The Roundtable is scheduled at 4pm eastern time on Wednesday, February 1. 

 To participate in the Roundtable, please follow these instructions.

 1)  Go to http://intercall.webex.com anytime after 3:00 pm (eastern time) on February 1. 

2)  Type in the following meeting number: 598 823 122 and click “Join Now”.

3)  On the next page, fill in your name, email address, and the password “Fasri001” (case sensitive).  Then click “Join”. 

4)  After joining the meeting, you will be prompted for your telephone number.  Insert your telephone number and click the “Call Me” button.  Your phone will ring, which you can use to hear and speak. 

5) If you experience trouble with the call-back feature, you can dial in yourself using the following numbers: 866-478-6348 or 224-554-0243.

Who knew that reclassifying AOCI into income could be so complicated for preparers?  As it turns out, some AOCI items can flow through multiple income statement line items when recycled (cost of goods sold, depreciation/amortization, and virtually all SG&A expenses), and information in a decentralized system is not always gathered in a manner that companies can readily allocate the amount to different line items.  The requirement seems particularly costly when recycled items are capitalized.  For example, the problem is articulated in a comment letter from Gregg Nelson, a VP from IBM, as follows:

“… certain pension-related costs reclassified out of OCI are included in cost pools and subsequently capitalized as inventory or PP&E. These amounts immediately lose their nature, and the OCI portion related to capitalization is not tracked. Thus, when inventory is subsequently sold or PP&E is depreciated, a portion of the cost of sales / depreciation would include amounts previously reclassified from OCI. We are uncertain whether the intent of ASU 2011-05 … was for entities to track such amounts. If this is a requirement, we would certainly question the usefulness of this information and the cost/benefit of identifying and tracking this information. This capability does not exist in our financial systems today.”

During the brief comment period, the FASB received 37 comment letters.  The letters can be categorized as coming from the following groups:

A)     Companies, Preparers, or Preparer Organizations – 25 letters

B)      Audit firms – 8 letters

C)      CPA organizations or Societies – 2 letters

D)     User Organizations – 1 letter

E)      Individual with no affiliation – 1 letter

It’s interesting to note how few letters come from financial statement users.  This lack of user input is typical and a reason why the FASB has established various user groups to get more feedback from this important stakeholder.  Also, academics are relatively under-represented.  One might believe that academics could provide a unique and unbiased perspective on many issues faced by the Board. 

The ED posed three questions for respondents to answer.  The first question was whether respondents agreed with the proposal to defer the effective date for OCI reclassification presentation.  Of the 37 letters, 36 stated they agreed with the deferral.  The one letter that expressed disagreement was from the CFA Institute – the only user group that responded – but even this was only a partial dissent, as I’ll explain later. 

Questions 2 and 3 asked for alternatives that the Board should consider for presenting reclassified OCI that would be more cost effective and if so, how these alternatives would serve the needs of users.  Only two of the letters indicated that the FASB should continue to require that firms prominently display the effects of recycling on the face of the income statement.  Thirty-two letters strongly opposed the requirement and generally indicated that footnote disclosure would be adequate (3 letters expressed no opinion). 

Besides the significant cost of tracking the AOCI amounts to earnings, respondents who disagreed with the requirement indicated that the reclassifications are almost always immaterial (further suggesting that costs exceed benefits), the income statement would be complicated with greater clutter, and the requirement diverges from IFRS.  In addition, many respondents questioned the demand for such reporting because they are not asked for this information by investors and analysts. 

