets
Other current assets Other core current assets
Non-core current assets (measured
Current assets at value)
Current assets
Property, plant, and equipment
Other long-term assets Property, plant, and equipment
Other long-term assets
Long-term non-core assets
Total assets (measured at value)
Current liabilities: Total assets
Accounts payable and accrued
liabilities
Income tax payable Current liabilities:
Current portion of debt Accounts payable and accrued
liabilities
Income tax payable
Current portion of debt
Current liabilities Non-core current liabilities
(measured at
Long-term debt value)
Deferred tax liabilities Current liabilities
Other liabilities
Long-term debt
Total liabilities Deferred tax liabilities
Other liabilities
Stockholders' equity (list Non-core liabilities (measured at
components) value)
Total liabilities and Total liabilities
stockholders' equity
Stockholders' equity (list
components)
Total liabilities and
stockholders' equity
The current model for measuring core assets and liabilities should be retained. However, for the reasons described below, noncore assets and liabilities should be measured at fair value. Further, changes in unrealized appreciation or depreciation in those assets or liabilities should be charged or credited directly to shareholders' equity. The fair value of noncore assets or liabilities is directly relevant to many users that value companies using the following general formula. Those users usually follow fundamental approaches and often apply the formula segmentbysegment.
Improve disclosures about the uncertainty of measurements of certain assets and liabilities. Under the current accounting model, all assets and liabilities must be measured and reported at an exact amount. There is little on the balance sheet or income statement indicating the relative precision of measurements ; all appear to be equally precise ; even though the various types of assets and liabilities may be subject to widely different degrees of precision.
The precision of measurements depends in large part on whether the measurement involves assumptions about future events. The measurement of some types of assets and liabilities does not involve those assumptions and therefore can be more precisely measured. Examples include:
In many other cases, however, the measurement of assets and liabilities involves assumptions about future events. Examples include:
Information about the relative precision of the measurement of assets and liabilities is critical for users. It provides users with insight into:
Users agree that disclosures should be made about the estimates and assumptions used to measure assets or liabilities whose measurement is inherently imprecise (measurement uncertainties). They suggest that current disclosures about the imprecision of measurement are not adequate to meet users' needs for information. The Committee recommends that disclosures about measurement uncertainties be improved. More specifically, companies should:
The goal of the disclosure is to convey information about the relative imprecision of a measurement and the key assumptions about the future on which that measurement is based, as well as, if possible, the sensitivity of the measurement to changes in those key assumptions. The key to meaningful disclosure is to be selective about the measurement uncertainties disclosed. Boilerplate statements that the measurement of various items in the financial statements is inherently imprecise are not helpful to professional investors, although it may serve as a useful caution to unsophisticated readers of the financial statements. However, focusing users' attention on the specific facts related to key measurement uncertainties is useful to all types of users. Whether to discuss a particular measurement uncertainty should depend on:
Under those criteria, many measurement uncertainties are not sufficiently important to be discussed. For example, a company's trade receivables may be subject to credit risk. However, if the company's experience suggests that bad debts consistently have been immaterial and nothing suggests that it will be different in the future, there is no reason to discuss the measurement uncertainty associated with trade receivables. Accounting standards already require disclosures that provide some insight into the precision of measurements. For example, FASB Statement No. 5, Accounting for Contingencies, focuses on the accounting and disclosure for loss contingencies. The Committee's suggested disclosures for measurement uncertainties, however, differ from the disclosures required by Statement 5 in two important respects:
The AICPA Accounting Standards Executive Committee (AcSEC) has issued a proposed Statement of Position, Disclosure of Certain Significant Risks and Uncertainties and Financial Flexibility, which deals in part with measurement uncertainties. The Committee recommends that standard setters adopt a broad perspective on measurement uncertainties consistent with users' needs for information and the Committee's recommendations.
Improve quarterly reporting by reporting on the fourth quarter separately and including business segment data. The importance to users of quarterly reporting, particularly quarterly reporting by public companies, is discussed in chapter 3.
