I’ll start the ball rolling with an exercise: Is the net pension liability/asset a financing or operating item? Is the lease liability a financing or operating item? Both appear in the operating-finance category according to the current staff draft.

I’ll go out on a limb and suggest that the pension obligation belongs in operations because it arises out of the accrual accountinig decision to match labor expense with the periods in which the labor occurs; and the lease liability belongs in the financing section because it’s an obligation that does not arise out of an accrual accounting decision to match the cost of the underlying asset to periods benefited. What do others think?

Can you think of any items that clearly belong in an operating-finance category, or do you have a concept in mind that clearly separates operating from financing activities?

If there are other lingering questions from yesterday’s thought provoking presentation, please don’t hold back. Thanks!

Go directly to the meeting HERE

At 4pm Eastern time today, we will have our first roundtable for this academic year. Please join us!

• See the new FASRI Roundtables WebPage describing how to use VenueGen, our new platform from which you can join the Roundtable discussion.

Nick Cappiello, an FASB Project Manager, will join us to discuss the IASB-FASB Financial Statement Presentation Project. This project has potentially enormous implications for our teaching and research. It proposes to change the face of financial statements to promote more rigorous theory-based financial statement analysis. Nick will discuss academic research that has influenced the development of the staff draft of an exposure draft and research opportunities that can inform the ongoing debate about the nature and effectiveness of the proposed standards. In addition to the staff draft of the exposure draft, here are some additional suggested sources of information about the issues we will discuss on Tuesday:

• A FASRI conversation initiated by Bob Lipe regarding the 2010 AAA Meetings’ panel discussion of the Financial Statement Presentation Project. 
• An Experimental Study on Financial Statement Presentation, supported by FASRI, and conducted by Rob Bloomfield, Frank Hodge, Pat Hopkins and Kristi Rennekamp.
• Steve Orpurt and Yoonseok Zang’s 2009 article in The Accounting Review titled “Do Direct Cash Flow Disclosures Help Predict Future Operating Cash Flows and Earnings?“
• Steve Penman’s White Paper on Financial Statement Presentation.

Don’t forget to see the new FASRI Roundtables WebPage describing how to join the discussion or simply call in using VenueGen.

I thought the title sounded interesting. It seems like a lot of recent research has focused on reducing accounting complexity (e.g. simplify presentation format, make things more transparent, etc). The premise is that reducing complexity will result in improved efficiency (defined in this case as market value = fundamental value) and improved fairness (defined as novice investors not getting taken advantage of). This has been especially emphasized in recent months as a potential magic bullet for preventing future bubbles. If we could only make the accounting and presentation simpler, we could potentially prevent another dot.com bubble, housing bubble, etc.

So, what if that premise is wrong? What if reducing accounting complexity really doesn’t help at all? This paper argues that there are two links required for a reduction of complexity to result in greater efficiency: (1) reduction in complexity must result in greater processing of information and (2) greater processing of information must result in greater market efficiency.

So, does it work? Does reducing complexity improve efficiency? To quote from the paper,

Consistent with the SEC’s efforts to make accounting information less complex, I find that such measures do indeed lead to greater processing of that information. However, inconsistent with the SEC’s goal to protect (particularly novice) investors, I find that when markets are prone to bubble, greater processing of information does not translate into more efficient markets, and does allow traders choosing to become informed to extract money from other, less informed traders.

So, to answer the question posed by the title of the paper: no. Reducing accounting complexity doesn’t appear to be the magic bullet to prevent another bubble crash.

My key take-away from these conversations is that analysts’ request for the direct method is in part a request for symmetry in how information is displayed/disaggregated across the financial statements, and a way to encourage companies to give equal weight and equal treatment to each of the primary financial statements. GAAP net income is largely an accrual-based number and the income statement disaggregates that accrual-based number into accrual-based line items. Total assets, total liabilities, and shareholders’ equity are disaggregated on the balance sheet into the components that constitute those totals. This lets users identify the sources of those totals and assign different valuations to each asset and liability component if they choose to (especially since many of the line items are measured at historical cost).