The only outlier from this predominant view comes from the CFA Institute and its Corporate Disclosure Policy Council.  Kurt Schacht and Gerald White lay out a well-reasoned response to the ED that includes several interesting points (the entire letter can be read here).  The first point made in the letter is somewhat flawed, which is that they disagreed with the deferral of the effective date because they interpreted the ED to mean that the FASB would simply delay and never revisit the presentation requirement.  However, Board deliberations clearly indicate that the Board never intended that the deferral would be permanent.  They then proceed to provide support for the deferral if it is limited to a one year time frame.  Other than this misinterpretation, however, I believe Messiers Schacht and White make many interesting, and valid, arguments.  They point out that OCI reporting in the first place is a concession to preparers, and if preparers are unable to provide information on reclassifications, then perhaps we should do away with it entirely.  Second, they articulate frustration with interpreting economic events that are initially presented in OCI when they occur and allocated in piecemeal to net income in subsequent periods when they do not occur.  They argue against the position that prominent display of OCI reclassification would confuse investors with clutter but rather, claim that the disclosures result in greater transparency and that, like every other standard, immaterial items would not need to be presented. 

What struck me when reading these letters is that we still don’t really know what we want to accomplish with OCI reporting and recycling.  This was a topic at the most recent FASB/IASB Issues Conference.  A comment letter from Richard D. Levy, Executive VP and Controller for Well Fargo, stated the issue succinctly as follows:

“The first step in evaluating how to present reclassification adjustments should be to understand what the balances are intended to represent and to define a principle or characteristics for items qualifying for inclusion in OCI. The FASB has not provided a formal definition of what OCI is intended to represent, and instead relies on existing guidance, which was created over many years and through several independent projects. We believe that questions raised in the deliberations related to the classification and measurement component of the Financial Instruments ED and through ongoing international convergence efforts have increased the focus on the importance of clarity regarding the intended purpose of OCI. These issues are fundamental to understanding comprehensive income and should be resolved before the issuance of further guidance.”

As the statement above indicates, the fundamental issue with what OCI reporting is supposed to accomplish continually crops up across other projects, like Financial Instruments and Insurance Contracts.  The issue of reclassification presentation is related to the broader issue of the overall objective of OCI reporting and recycling.  Although not explicitly asked for in the ED, several comment letters urged the FASB to take on this more fundamental issue (Ford, E&Y, Wells Fargo, Allstate Insurance, Grant Thornton, and CFA Institute).

The least informative statement was made by the IASB Chair, Hans Hoogervorst.  In a speech made at the IFRS Foundation conference in Australia, he stated that the convergence efforts by the IASB and the FASB have served their purpose, but it’s time to move on (see here).  He further stated, “Whichever way the SEC goes, what is needed more than anything is clarity.”  I label this the “least informative” statement because the IASB has long been calling for the SEC to just make a decision already, and they’ve campaigned for that decision to be some form of IFRS incorporation into US GAAP.  Hoogervorst’s speech has the same tone as other statements made by the IASB indicating that the current cooperative model followed by the IASB and the FASB is not sustainable (see here). 

A BNA article reports that yesterday, FASB Chair Leslie Seidman made similar comments at the AICPA’s National Conference on Current SEC & PCAOB Developments.  Specifically, she indicated that the current convergence model followed by the Boards is not a long-run solution and would be challenging technically and administratively if applied beyond the current major joint projects on revenue recognition, leasing, financial instruments, and insurance contracts.  “Plus we appreciate that the IASB as an international body must be responsive to the priorities of other countries that have already adopted [international financial reporting standards],” she said.  In speaking about convergence “you might relate it to the words of American poet Ogden Nash, who said, ‘Progress might have been alright once, but it has gone on too long.’”  These comments seem to project the same message conveyed by Hoogervorst that standard-setters are ready for some new direction from regulators on how the Boards are to work together going forward.  Chairman Seidman also provided in her speech yesterday a vision for the FASB’s role if the SEC were to decide on the FAF’s proposed approach written in a letter to the SEC last month (broadly consistent with the SEC’s “condorsement” approach). 

The third piece of news comes from the same AICPA conference when Jim Kroeker, Chief Accountant at the SEC, indicated that the SEC’s eagerly awaited decision on IFRS adoption will not be forthcoming, as promised, sometime this year (see here).  Instead, Kroeker indicated that a few more months are needed for the SEC staff to complete their work plan and submit a completed report to the commissioners.  The announcement by Kroeker likely disappoints not only standard-setters, but also preparers, auditors, and users.  Perhaps to lessen the disappointment, Kroeker made this statement suggesting that some form of IFRS integration into US GAAP is a strong possibility, “I’m encouraged for the prospect of incorporation of IFRS.”

