Huge Changes in Store for Financial Statements

Thought the economy wreaked havoc on your financial statements? Wait until FASB gets through with them.
Tim Reason and Marie LeoneJanuary 30, 2009

A balance sheet that doesn’t balance?

Financing and operating classifications that depend on your company type?

A (gulp) cash-basis income statement?

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Well, not quite. But accounting standards-setters are online and on the road urging investors and companies to weigh in now on a proposal to radically alter financial statements. And while accrual accounting isn’t going away, preparers of financial statements might be surprised to find that the above descriptions do accurately describe the look and feel that financial statements might have just two years from now.

“This particular project will change the face of financial statements in a very, very significant way,” said Financial Accounting Standards Board member Thomas Linsmeier at a January 22 conference sponsored by the New York State Society of CPAs.

Issued as a discussion paper in October by both FASB and the International Accounting Standards Board, the goal of the redesign is to address investor complaints that items on each of the financial statements are not linked across the three statements, and that dissimilar items are often aggregated.

Among the notable features: all three statements — balance sheet, income statement, and cash-flow statement — will be divided into two major sections: business and financing.

“Users of financial statements analyze how a company creates value separately from how it funds that value creation,” said FASB senior project manager Kim Petrone in a Webcast on Tuesday. “So we want to separate the creating activities from the financing activities.”

The “business” section — which is subdivided into operating and investing categories — will focus on what a company does to produce goods and provide services. The operating category will include its primary or “core” revenue and expense-generating activities, and the investing category will include activities that generate a return but are not “core.”

The “financing” section will include those activities that fund a company’s business activities. For nonfinancial institutions, that would primarily include cash, bank loans, bonds, and other items that arise from general capital-raising activities.

One effect of the new format is that “the balance sheet won’t balance the way we expect it to,” said Linsmeier. “That is, assets won’t equal liabilities and equity because assets and liabilities will be in each category.”

Another feature guaranteed to generate some controversy is that management will decide whether items in the financial statements are related to operations or to financing. That means different companies might account for the same item differently. A manufacturer might record proceeds from mortgage-backed securities as investment earnings, while a bank might record identical proceeds as operating earnings.

“You’re going to begin [preparing your financial statements] by classifying assets and liabilities based on how the asset or liability is used by management,” explained Petrone. “That management approach is going to be very important because it allows [the accounting] to apply to many different entities. It’s been asked if this will apply to banks, and it will apply to banks.”

Although the new statement categories may resemble those used on current cash-flow statements, they won’t actually be handled the same way. “Don’t jump to Statement 95,” said Linsmeier, referring to the existing accounting standard on cash flows. “In [FAS] 95, if you’ve invested in property, plant, and equipment, you would call that an investing activity.” But under FASB’s new proposal, capital expenditures may well end up in the operating category. “Property, plant, and equipment used to develop your inventory is an operating asset,” Linsmeier explained.

Cash Flow Goes Direct

Another big change for preparers: using the direct method to generate a cash-flow statement. Though companies have the option to do so under current accounting, that option is almost universally ignored in favor of the indirect method.

Over the years, analysts have used the indirect method to analyze cash flows “because that’s all they have,” said Moody’s managing director Greg Jonas during the recent FASB Webcast. He and panelist Joe Joseph of Putnam Investments both said they thought the direct method was superior for predicting future cash flows, but admitted it will take analysts time to adjust their models. In the meantime, said Jonas, “What [FASB] is proposing would give them the information they would need if they wanted an indirect method. It’s very much like a cash-basis income statement. It allows the analyst to relate what’s going on in the income statement to what’s going on in the cash-flow statement.”

Not everyone likes that idea, however. Controller Peter Bridgman of PepsiCo said the cost to companies of using the direct method “will be significant,” while the value would be low. “If there was any value to using the direct method, we’d be using it already,” he said. PepsiCo is participating in a field test of FASB’s proposal.

“The proposal creates what looks like a cash-flow P&L,” said Bridgman. “That makes sense if you are in a not-for-profit or a small business environment, managing like a checkbook. But in most corporations, that’s not the way you’re really managing the business.

“Most of the questions we get from a cash-flow point of view are really trying to get at reconciling ‘Why is your growth in cash flow different from your growth in earnings,’ and the [direct] method really helped lay that out. It shows you whether extra cash is going into working capital or wherever. You lose that with the direct method.”

“Candidly, from a user’s perspective, I think this is at least one step back and maybe more than one step back,” said Bridgman. “From a preparer’s point of view, it’s a huge burden. If I look at the systems we’ve got, the consolidation system is designed to extract period-end or month-end balances, not to extract all the transactions in the middle that you need to prepare the direct method. It has got to be in the tens of millions of dollars to develop a system that would extract transaction-level data into consolidation.”

Moody’s Jonas and FASB member Marc Siegel both conceded that the use of the direct method would be costly, though Jonas disputed Bridgman’s characterization that the direct method had no value, saying it would prove useful to analysts. Both Jonas and Siegel stressed that it was important for FASB to finish its field testing and for companies to weigh in on the costs before condemning the proposal as too costly.