Appendix 10
Comments on the AICPA Report:
Improving Business Reporting
A Customer Focus
After this book was completed in draft form the above report was placed on the Internet by the AICPA. The following comments are based on that report. We show how AFTF depends on many of the key concepts cited and satisfies most of the recommendations that are made. There are some important underlying differences.
General Comments
This report was the culmination of the work of many people over several years. It raises many issues of importance and its recommendations are generally quite useful. The individuals who contributed are to be commended for their efforts. They did a fine job. They did not, however, do the right job. In fact, they were given an impossible job.
The major charge of the Special Committee on Financial Reporting was to find ways to make accounting more relevant and useful to the end-user. In Chapter 3 of this book we investigated the current retrospective model and argued convincingly, I believe, that the current GAAP model is fundamentally and fatally flawed. When the committee chose to retain the basic current retrospective model, failure of the revised model was inevitable.
Why the committee did not address the fundamental flaws in GAAP is puzzling. On one hand,
"The AICPA Futures Issues Committee reported the same year (1991) that business reports are losing their significance because they are not future oriented and do not provide value-based information."
On the other hand, they stated, as a recommendation,
"Standard setters should defer considering issues that have low priority according to the current evidence of users’ needs. The Committee’s study identified the following five areas that the standard setters should not devote attention to at this time:
This text provides current evidence that a value-based accounting model that incorporates intangible assets by using forecasted financial statements is a high priority of users.
It is incredible that the Committee would cite users’ needs to dismiss a value-based model when users focus on value. There is no higher priority to the shareholder than to know the shareholder value and shareholder value added. AFTF is a shareholder value-based system.
It is incredible that the Committee would cite users’ needs to dismiss forecasted financial statements when forecasting is a user need. Users (shareholders, analysts, management, creditors, etc.) need to be informed of the future. Forecasted statements obviously provide predictive information about the future. AFTF anticipates and measures the future.
It is incredible that the Committee would cite users’ needs as a reason to dismiss intangibles when intangibles are so important to the user. In the text, we have argued that traditional accounting intangibles may be the dominant values; these cannot be ignored. AFTF captures intangible values in the expected cash flows.
Assigning a low priority to alternative accounting principles summarizes the issue. The Committee, as a body, did not want to change the basic accounting model even at the cost of not succeeding. Not being privy to the actual reasons for this position I am free to conjecture. I believe that some of the reasons were,
If these were concerns of the Committee then AFTF may help overcome those concerns. If these were not concerns of Committee, I’m mystified.
Comments on Chapters II and III of the AICPA Report
Chapters II and III deal with the user’s needs for information. End-user needs are a good starting point for investigating and designing accounting and financial reporting systems. It is critical that these needs are correctly identified. I don’t believe they were.
First, the committee restricted needs to the facts. Facts are like slippery eels, for every one grabbed, ten slip away. It is a fact that,
The study revealed that the main information goal of investors was to permit the projection of future financial results in order "to form opinions about the absolute and relative value of companies and their equity securities." The study revealed that the main information goal of creditors was to project cash flows in order assess the future debt servicing ability of the company. Traditional accounting does not furnish projected financial results or company value. Hence, the main information goal was to correct the deficiencies of traditional accounting, in essence, to substitute "alternative accounting principles".
It might be acceptable to furnish such information if there was a chance of actually correcting the traditional accounting deficiencies. It won’t happen; it can’t happen. There is no way of providing enough statement data to permit meaningful external valuations. There is no general capacity in the capital markets to do this. The closest thing to a meaningfully complete cash flow projection and valuation occurs with Mergers and Acquisitions. M&A valuations require months of professional attention based on volumes of data and costing well into six figures. The appetite for data will always be insatiable because it is not really data that is needed.
The solution to meeting users' goals is to directly satisfy those goals. This can only be done by changing basic priorities. AFTF is designed to encourage this.
The following sections of this appendix cover more comments that pertain to Chapters II and III of the AICPA Report, so I stop here.
Comments on the Recommendations
These comments follow the order of Appendix I: Summary of Recommendations of the AICPA Report. The bolded text is copied from the appendix.
Improving the Types of Information in Business Reporting – Chapter 5
Recommendation 1: Standard setters should develop a comprehensive model of business reporting indicating the types and timing of information that users need to value and assess the risk of their investments.
The Model Of Business Reporting (MOBR) suggested is given in Appendix II which is discussed in detail below. AFTF satisfies the essential purpose of this recommendation, in my opinion, better than MOBR. AFTF is business reporting for external consumption.