Here is the abstract:

This paper uses a Pragmatic theory of language (drawn from philosophy and linguistics) to diagnose the causes of excessive and inefficient financial disclosure and propose a regulatory solution. The diagnosis is that existing regulations are effective at encouraging firms to adhere to some, but not all, of the Maxims of Conversation identified by Pragmatics. Regulations encourage firms to disclose any information that might be relevant, but are ineffective in discouraging excessive disclosure of information that is of little relevance given what investors already know. This one-sidedness makes financial disclosures inefficient by limiting the ability for investors to infer that items the firm chooses not to disclose are not particularly important (an inference Pragmatic theorists call “implicature”). The solution is to encourage or require firms to supplement comprehensive disclosures with an “elevated” disclosure that is brief enough to force firms to be selective in choosing what information to include. Regulations can enhance implicature through rules that prohibit firms from elevating disclosures that are less newsworthy than disclosures that are not elevated, thereby enhancing the information conveyed to investors through implicature.

Philosophers are keen on distinctions, and the first part of the paper is largely devoted to describing the most important ones to accountants.  One key distinction is between speech and the speech act:  speech is the content of what we say, while the speech act is the choice to say it.  This becomes important because (as game theorists in disclosure know well) the choice to say something or not say something conveys information on its own.  A second distinction is between implicature–the information content conveyed by the choice of speech act–and explicature, which is the content of the speech itself, and all that it logically entails.  One of the main points of the article is that mandated comprehensive disclosure limits speech acts by forcing firms to say everything.  This is an extremely inefficient form of disclosure, because speech acts are the foundation of implicature, which is a wonderful source of efficiency: it allows investors to draw inferences from what is not disclosed.  What could be more efficient than that?

The bottom line of the paper is a set of three disclosure regulations to increase the implicature in an “elevated” disclosure that would supplement the comprehensive disclosure firms already provide:

1. Firms must elevate material deviations from prior understanding.

2. Firms must not elevate so many deviations as to eliminate the advantages of elevation.

3. Firms must not elevate deviations from prior understanding that are less material than a deviation that is not elevated.

The first rule mandates that the firm flag some content as particularly newsworthy, while the second prohibits firms from elevating everything (which is the same as elevating nothing).  The third rule is the key to implicature:  firms can’t elevate one thing without elevating everything else at least as newsworthy.  As a result, investors can infer that a firm that chooses not to elevate information about X believes that X is not as newsworthy as the least-newsworthy information that is elevated.

Two final comments.  First, “newsworthy” refers to the deviation of the information from what readers would expect given what they already know. For example, revenue recognition policies that are typical for the industry are important, but not newsworthy.  It’s interesting to note that the current definitions of materiality don’t focus on newsworthiness, but just whether an investor who knows nothing would find the material relevant.  This is one reason corporate disclosure is so inefficient.

Second, most people who comment on the paper raise questions about how such a regulation could be implemented.  I don’t address that in the paper, but I don’t see that this type of regulation would be much more difficult to implement than many disclosure regulations already on the books.  That doesn’t make it easy, of course, but such concerns are no reason to dismiss the idea out of hand.]]>

This paper reports data on the forms/filings that are most often requested and their relationship to firm information environment, extreme firm performance, and the sophistication of the investor base. Among other things, we learn that more than a million requests for SEC filings occur on a daily basis. We learn that 10% of the most highly demanded form types represent 95% of the requests. With over 200 forms/filings required by the SEC, this makes you wonder about the other 180 forms/filings.  In fact, when I saw that statistic, it made me think of the disclosure framework project, which I know is trying to grapple with information overload.  Wouldn’t you love to know which footnotes in a 10k are most often requested?  Unfortunately, the data in this paper is not that granular.