Quarterly reporting by public companies has been accepted for years and many private companies report on an interim basis at the request of users. However, in many cases, interim reporting is not needed by users. For example, a trade creditor of a wellestablished, profitable company may be comfortable with annual reporting by its customer. The Committee is not suggesting that all private companies report quarterly. Because the need for interim reporting varies for private companies, they and the users of their business reporting should continue to negotiate and agree on the frequency of interim reporting, if any, as they do in current practice. Because of its importance, the users of quarterly reporting are very interested in the quality and completeness of that reporting. They have offered several ideas for its improvement, two of which they feel particularly strongly about: fourthquarter reporting and quarterly segment reporting.
Currently, public companies file quarterly reports with the SEC for the first three quarters as well as an annual report. They do not report separately on the fourth quarter. The users of quarterly reporting see little difference between the first three quarters and the fourth; they want to analyze a company quarter by quarter, including the fourth quarter. Users acknowledge that fourthquarter financial statements can be derived easily from annual and thirdquarter statements. They argue, however, that they would benefit from management's analysis of fourthquarter results, including an update about trends affecting the business, the effects of unusual and nonrecurring transactions and events, and significant fourthquarter adjustments.
Current reporting does not provide users with that information. Users recognize that companies cannot report on the fourth quarter until they are ready to report on the annual period. The Committee believes reporting on the fourth quarter would be useful to users. Management's insight into trends and the effects of unusual and nonrecurring items is as useful in the fourth quarter as it is for the first three quarters. Without fourthquarter reporting, many users have no access to that insight. Fourthquarter reporting should be no different from reporting on other quarters except for disclosure of significant yearend adjustments. Notes related to yearend balance sheet amounts can generally be omitted if the fourthquarter financial statements are included in annual reporting.
The Committee also believes public companies can report on the fourth quarter at acceptable cost. Most, if not all, of the information that would be reported for the fourth quarter, such as unusual and nonrecurring items, management has had to identify and consider in developing the annual report. Further, the fourthquarter report could be abbreviated by crossreferencing to material included in the annual report.
Users also suggest that multisegment companies provide segment data in quarterly reports on the same bases as they provide them in annual reports. The call for interim segment information results from two analytical techniques that already have been discussed: analysis of a company segment by segment and quarter by quarter. The logical result of those techniques is analysis of a company's business segments quarter by quarter. As discussed earlier, segment reporting provides users with insight about the different opportunities and risks of a company's diverse businesses. For many users, the business segment is the unit of analysis.
Quarterly reporting by segment would combine the power of two useful analytical techniques and would allow users to better perceive changes in trends affecting each segment. For that reason, quarterly segment reporting is a high priority for users. Some companies already report segment information quarterly because of user interest in the information. Companies that do not may refer to business segments in their quarterly MD&A, a point that frustrates users. Those facts underscore the usefulness of quarterly segment information.
The Committee believes companies can provide quarterly segment data at acceptable cost by following the Committee's earlier recommendation for segment reporting. Aligning external segment reporting with internal reporting, limiting segment data to key statistics that are available, and not requiring arbitrary allocations of costs for segment reporting would reduce the cost of reporting segment data on a quarterly as well as an annual basis.
Standard setters should search for and eliminate less relevant disclosures. Over time, the cumulative effect of disclosure standards has resulted in a significant increase in the volume of information disclosed. For example, over the past twenty years, disclosures in financial statements have increased significantly in major areas such as leasing, business segments, related parties, pensions, postretirement benefits other than pensions, income taxes, fair value of financial instruments, and offbalancesheet risk of financial instruments.
The expansion in business reporting has been wellreceived by users and has been generally sound, given the benefits of improved reporting and the increased complexity of the business environment and transactions. However, certain disclosures no longer may be as useful after a reporting standard has been in place for a period of time. For example, disclosures introduced to educate users about the mechanics of a new standard no longer may be as useful after users have become familiar with the new standard. Further, business conditions may have changed, thereby reducing the importance of a certain disclosure.
Finally, despite research and due process by standard setters, a disclosure may not be as useful to users in practice as originally thought. Standard setters and regulators periodically have reconsidered and deleted from their requirements less useful disclosures. For example, the FASB rescinded requirements for disclosures related to current cost/constant purchasing power information and earnings per share information related to nonpublic companies. Similarly, the SEC recently proposed eliminating some of the information now required in supplemental schedules. Standard setters and regulators should expand their efforts to eliminate disclosures that are less useful. Eliminating less useful disclosures offers several advantages. First, it would reduce the costs of preparation and auditing without significant loss of benefit. Second, it would reduce the need for users to wade through excess material.