Recommendation 2: Improve understanding of costs and benefits of business reporting, recognizing that that definitive quantification of costs and benefits is not possible.
It is believed (by me) that AFTF would provide much greater benefits than MOBR. It is believed that the total cost of AFTF would be less and that the cost to the accounting profession would be less.
Financial Statements and Related Disclosures – Chapter 6
Recommendation 1: Improve disclosure of business segment information.
Under AFTF, segments would be defined by the cash flow models. Each model would have sub-segments with similar structures, characteristics and behavior so that the models would be internally consistent. In effect, segment reporting would be system driven, not significantly different from the general scheme currently in effect. With AFTF the segments would be fewer than envisioned for MOBR. The reason is that the details of the company’s performance and operation are left to management to interpret and act upon under AFTF. See the AICPA Appendix II discussion for further comments. With AFTF the improvement is directed more at the type of information disclosed rather than at the disclosure process.
Recommendation 2: Address the disclosures and accounting for innovative financial instruments.
This will be nearly impossible to do with a traditional accounting model. AFTF is based on expected cash flows taking the various contingencies in account so that a mechanism exists, but it won’t be easy. Perhaps stochastic expected cash flows could be used. This is not adequately addressed in the AFTF text.
Recommendation 3: Improve disclosures about the identity, opportunities, and risks of off-balance sheet financing arrangements and reconsider the accounting for those arrangements.
I’m not sure what these are, but if they can be expected to affect cash flows then they can be part of the expected cash flows of AFTF. If not, they can be ignored.
Recommendation 4: Report separately the effects of core and non-core activities and events, and measure at fair value non-core assets and liabilities.
Under AFTF there is no distinction between core and non-core activities. Since AFTF is anticipatory, extraordinary items seldom "pop-up". If an extraordinary item does appear, it become a real fact of experience, an actual that differs from the expected. It would be accorded the appropriate attention. A much more common "non-core" item under MOBR is financing costs. Under AFTF debt financing costs are treated like any other expense. Under AFTF equity financing costs are built into the model as a cost of capital. Under MOBR the cost of equity capital is apparently ignored. This recommendation should be dropped. More later.
Recommendation 5: Improve the disclosures about the uncertainty of measurements of certain assets and liabilities.
Under AFTF the disclosures cover all assets and liabilities. They are several AFTF disclosure mechanisms. The actual-to-expected ratios, the cost of capital, expected values themselves and the sensitivities exhibit, all reveal or take into account uncertainties and provide measures.
Recommendation 6: Improve quarterly reporting by reporting on the fourth quarter separately and including business segment data.
It is a good idea to make quarterly reporting as consistent as possible with the annual report. With AFTF special year-end adjustments and related notes, and in fact most adjustments, are a thing of the past. It would be possible to report only on a latest 12-month period or only on a quarterly period so there would be no difference between quarters and year-end.
Recommendation 7: Standard setters should search for and eliminate less relevant disclosures.
No comment.
Other Recommendations (selected)
It is heartening to see cash flow statements recommended for quarterly statements as well as annual. With AFTF it should not be a burden to include the same notes quarterly as annually and no explanations of different methods would be required.
Auditor Association with Business Reporting – Chapter 7
Recommendation 1: Allow for flexible auditor association with business reporting, whereby the elements of information on which auditors report and the level of auditor involvement with those elements are decided by agreement between a company and the users of its business reporting.
It is important that auditors serve an appropriate purposes and those purposes involve companies and end-users. However, I believe that the accounting profession and its auditors have a responsibility to determine themselves what needs to be audited; this is part of their independent role. It is unreasonable to expect companies and end-users to even get together, let alone reach agreements. If they did, there would be an impossible melange of incomparable elements. Auditors are best equipped by reason of training and experience to decide the elements. This cannot be left to others; it is the auditor’s responsibility.
Recommendation 2: The auditing profession should prepare to be involved with all the information in the comprehensive model, so companies and users can call on it to provide assurance on any of the model’s elements.
The detailed recommendations all seem appropriate. For AFTF an audit function is specified (see Appendix 3), but it may be also useful for the auditor to "review" the entire AFTF process. The auditor could state that the AFTF valuation is a reasonable basis for presentation made in conformity with presentation standards. This would lessen the absolute dependence of the auditor on the management and modeler opinions. This would be a revision to Appendix 3.
Recommendation 3: The newly formed AICPA Committee on Assurance Services should research and formulate conclusions on analytical commentary in auditor’s reports within the context of the Committee’s model, focusing on users’ needs for information.
It would be best, at least for AFTF, if the Committee on Assurance Services did not restrict itself to the MOBR.