Regardless, I thought I would post this paper for your general enjoyment. I also posted this paper because it reminds me of the usefulness of thinking outside of the data we normally use, and instead thinking of where you might be able to get data that would help you answer the questions you really care about.  I’m sure there’s a string of papers that will come from this data, and I’m looking forward to seeing those papers. In the meantime, feel free to post your thoughts and reactions to this paper right here, including any thoughts on the questions you might ask if you had such a dataset.  I look forward to your comments!]]>

I’m not trained in behavioral economics, but I recognize the potential that this research methodology can have on standard setting.  Recently, the Miller paper was informally discussed among some FASB staff as to whether it might have implications for the FASB’s disclosure framework project.  That discussion is the impetus for this post, which requests information from all of you behavioral economists out there (and anybody else who has something to add).

Disclosure overload is a pervasive complaint received by the FASB and the hope is that one outcome of the disclosure framework project will be fewer disclosures (although this is not the overriding objective).  I doubt the FASB would subscribe to a notion that disclosures should be limited based on any one individual’s ability to process; put many individuals together to form a market and it would seem that the limitations of any one individual can be mitigated or even eliminated by the market.  Further, I know from experience that valuation, bankruptcy prediction, earnings management, and other types of models used in practice often employ more than seven pieces of information.  However, the Miller paper might still have implications for standard setting.  As an example, might the research evidence suggest a limit on the level of disaggregation provided to financial statement users?  In prior standards, the FASB has reduced proposed disclosures because users expressed their opinion that the smaller information set would be easier to read and understand.

Perhaps even more important than the level of disclosure is questions related to formatting and organization of information.  Is there research available since 1956 that provides evidence on how human capacity to process information is affected by how the information is formatted and/or organized?

Replies and comments to this post that refer to research with implications on the following issues would be very useful to the FASB:

1)      How much information can be effectively processed by individuals or markets?

2)      Why types of format and/or organization maximize the usefulness of information?]]>

As far as I can tell, financial statements have no such causal connections.  It might be tempting to say that “revenue causes a firm’s wealth to rise”, but I would view that as a misinterpretation.  Instead, revenue (just like any other item on the income statement or statement of changes in shareholder equity) is just a way of classifying a change in wealth according to its type. The change in wealth is in fact caused by an event that is external to the financial statements, and results in the simultaneous recording of an increase in assets and an increase in revenue.

Why do I bring it up?  When I put on my managerial accountant’s hat and ask “what do I want to know about a business”, the answer isn’t “I want to know how events were classified on the financial statements.”  Instead it is “I want to know the causal model that leads to future increases in wealth.” Financial statements don’t seem to shed much light on that causal model.  Neither do most of the disclosures discussed as possibilities for the Disclosure Framework; those simply shed more light on the financial statements.

Put another way:  The Conceptual Framework emphasizes the user’s need to predict future cash flows.  If you really wanted to predict future cash flows, would your first step be to create financial statements as you see them today?  Or would you want a balanced scorecard?  If the latter, does the existing Conceptual Framework misstate the goal of financial reporting?

But the biggest thought provoker for me came from Greg – he questioned how useful the conceptual framework would ever be if it continues to ignore human behavior.  Deducing standard practices from a framework might be possible if the practices were applied to/by objects that could not alter their behavior given the standards.  However, we are all familiar with cases where financial engineers are at work soon after the ink is dry on a new standard.

Shyam had an interesting photographic analogy – if a reconnaissance satellite takes a photo, the subject of the photo has no idea that his/her picture is being taken.  Therefore the person does not take any special action at the time the shutter clicks.  On the other hand, when a studio photographer is taking a picture of a model, the model responds to each click of the shutter.  I believe Greg and Shyam view the FASB and IASB conceptual frameworks as being designed to govern satellite photography whereas the reality of accounting practice is closer to studio photography.

I have heard some standard setters opine that their standards should not anticipate “economic consequences”.  But totally ignoring the feedback from standards to behavior seems a little too strong.  Two recent posts to this blog (Lisa Koonce: compensation disclosures and me: disclosures regarding the use of minerals from certain countries in Africa) discuss disclosures that are apparently intended to shame companies into different (better?) behavior.  These are not isolated incidents; a variety of standards (remember SFAS #123 pro forma disclosures?) are designed implicitly to change behavior of the reporting entity.