For some reason, operating cash flow under the indirect cash flow method does not receive the same treatment. The total operating cash flow number is the only item in the operating section of the cash flow statement that is a true cash-based number. The indirect cash flow statement is an itemized list of changes in the other financial statements that are necessary to get from net income to operating cash flow. As a result, unlike with the income statement, an analyst cannot make judgments about which components belong and don’t belong in a normalized operating cash flow number because the analyst does not know what the operating cash flow cash components actually are! In that regard, operating cash flow is a bit of a “black box.”

I confess, I still find myself wondering how much effect direct cash flow reporting will have on decision making. More information is better—free disposal, and all that–but there are other ways of conveying cash flow information (such as extensive footnote disclosure). One possibility is that a direct cash flow report would focus more analyst attention on cash flows, which in turn would lead to more and earlier cash flow disclosures in earnings announcements, more discussion of in conference calls, and so on. Unfortunately, direct cash flow reporting is so rare in the US, and so abbreviated in other countries (compared to what the FASB and IASB are proposing) that it is hard to infer the benefits of the proposals from existing data.

In particular, they kept stating that analysts’ use of earnings in valuation (specifically PE multiples) would probably decrease when the analysts could take the numbers from the direct method cash flow statement, plug them in a spreadsheet, and use those numbers to project future cash flows.  If you listened to their words, it seemed like they preferred a valuation model that did not use any accrual accounting concepts.  Several audience members mentioned this to me later.

I believe that their push for the direct method resulted in the use of short-cut terms like “cash earnings”.  Having read some explanations of what analysts do in projecting future profitability, my impression is they start with accrual earnings and then back out a few accruals that they feel might behave in special ways (e.g., special items) which could reduce the predictive ability of their model.  But the majority of accruals are incorporated in the “cash” numbers that are the main inputs for their analysis.

If I am wrong, and they really meant what they said, then maybe the direct method cash flow statement is not such a good idea.  Research shows that the accrual numbers are more correlated with stock price performance than cash flow numbers (see Dechow 1994).  Investors might give more weight to the cash and less to the earnings because the cash is now salient and some finance professors seem infatuated with cash.

Did any of the rest of you attend the session?  What was your impression?

“June 30, 2011, is an arbitrary deadline and it’s not one that’s been put in place by the SEC or by our road map,” said Kroeker. Citing FIN 46(R) as an example of an accelerated project that later needed to be reworked, Kroeker said that what’s most important is to ensure through the exposure process that the final standards are a “long term, sustainable solution.”

I suspect the FASB is not all that surprised by Kroeker’s view, given how good the lines of communication typically are between the FASB and the SEC. However, I suspect the IASB and other supporters of a single, global accounting standard will be a little surprised and will interpret Kroeker’s comments as (further) evidence that the US will not be adopting IFRS any time in the near future. They may even increase the volume on their arguments that the IASB should not give so much preferential treatment to the FASB and SEC in its standard setting activities. Should make for some interesting articles over the next few weeks!

However, what if the company creates value by synergistically combining the machine with a trained workforce and results of its research department?  I see nothing in the deliberations of the IASB or FASB to say they support recording increases in the value of the workforce or research this period, as increases in value of workforce training and basic research do not meet the definition/measurability criteria required for asset recognition.  Thus, anyone who believes that the so-called “balance sheet view” has a goal of equating a company’s book value and market value are complaining about a straw man that is not part of the FASB’s agenda.

But back to Stephen’s views.  I believe he would reject fair valuing the company’s plant asset even if a non-subjective level 1 fair value was available.  He expects reported operating earnings to reflect the enhanced value of a trained workforce or proprietary research over time as the company is able to earn higher margins than its competitors.  He also believes these margins are persistent.  I agree with these views.  Stephen’s concern is that if the company records fair value increases for the plant, the reported margins would include transitory gains and losses.  He would rather use some sort of allocated historical cost for the plant in the belief that using a comparable measurement approach for all operating assets produces operating margins that are easier for analysts to use in predicting earnings and valuing the company.

As a result, the debate seems to be less about subjectivity and more about how mixing measurement attributes for operating assets can reduce the ability of analysts to do their jobs.  I would think some of the propositions underlying Stephen’s views are empirically testable.  What do the other bloggers think?