Recommendation 4: The profession should continue its projects on other matters related to auditor association with business reporting.
No comment.
Facilitating Change in Business Reporting – Chapter 8
Recommendation 1: National and international standard setters and regulators should increase their focus on the information needs of users, and users should be encouraged to work with standard setters to increase the level of their involvement in the standard setting process.
This recommendation is a good idea and the detailed sub-proposals are on target. I would place less emphasis on users’ involvement in the standard setting process and perhaps more emphasis on contributing to the process.
Recommendation 2: U.S. standard setters should continue to work with their non-U.S. counterparts and international standard setters to develop international accounting standards, providing the resulting standards meet users’ needs for information.
This last proviso may be too restrictive for true international cooperation if value-based or prospective statements are excluded a priori.
Recommendation 3: Law-makers, regulators, and standard setters should develop more effective deterrents to unwarranted litigation that discourage companies from disclosing forward-looking information.
This would be good for AFTF. I believe this may be better targeted as an educational process. I believe the best defense would be understanding, general acceptance, and standard practice. In other words, encourage the profession to discipline and enforce good practice and disclosure, including disclosures as to the limitations of forward-looking information.
Recommendation 4: Companies should be encouraged to experiment voluntary with ways to improve the usefulness of reporting consistent with the Committee model. Standard setters and regulators should consider allowing companies that experiment to substitute information specified by the model for information currently required.
Not much voluntary experimentation is possible within the confines of the model. This recommendation should not refer to a particular model.
Recommendation 5: Standard setters should adopt a longer-term focus by developing a vision of the future business environment and users’ needs for information in that environment. Standards should be consistent directionally with that long-term vision.
AFTF provides a long-term perspective not only of the external business environment, but also of the company’s internal business environment: the company’s capacities, plans, and decisions as expressed by expected cash flows. AFTF quantifies vision.
Recommendation 6: Regulators should consider whether there are any alternatives to the current requirement that public companies make all disclosures publicly available.
No comment.
Recommendation 7: The AICPA should establish a Coordinating Committee charged to ensure that the recommendations in this report are given adequate consideration by those who can act on them.
The recommendations of the AICPA are generally sound and well motivated and should be considered. The MOBR is another thing. Perhaps the Coordinating Committee could provide an alternative view as well, namely AFTF. I don’t expect this to happen, however.
Comments on the Model of Business Reporting (MOBR)
These comments follow the order of Appendix II: A Model of Business Reporting of the AICPA Report.
This text has shown that traditional accounting lacks relevance and is only reliable in the sense of being reliably wrong. It is impossible to expand, reorganize and change the information currently provided in traditional reporting and produce relevant information. The basic model must be changed. MOBR does not do this. MOBR rearranges the deck chairs.
"It is designed to provide information that fits into the decision processes that many investors and creditors use to make forecasts, value companies, or assess the prospect of repayment." MOBR does not do this. It is impossible to provide enough information in a periodic financial report to enable others to forecast cash flow or to value a company. The investor would have to be informed in detail of characteristics, structures, and experience of the company; of management decisions, plans, and expectations. Even if MOBR could succeed in providing complete and appropriate information, the individual investors could not meaningfully assemble the information, create models, discount cash flows, calculate value added, etc. It is absurd to expect end-users to produce meaningful valuations or forecasts without extraordinary effort. It is inconsistent to expect the end-user to do what the accounting profession believes is impossible.
More important, it is the responsibility of management, the modeler, and the accountant to make the forecasts, report on the value of the company and changes therein, and to assess the prospect of repayment. Most important, AFTF furnishes a consistent accounting theory and a disciplined accounting methodology to accomplish these tasks. It is not impossible.
On more than one occasion the AICPA Report raises the specter of litigation arising from forward-looking information. This is a bogeyman. With AFTF there should be fewer surprises since AFTF is prospective and anticipatory. If management expectations are not realized due to poor management judgment, AFTF will soon reveal this and the shareholder can quickly express his dissatisfaction.
Key MOBR Concepts
Flexible reporting may satisfy the special interests of the reporting entity, but it doesn’t necessarily satisfy the interests of financial reporting. There is a need for objective, uniform, comparable standards. The accounting profession must have the determination to develop such standards and the courage to enforce them. It is not feasible or desirable for companies and end-users to do this.
Reporting separately for each business segment having diverse opportunities or risks ties in well with AFTF sub-models.