So I tried to think of how one would change the conceptual framework to incorporate the interaction between standards and people who apply the standards.  One possibility that the panelists mentioned was to avoid being overly prescriptive (somewhat like principles instead of rules) because people often respond badly when authorities (e.g. parents) impose very restrictive and detailed rules of behavior.  What other changes would we need in the conceptual framework?  This is very important, as many people are calling for more work on the framework once the crush of convergence projects are completed.  While I think imbedding behavior into the framework will be very difficult, but we should at least have the discussion on whether/how it could be done.

“Difficult as the decision may be, it is hard to imagine the possibility of the United States not taking a positive decision.  … it is in the economic interest of the US to adopt IFRSs. As a signatory to G20 communiqués, the US has repeatedly expressed its support for global accounting standards.  But the main thing is this: if you believe in a global language for financial reporting, then IFRSs are the only possibility.  I am convinced that the United States will want to maintain its position of leadership in international financial reporting, and therefore it is hard to fathom a negative decision on the part of the SEC.”

While the above opinion might be biased, there is no question that the United States has demonstrated support for a single set of high quality standards that can be accepted worldwide.  However, is this really the correct course of action for the U.S. to take when U.S. GAAP is already the most developed set of standards in the world and arguably of higher quality than IFRS (of course, that could be debated)?  Then, there is the significant issue of whether the U.S. should give up their sovereignty over accounting standards. 

Why not simply continue with the working model established by the Memo of Understanding of working closely with the IASB in establishing standards that, while perhaps not exactly the same, are converged in most material respects while maintaining nuances based on differences of opinion on what constitutes the most decision-useful information?  Interestingly, the IASB’s vice chairman, Ian Mackintosh, was quoted as saying that joint work between the IASB and FASB would be less going forward if the SEC’s decision was to not adopt IFRS (click here for the article).  That comment is difficult for me to understand as I believe both boards have benefited from the cooperation. 

I know this is an area where academic research has something to say.  I would be interested in receiving feedback as to what inferences can be made from specific studies (either published or in working paper form) with respect to whether the U.S. should allow IFRS for domestic filers. 

The topic of our next Roundtable will be on international convergence.  I am pleased that Russell Golden, a FASB Board Member, will speak to us and give us his perspective on the challenges and opportunities related to international convergence.  If you are interested in this topic, and I suspect most of us are, then this Roundtable provides a unique opportunity for you to gain a better understanding of what U.S. standard setters are thinking about the topic. 

A formal announcement and details on how to join the Roundtable discussion will be forthcoming, but for now place a holder on your calendar to join us August 30^th, at 4:00 pm eastern time.

However, a more recent study by Donelson, Jennings, and McInnis (2011) in The Accounting Review sheds important light on these earlier findings. Donelson et al. examine individual expense lines to discover which line items are most responsible for the decline in the revenue-expense correlation over time. They disaggregate total expenses into cost of goods sold, SG&A expense, depreciation, taxes, other income/expenses, and special items. They find that the decline in the revenue-expense correlation over the past 40 years is primarily attributable to one line item—special items, which consists of asset impairments, restructuring charges, and gains/losses from asset sales. When the authors factor out the effect of special items, they find that the changes in the revenue-expense correlation are substantially reduced (as much as 90% in some cases). The authors go on to provide additional evidence suggesting that the cause of most special items is from changes in the incidence of underling economic events, and not from changes in accounting standards.

So why should this matter to financial reporting standard setters? For those who don’t agree with the idea that matching is an important concept in accounting, the results of these two studies are probably not that useful. But for those standard setters who may still hold on to traditional ideas on matching, and who may deplore any decline in matching over the years, these two studies suggest that new accounting standards have contributed very little to any decline in matching. Instead, it is the changes in the underlying economics of businesses that have caused any decline in matching. Standard setters probably wouldn’t want to undo financial reporting that actually captures changes in underlying economics, would they?