Third, it would demonstrate to constituents the standard setters' concern for reducing costs associated with business reporting where possible and thereby reduce barriers to constructive changes. Finally, eliminating less useful disclosures would make room for more useful information, such as that consistent with the Committee's recommended model of business reporting. In the Committee's discussion groups, other meetings with users, and survey, the Committee asked users to identify less useful disclosures that are now required. Unfortunately, users are reluctant to identify disclosures that should be eliminated. They reason that any disclosure could be helpful in at least some circumstances. Their reluctance also reflects a desire to know as much as possible about the company under analysis. Thus, the Committee's efforts identified few disclosures that are candidates for elimination. Standard setters and regulators should not be discouraged because the Committee's work did not identify less useful disclosures.
Although asking users to identify what to eliminate was not helpful, perhaps other approaches would be more effective. For example, standard setters could undertake or sponsor research that identifies current disclosures that are used rarely by users in their work. Users may well support such a review: a substantial majority of users indicated in the Committee's survey that they would be willing to give up less important disclosures to make room for more important information.
Based on its work with users, the Committee developed additional recommendations related to display, interim reporting, comparability and consistency, and key statistics and ratios.
Distinguishing between the effects of core and noncore activities is one important way to improve the display of information in financial statements. There are others. In general, companies should increase the amount of detail in financial statements, particularly in the income statement, as a means of helping users better understand a business, the linkage between the financial statements and actual events, and opportunities and risks. More specifically, companies should consider the items listed in section I(A)4(b) of appendix II.
As discussed in chapter 3, users often analyze public companies quarter by quarter. Public companies currently report, in quarterly filings with the SEC, cashflow information on a yeartodate basis and not for the quarter. Because users analyze companies quarter by quarter, interim reporting should include quarterly cashflow statements. Under current rules, interim financial statements can show less detail than financial statements filed for an annual period. In contrast, interim information should include uncondensed financial statements, consistent with users' need for more detail. However, condensed note disclosures remain appropriate at interim periods.
Certain amounts in interim financial statements are derived by estimation methods that may cause those amounts to be less reliable at interim dates than at yearend when reported amounts are based on more refined estimation methods. Examples include pension expense and costofgoods sold, both of which may ultimately depend on yearend valuations of the pension liability and inventory.
Consistent with users' need to understand the relative reliability of information, companies should disclose the methods of computing reported amounts used in interim periods that differ from the methods used at yearend.
In current practice, financial data for prior periods are restated in only very limited circumstances. Examples include changes in the definitions of business segments, corrections of errors, and changes in accounting principles when standard setters permit or require restatement. Consistent with users' needs for comparable and consistent information, companies should restate information in more circumstances than allowed in current practice. More specifically, financial data should be restated or reclassified for dispositions, accounting changes, changes in the definitions of business segments, and possibly other items as well if the restated information can be reasonably assembled and is necessary for a better and more complete understanding of the business.
As discussed in chapter 3, 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 allow a choice of how to adopt, such as retroactive application, prospective application, and the like, are particularly troublesome for users. Standard setters should consider simplifying the procedure for adopting new pronouncements by making them effective for all companies in a single year and prescribing only one method of adoption.
To help users with analyzing trends affecting a business, the Committee's model calls for a summary of key financial and nonfinancial data on a consolidated basis as well as for each industry segment. A company and the users of its business reporting should agree on the periods to be reported, which generally need not exceed five years.
Standard setters should defer considering issues that have lower priority according to the current evidence of users' needs. One advantage of focusing on the information needs of users is that it helps identify highpriority areas for improving business reporting. A less apparent, but still important, benefit is that it provides insight about what areas are less important. This is particularly useful because it channels debate and resources away from highly contentious but less important areas and into more important issues, where improvements are likely to be of greater value. The Committee's study identified five such areas that standard setters should defer considering at this time; these are discussed below.