The paper discusses disaggregation in some depth, providing guidelines for how line items should be disaggregated on both the income statement and the balance sheet.  I need to read more carefully, but Stephen’s proposals seem more similar to what the FASB and IASB are proposing than they are different:  disaggregation on the balance sheet should separate items with different risk profiles, while disaggregation on the income statement should allow better prediction of future cash flows.

More novel, to my eyes, is Stephen’s advocacy of a ‘forward looking earnings’ number.  Stephen starts with the problem that comprehensive income includes many highly transitory items, which can be a problem in using earnings to predict the future.  From the paper:

We suggest the following solution. Report per-share (comprehensive) Earnings to Common Shareholders but also report a second per-share number that bears on the future. This is not a forecast, but rather current Earnings to Common Shareholders stripped of items reported in the disaggregated income statement that do not bear on the future. Discarded items would include one-time items and transitory gains and losses which, though recurring in the future, do not predict next year’s gain or loss. One way to think about it is as follows: What number would a (diligent) analyst forecast as forward earnings? What income statement line items are omitted from the analyst’s forecasting spreadsheet? Clearly that analyst is not forecasting the one-time items of the previous period that will not repeat, nor components of earnings that are not predictable. The second earnings-per-share number might be called Forward-Looking Earnings (to Common) with the understanding that it is to align with “forward earnings” that analysts forecast. In this way, financial reporting and analysts’ forecasts would align such that analysts’ forecast errors could be determined by comparing their forecast to next year’s realization of Forward-Looking Earnings (and not earnings-per-share that includes gains and losses, write-downs, etc. that they could not be expected to forecast). Not only would a summary number be produced with forward-looking information but a discipline would be imposed on the analyst community, so that investors who use analysts’ forecasts would know just what is being included in their “forward earnings” and in a “forward” P/E ratio.

With its focus on forecasting, our proposed income statement template is designed to identify items to be stripped out in determining Forward-Looking Earnings. The components retained could be presented in a second column in the income statement that totals to Forward-Looking Earnings, or as a supplementary schedule. We are aware that a division between forward-looking and other income invites opportunistic reporting. A requirement that management justify classifications in the accounting policy footnote mitigates, as does rigorous auditing. The FASB-IASB might engage the analyst community on the matter, in the hope that a strong consensus would emerge to which management would then be committed.

Well, maybe not that novel.  This sounds to me somewhat similar to the notion of ‘headline earnings’ proposed a good 15 years ago by the UK Society of Investment Professionals:

UKSIP Headline Earnings has been used in the calculation of the price/earnings ratios of the United Kingdom companies in the Financial Times since 1994 and has also been used by computer bureaus and other intermediaries in the United Kingdom. At the same time Headline Earnings has been adopted in South Africa not only for use by but also as a standard definition for the announcement of company results.

The aim, as set out in Paragraph (vii) of the Summary of SIP 1 is “… to define an earnings figure calculated on a standard basis, which can be used as an unambiguous reference point …”. It should be noted that SIP 1 in defining Headline Earnings in accordance with this aim delineates clearly between such a reference point and an earnings figure calculated as a measure of the company’s maintainable earning capacity, which in the view of SIP 1 is a figure which cannot be calculated on a standard basis, but will vary from company to company and in other ways.

I will be interested to hear Stephen’s thoughts on the similarity of these earnings notions, and on how this idea could be made workable — and also, whether this earnings number would need to be reported as part of GAAP, or could be something outside of accounting standards.

More recently, Stephen has been visible as a critic of the direction of accounting standard setting.  Stephen is a fellow member of the AAA Financial Accounting Standards Committee.  In that role, he has been a primary author on a proposal for a Conceptual Framework for accounting standards that differs substantially from those approved and being considered by the FASB and IASB.  He has also published, through CEASA, a white paper titled Accounting for Intangible Assets:  There is Also an Income Statement, and has a forthcoming CEASA white paper on Financial Statement Presentation.

Join us on Wednesday, November 11th at 11am, when Stephen will lead a Roundtable discussion.  While our first order of business will be to discuss Stephen’s views on accounting standards, and his thoughts on related research opportunities, we will surely devote some time to Stephen’s thoughts about the state and future of accounting research more generally, given Stephen’s extraordinary success and influence in the field.

Details about participation are here.