1.3 Rethinking the Role of the Standard Financial Statements

Printer-friendly versionPDF versionThe current financial reporting system is centered on the annual income statement and balance sheet as prepared and distributed by the firm. They serve as summary measures of the state of the firm and its performance. Such summarization and condensation inevitably results in a loss of information which cannot be in the best interest of users unless the measure perfectly captures future firm value, or the costs of more detailed information exceed its benefits to users. Given that the former is an unlikely prospect, the rationale for the current systems of disclosure is predicated on the basis that: a) users are assumed to be unsophisticated (the “widows and orphans” mentioned at the time the ’33 acts were passed) and incapable of processing more disaggregate information for themselves, and b) it is costly to prepare and report information on a more timely basis. These conditions speak more of the 19th century beginnings of financial reporting than they do of the circumstances in which financial markets operate today. Firstly, technology enables the firm to manipulate data at low cost, meaning that there is no longer a compelling reason to restrict information disclosures to an annual basis. Second, the purpose of financial reporting has shifted from its original stewardship function toward valuation and comparative evaluation, which necessitates a broader, future oriented set of information. As these statements have proven to be insufficient for the needs of more sophisticated users, they have been expanded periodically in response to demand or the latest scandal, in a largely haphazard fashion. In some cases, the statements themselves have been reconfigured (for example, to allow mark to market accounting to reduce the dependence on historical cost) or else additional information has been provided outside the statements, as through the use of footnotes. But the centrality of the two primary statements has been retained, along with their underlying assumption that it is important to restrict the scope of information provided to users in order to avoid overwhelming them (akin to the recent proposals for a condensed and simplified version of mutual fund prospectuses). The end result is a highly aggregate, episodic flow of information from the firm in which a small set of standardized information attempts to satisfy the widely varying needs of users. This approach implies that auditing is also centered on the mandated financial statements. Thus auditing is also episodic and focused largely on whether the firm has correctly condensed and aggregated its information into those statements (which is what “prepared in accordance with GAAP” literally means). Validating information on a more concurrent basis is held to be outside the scope of the external auditor and assigned to the internal auditors instead. But it has also become steadily apparent that the mandated statements cannot be considered independently of the underlying data of the firm and the firm’s accounting and control infrastructure that gives rise to that data and records, manipulates and aggregates it. Thus, as with financial reporting, auditing has been periodically expanded, albeit also in a largely haphazard fashion, first to encompass general examination of controls, and with the passage of Section 404 of the Sarbanes/Oxley Act, to a detailed attestation of financial reporting controls. With the financial reporting environment almost exclusively focused on the income statement and the balance sheet[m9] it is not surprising that the financial markets also have tended to view a firm largely through the prism of those documents. In an extreme, this can lead to forms of functional fixation, where form can seem more important than content, as when information in the statements themselves dominate the market’s reaction even when information in footnotes modifies or contradicts it. In turn, firms expend vast resources in fighting accounting changes that impact the income statement even if that same information is presented elsewhere and could be readily used to recalculate the reported numbers, as in the current debate over stock option expensing. [m10] The continuing fascination with reported net income is not, however, due to the lack of sophistication of market participants. Financial markets today have today some professionals who are not only capable of handling highly disaggregate financial data and forming their own conclusions about it, but actively do so. Thus some analysts simply discard the financial statements issued by firms in favor of extracting specific information from them and inserting it, along with other external information, into their own models of firm performance[m11] . However, there are a some constrains including a) the focus of the financial reporting system on the mandated statements leaves them with few other options on which to base their analysis, and, flowing from that, b) the lack of other instruments of communication lead firm managers to use those statements to signal information, requiring a continuing focus on the form of those statements, independent of their content.; and of course, c) the assurance that is attached to those statements alone, requiring that they receive disproportionate weight, again regardless of their information value. The lack of other audited information has also resulted in auditors becoming insurers of last resort[m12] , as users who are forced to view the firm through those statements come to see the auditors as gatekeepers for the firm, and so hold them responsible not only for the preparation of those statements, but also for their content. If the financial reporting system was being built from scratch today, it would likely be aimed also to the needs of these very sophisticated users than the “mother and orphans” type of investors predominant at the time of the ’30’s acts. In particular, there exists today a large group of financial intermediaries that work on behalf of these unsophisticated users, or who interpret information for them, (for example, mutual fund managers, financial analysts) so that there is no real need for these investors to personally assimilate financial information, obviating the need to pitch financial information at the lowest common dominator. A reengineered financial reporting system would be predicated on two underlying assumptions: First, that technology has reduced the cost of preparing and reporting financial information with much finer detail on a more timely basis; and Second, that some very important users are much more sophisticated and capable of forming their own metrics for firm performance, rather than having to depend on the condensed and aggregate annual statements issued by the firm. These two assumptions have to be applied against the financial process value chain of financial information which extends from the raw data of the firm at one end to sophisticated users at the other. Part of this chain takes place within the firm and part of it is external to the firm, with a handover of financial statements taking place at the boundary between the firm and its constituents. As the forces affecting the supply and demand of financial information have changed, it is surely time to ask whether the location of that boundary point is still appropriate. So the question becomes whether the firm should aggregate and condense information to such an extent before releasing it, or whether users can be assumed to be sophisticated enough to perform these functions on their own. That is not to say that firms will not prepare income statements and balance sheets. After all, they already do so for their own internal management purposes. But there is no reason why users should be restricted to that one perhaps self serving and highly restrictive method of aggregation when users can be allowed to see how that report was created and either accept it as it is, or else use the underlying data as they see fit. Reducing the single minded emphasis on just the income statement and balance sheet will not only increase the information content in the marketplace about a firm, but would reduce the likelihood of functional fixation, since it would be clear that valuation is meant to be based on a broad set of information. Questions that have to be examined are a) the degree of aggregation that will take place given the needs of users and the concerns of the firm about revealing competitive data, b) how much pre-processing of information will be undertaken before information is released and who is in the best position to do that processing, and c) how much validation will be provided with the information and who will provide that assurance. These three are not independent issues, since aggregation is a form of information processing in which a great deal of information is lost. It also allows for those who have access to the raw information (i.e. the managers) to shape the degree and form of condensation that suits their interests best. At present, managers constrained only by their ability to get their interpretation of GAAP through the auditor, direct their energies towards making one metric of firm performance, earnings per share, as favorable for them as possible. Reducing the degree of pre-processing and aggregation of information by the firm would presumably also reduce the ability of firm managers to manipulate that information. Technology can be an effective tool in providing a richer flow of information to users, with tagging, as in XBRL, being a particularly promising technology. Tagging is particularly important because it makes information content independent of its presentation, thus reducing the tendency for functional fixation. Ultimately the latency between economic activity and reporting can be reduced, in order to bring the reporting frequency more closely in line with the dynamics of the business and the needs of users. A reengineered financial reporting system will also, of course, impact the role of auditing. With more information being issued more frequently, auditing will have to move away from an annual focus towards a more continuous auditing model. Moreover, with more disaggregate information being reported, auditing will also shift its emphasis away from verifying the way in which the firm aggregates and condenses its data, towards more data-level assurance. The degree of verification which users will demand from the broader set of data they receive will determine the extent to which data is actively audited, as opposed to being assured passively, for example, by threat of criminal liability or civil litigation.