Some accountants criticize historical costbased measurements used in today's financial statements. They argue that the historical cost of an asset or liability is either irrelevant or not as relevant as recent values and suggest that the mixedattribute model currently used in practice should be replaced with a valuebased model. The call for fair value accounting has been loud enough that it prompted the Public Oversight Board of the SEC Practice Section of the AICPA Division for CPA Firms to suggest that the question of the best accounting model be resolved:
The FASB should add to its agenda a project to study comprehensively the possibility of requiring the reporting of values and changes in values rather than historical transaction prices, either as a basis to propose changes to financial accounting standards or to explain publicly why such a change in accounting standards is impractical or otherwise inappropriate. Users do not favor replacing the current accounting model, which is largely based on historical costs determined in market transactions, with a valuebased accounting model. They would retain the current model because:
Conversely, users oppose a valuebased accounting model because:
Fair or market value information is useful when combined with and compared to historical cost information. Fair or market values, if disclosed, should be in the notes to the financial statements or in accompanying schedules. Detailed assumptions underlying the estimates should also be a required part of the disclosure in order to permit the user to adjust the disclosed amounts. Users are willing to accept less reliability in the context of supplementary disclosures than in the context of measurement in the balance sheet or the income statement. Users find value information useful for particular types of assets and liabilities and in certain types of industries. Some of the types of assets and liabilities mentioned include:
Users view fair value as conceptually more applicable to financial industry activities than manufacturing activities, although they question fair value disclosures that fail to reflect matching of financial assets and liabilities. Assets and liabilities should be recognized and measured at fair value only when users find it useful. Standard setters should continue to follow a mixedattribute model, whereby assets and liabilities are measured in financial statements at cost, lower of cost or value, or fair value, depending on which information is most useful to users in the circumstances. Despite the periodic calls to do so, they should not pursue a valuebased accounting model.
Companies recognize purchased intangible assets in financial statements and generally measure those assets at amortized cost. In contrast, most internally generated intangible assets are not recognized. Intangible assets include, for example, brand names, technology related to products and processes that provide competitive advantage, patents, trademarks, franchises, and the like.
They also include goodwill ; the difference between the cost of an acquired company and the value of its identifiable assets less the value of its liabilities. Some people suggest that internally generated intangible assets should be recognized in financial statements. They observe that, for many businesses, intangible assets are more important to a company's success than are its tangible assets. That importance is demonstrated, for example, by companies whose market values are several times greater than their book values, suggesting that the value of their unrecognized intangible assets may exceed the value of their tangible assets.
Further, the importance of intangible assets appears to be increasing with the growing importance of service companies in the economy, which tend to be intangibleasset intensive. Even tangibleasset intensive businesses appear to be competing in the marketplace by relying more on technology, information, and speed than on heavy investment in tangible assets. Critics ask why the balance sheet should omit such critically important assets. Despite the importance of internally generated intangibles, users generally oppose recognizing those assets in financial statements. In general, recognizing internally generated intangibles would not help users value companies or assess credit risk for the following reasons:
Some of these reasons are also applicable to purchased intangibles, suggesting that users may not find helpful the recognition of either purchased or internally generated intangible assets. Many users adjust reported amounts to exclude the effects of reporting purchased intangible assets, particularly goodwill. Other users do not. For them, recognizing purchased intangibles is consistent with today's transactionbased accounting model.
Further, the initial value of purchased intangibles is more reliable than internally generated intangibles because it results from a thirdparty transaction. Although an argument could be made to prohibit recognition of all intangibles, users believe it is not worth changing current practice. Users that choose to adjust the financial statements for purchased intangibles can do so using the amounts currently disclosed in financial statements. Although users oppose expanding the recognition of intangible assets, users are aware of the importance of those assets and the competitive advantage they may create for a company.
Thus, they would welcome improvements in disclosures about the identity, source, and life of both purchased and internally generated intangible assets. Improved disclosures in this area would be consistent with much of the information in the Committee's model, which would provide insight into the identity, importance, and sustainability of a company's competitive advantages.
