Financial Statements of the Future

Corporate accountants won't recognize their own income statement once FASB is done revamping it. But don't throw away your old accounting textbook ...
Marie LeoneDecember 13, 2006

A major overhaul of financial statements is underway, but standard setters on both sides of the Atlantic are not providing a firm timeline for what is certain to be a long-term project. Members of the Financial Accounting Standards Board met Wednesday morning to discuss staff recommendations on new financial statement presentation models. Their comments on the models will be sent to the International Accounting Standards Board on Thursday, for further review.

The presentation project is part of a larger joint effort between FASB and IASB to harmonize international accounting standards with U.S. rules. FASB hopes to begin rolling out new standards in 2008, while IASB wants to wait until 2009, say observers familiar with the project. Despite the difference in timelines, the roadmap is the same.

The joint effort is being guided by what FASB members called a “cohesive doctrine.” That is, the major thrust of the project is to integrate the balance sheet, income statement, and cash flow statement by providing similar subsections in each of the three statements.

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At the root of the effort is the notion that “geography does matter,” says Ed Outslay, an accounting professor at Michigan State’s Broad College of Business, referring to FASB’s goal of providing more transparency via better integration and organization of line items. Indeed, FASB supports a model in which all three financial statements will have subsections that include core operating results, discontinued operations, financing, and income taxes, so users have an enterprise-wide picture of each area.

For example, the financing section of the balance sheet may have line items reflecting liabilities tied to borrowing, as well as assets derived from equity sold or treasury assets (cash on hand). The income statement will list interest expense and interest income, while the cash flow statement will itemize cash from borrowings, cash used, dividend payouts, and cash from interest income.

Tax sections will also be expanded. For example, the balance sheet will reflect a standard tax statement, while the income statement lists an income tax expense, and the cash flow statement notes income tax paid.

The FASB spent most of Wednesday’s meeting trying to work out accounting minutiae related to the geography of line items. For example, the board recommended that on income statements, the item known as “other comprehensive income” should be distinguished separately in operating income and investing income, and that tax income should drop down to the bottom of the statement. In addition, the board agreed with the FASB staff’s recommendation that the so-called “direct method” of preparing cash flow statements is favored over the indirect method, as the former is more in line with the cohesiveness principle, noted FASB Chairman Robert Herz.

Under the direct method, a company records all of its cash transaction separately and prepares the cash flow state based on those records. The indirect method requires a company to determine the major classes of operating cash receipts and payments by indirectly adjusting revenue and expense amounts, and then records the change related to asset and liability accounts.

While FASB and IASB work on the details, the broader financial statement presentation project inches ahead. “The thinking [behind the project] is correct in that a lot of this information is what analysts want anyway,” notes Charles Mulford, an accounting professor that oversees the Financial Analysis Lab at the Georgia Institute of Technology’s DuPree College of Management. As a result, posits Mulford, analysts and investors will have to spend less time “peeling back” layers of financial statements to ferret out information.

Another practical promise of the proposed new models is that one statement wouldn’t carry more weigh than another, says Outslay. “You don’t want the income statement to trump the cash flow statement,” contends the professor. In the extreme, such a hierarchy could lead to an Enron-type situation, in which mismatched statements are ignored and the company is “lax about cash flow statements.” Under the new presentation model, “You have to love all your children equally,” says Outslay.

As the models are reworked and released for comment, FASB members expect more practical concerns to surface. “There will be some heavy duty field testing that will involve users and prepares, [working] side by side,” before standard setters can determine which model is “meaningful,” admitted FASB member George Batavick during deliberations. However, Batavick argued that FASB should not get bogged down in such details at this point, arguing that it should first establish broad principles about the new models.

Corporate executives have not formally weighed in on the models since they were first proposed in 2003. However, Kenneth Kelly, controller of spice manufacturer McCormick and Co., told earlier in the week that while he agreed with the subsection idea — because it gives users a new way of thinking about the cash flow and income statements — he was not convinced that all of the practical aspects of the models could be implemented without detrimental unintended consequences. “I don’t like the proposed aspect that each subsection will be required to flow through each of the three financial statements. It could create the need for too many rules that will ultimately defeat the general purpose of the transparency principle when looking at an entity as a whole.”

In the end, says Mulford, the new presentations won’t change net income — at least not yet. Mulford speculates that FASB may eventually want to move away from one net income number or a single earnings-per-share designation. Whether that is FASB’s goal, or not, the group is using the new models as a first step to creating the “financial statements of the future,” declared FASB member Leslie Seidman.

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