Users generally do not need forecasted financial statements from management for the reasons discussed in chapter 3. Thus, the Committee does not recommend that forecasted financial data be a required part of its business reporting model. However, the Committee's reporting model does include forwardlooking information, which is useful to users in preparing their forecasts of financial performance.
Although users generally do not need forecasted financial statements from management, some, particularly prospective lenders to small, private companies, seek management's forecasts. The Committee believes the need for a management forecast generally is restricted to prospective lenders to small, private companies in certain circumstances. Most lenders that need forecasts will have sufficient bargaining power to compel management forecasts. Thus, standards should not require forecasted financial statements.
The FASB frequently receives requests to reconsider the accounting for business combinations. For example, the FASB's advisory council, FASAC, in its annual survey of potential agenda projects, consistently has ranked highly a project to reconsider accounting for business combinations. The most common complaint relates to the distinction between the two methods of accounting for business combinations, the purchase method and the poolingofinterests method (pooling method).
Critics believe the criteria that distinguish purchases from poolings are arbitrary and not substantive. Thus, they assert, two business combinations that are substantially similar can be accounted for very differently depending on the form of the transaction. They suggest that the FASB do away with one method or the other. Defenders of the purchase method argue that only that method reports the economic reality that most, if not all, business combinations are acquisitions of one company by another. They believe that the pooling method ignores the negotiations over values involved in a transaction and that the pooling method permits the acquiring company to report profits on the use or sale of the acquired assets that should be reported as the cost of acquiring the assets.
Defenders of the pooling method argue that some combinations are true mergers and not the purchase of one company by another and that those mergers should be accounted for as poolings by adding the companies as if they had always been together. Further, the pooling method preserves trends and thus facilitates interperiod comparisons ; the assets, liabilities, revenues, expenses, and net income of the combined company are readily compared with those of the constituent companies before the combination ; while the purchase method tends to disrupt trends and make the company after the business combination less readily comparable with the constituent companies before the combination.
While it is true that some users prefer the purchase method and some prefer the pooling method, most also agree that the existence of the two methods is not a significant impediment to users' analysis of financial statements. A project to do away with either method would be very controversial, require a significant amount of FASB time and resources, and in the end is not likely to improve significantly the usefulness of financial statements. Rather than a project to reconsider accounting for business combinations, users would prefer a project to strengthen disclosures about business combinations. For example, many believe there is not enough disclosure under purchase accounting about how assets are written up or down at acquisition and about the liabilities created at acquisition and how those liabilities are settled in later periods.
They are concerned, for example, that some companies are overly conservative in measuring liabilities at the date of acquisition, resulting in inflated reported income in later periods.
In certain cases, such as accounting for inventories and property, plant, and equipment, companies have a choice of accounting principles. For example, in the case of inventories, companies can select firstin, firstout (FIFO); lastin, firstout (LIFO); average cost; or in some cases other methods. In the case of property, companies can depreciate the cost of those assets using the straightline method or choose from a variety of accelerated methods. The accounting method used can significantly affect reported income and financial position.
For example, in times of higher inflation, companies may report significantly lower income and inventory under the LIFO inventory method than under the FIFO method. Reducing the number of choices would improve the comparability of financial information from one company to another ; a key objective of financial analysis. That fact argues to narrow or eliminate the accounting principle options available to a company.
Thus, for example, standard setters could pick one method of accounting for inventory and one method of depreciation for property. A project to reduce or eliminate existing accounting options would be controversial. There are conceptual reasons that support each of the various methods currently used in practice, and different users have different preferences for the alternative methods. As a practical matter, users indicate that the current flexibility is not a significant impediment for users' analyses, provided the methods used are disclosed.
Because of costs, the Committee does not recommend that business reporting provide all the companyspecific information that users need for which management is the best source. The practical constraints discussed in chapter 5 restrict the information to be provided in cases where costs could be significant. In addition to those constraints, the Committee rejected disclosure of certain specific financial information because it judged the costs to exceed the benefits. That information is discussed below.
Because of the costs involved, the Committee chose not to recommend disclosure of information about the individual legal entities constituting a consolidated company. Creditors often lend money to such a legal entity and have an interest in understanding its opportunities and risks and how its operations and financial affairs relate to the other legal entities in the consolidated group. To meet their needs for information about legal entities, creditors sometimes request financial statements by legal entity, in a consolidating format.
The Committee rejected the idea of requiring segment reporting on a legal entity basis for three reasons. First, it is not practical to require companies consisting of many legal entities to report on each entity. To do so would result in considerable costs for accumulating, preparing, and auditing the information. Second, the information may not be helpful because it frequently would require arbitrary allocations, allocations made solely for business reporting and not reported internally. Finally, while some users may find reporting on a legal entity basis useful, other users would not. They would prefer to focus on the consolidated company and its industry and geographic segments. Because legal entity reporting is needed by only a subset of users, it is too specialized to be required in general purpose business reporting and is best left to negotiation between a company and the users of its reports that have an interest in particular legal entities.
The Committee also considered recommending complete financial statements for industry or geographic segments but rejected that idea because of the potential cost of providing that information. Ideally, users would like a complete set of financial statements for each industry and geographic segment. Since users view segments as the sources of a company's earnings and cash flows, they often apply valuation assessments to segments similar to the ones they apply to the company as a whole. Despite the appeal to users of complete financial statements for each segment, the costs of providing the information likely would exceed the benefits and the usefulness is questionable. On the cost side, many companies do not prepare financial statements by segments for internal reporting purposes. Requiring companies to do so would mean they would have to create information for business reporting they do not use to manage the business. Preparing that information could be both difficult and costly.
Further, public companies already are concerned about the potential competitive costs of disclosing segment data to competitors. Requiring complete financial statements would exacerbate those concerns. In practice, complete segment financial statements may not be as useful as some believe. First, key financial statistics, such as sales or margin, could provide most of the insight provided by complete financial statements. If so, the incremental benefit may not be worth the added cost. Second, preparing segment financial statements often would require arbitrary allocations. The usefulness of statements based on those arbitrary allocations is questionable, particularly if management does not use the statements to manage the business. Rather than complete financial statements for each segment, the Committee suggests that companies report key financial statistics they already report internally.
Users generally want geographic segment information from companies that operate in geographically diverse regions. Although useful for many companies, geographic information may not provide much insight for some, as discussed in chapter 3. Because of that fact and the costs of reporting segment information, the Committee proposes flexible standards that would require geographic segment information only when it provides insight about the opportunities and risks a company faces, rather than require geographic segment information in all cases.
A majority of users prefer the direct method of reporting cash flows from operations to the indirect method. Some users would find it most useful if the cash flows from the operations portion of the cashflow statement included the same captions as those on the income statement, that is, a cashbasis income statement. Users prefer the direct method because:
The Committee does not recommend the direct method for three reasons. First, a substantial minority of users believes that the indirect method in current practice is acceptable or preferable. Second, the Committee's recommendations should provide most of the information that users who support the direct method seek. For example, many of the Committee's recommendations help users understand a company's business and the recommendations related to display help users predict core income and core cash flows. Third, the costs of reporting under the direct method could be significant because most companies do not currently capture the information required. Converting information systems to provide the information or determining the information from existing reporting systems could be costly.
Quarterly reports now provide information on a quarterly and yeartodate basis. Some users suggest that the information for the latest twelve months replace information on a yeartodate basis. They argue that the twelvemonth information would allow them to better compare companies with different fiscal years. They also note that yearly periods are more consistent with the data they consider in their analysis. The Committee does not recommend latest twelvemonth data for two reasons. First, although some users argued for the idea, others preferred current reporting. For example, some users, particularly creditors, preferred yeartodate information over information for the latest twelve months. Second, users who want twelvemonth information or information about quarterly cash flows could compute the information for themselves based on information already provided in business reporting.
To analyze the effects of trends, users want key data over a long time frame ; often ten years. Although the Committee's model includes a summary of key statistics, it is limited to five years of data. The Committee rejected reporting data for ten years for three reasons. First, the accelerating pace of change is making information about the more distant past increasingly obsolete. Second, the Committee believes that consistency of reported information is critical for users; thus the model encourages that companies restate information more frequently. Restatement is costly, particularly for ten years of data. Third, restatement of data from distant years would sometimes be impossible because necessary information is not available
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