In order to permit the end-user to "make forecasts" and "value companies" it would be necessary to "Explain the nature of a company’s businesses, including the linkage between events and activities and the financial impact on a company of those events and activities." It is difficult enough for the full time management, modelers, and accountants to do this; the investor doesn’t have a prayer. The burden of the deficiencies of traditional accounting shouldn’t be dumped in the end-users lap. Accounting should serve a purpose. With AFTF and the close cooperation of management, modeler, and accountant, accounting can itself "make forecasts" and "value companies".
AFTF provides a forward-looking management perspective since it is a prospective system based on management expectations.
The sensitivity analysis and other AFTF features "indicate the relative reliability of information".
"Management should disclose the measurements it uses in managing the business that quantify the effects of key activities and events." AFTF distills all measurements to a single measure: shareholder value added.
A company should "promptly communicate important changes affecting a company". This should be done under AFTF. AFTF will also quantify those changes as value added. If this is done there is little point in reporting more frequently than quarterly.
Charts and graphs can be very effective and efficient communicators. This should be given greater emphasis in the AFTF text. Graphs may be especially effective in showing modeled expected past and future net cash flows.
Any investment must weigh costs and benefits, including an investment in accounting. Within this context the goal is to maximize the benefits not minimize the costs. Retaining the existing GAAP model is cheap.
"The committee’s recommendations also seek to improve the credibility of business reporting by including elements that help ensure balanced, neutral, and unbiased reporting. Those elements include
AFTF reports positive and negative cash flows in a balanced manner. Expected cash flows are discounted with respect to all contingencies and are neutral and unbiased. All qualitative information is converted to cash flows in the fullness of time. They are measured as present values. AFTF features detailed actual and expected cash flows so that actual performance is compared to projected. Finally AFTF provides reliable quantitative measures of uncertainty.
Although basically different from MOBR, AFTF nevertheless satisfies most of the general concepts developed from the study of user needs.
Differences Between the Model and Business Reporting by U.S. Public Companies
MOBR encourages more reporting segments. Some limited segmentation is useful for reporting purposes, but it unlikely that more than the five largest segments are useful since segment size drops off. Using more than a few segments may be counterproductive since too much data obscures rather than reveals. Only the bravest shareholder would look at 10 segments’ financial reports. One could argue that a single segment is all that is required from the shareholder perspective, especially if forecasting and valuing is already part of financial reporting. AFTF provides the answers that detailed segments are required for.
High level operating data would be expanded. This is necessary for management purposes, but not for reporting. It would be useful if the end-user were creating models, forecasting cash flows, and valuing segments or the company as a whole, but this will be extremely rare. Under AFTF this high level data is reported on in the form of the present value of the cash flows affected by that high level operating data. If such data has no effect on cash flows it can be ignored; if it has an effect it must be made part of expected cash flows. Under AFTF high level operating data is utilized and the financial consequences to the shareholder is reported on.
Management analysis should be limited just as segments are. With AFTF trends and changes in performance measures are the same as trends and changes in financial statements. As mentioned in the text, value added, cash flows and values all involve the same components, c.f., the traditional income statement and balance sheets.
The MOBR suggests a balance between past and forward-looking information. AFTF is primarily focused on the future, except for actual-to-expected cash flows.
The suggested background information would fit the AFTF scheme.
Improvements in Financial Statements
In the MOBR a distinction is made between core and non-core activities. One purpose of this is to be able to segregate the unusual and unrepresentative from the normal which is representative and may be expected to continue. Another separate purpose appears to be to separate the financing activities from operations. There are several problems with the core/non-core approach, which we will gratuitously explore.
It appears that interest income would be non-core, except for those companies or sub-entities which are financial-services entities, in which case some portion would be core. These are difficult distinctions to make and they may not be made in a consistent manner within a company, among companies, or from year-to-year. Apparently "recurring non-operating gains" from investments would be considered core so that investment returns may be split core/non-core for the same investment.
It appears that interest expense would be non-core except for those companies or sub-entities which are financial-services entities, in which case some portion would be core. The interest expense, to the extent included, would include the interest expense of debt, but seems to exclude the cost of equity, either actual dividends or the implicit market cost of capital. The goal of separating financing from operating results cannot be satisfied by ignoring cash flows to and from the equity capital markets. Financing is a normal business activity that should not be given separate and unequal accounting treatment. It should be integrated into normal financial reporting.
In addition to interest activities, unusual or non-recurring activities are classified as non-core. Such activities must, by definition, be somewhat rare. Is it necessary to create new financial statements for rare or exceptional items? Would a comment or footnote suffice? Again we have a problem of definition. Unusual activities are non-core only if they are "unusually large"; this is a judgement call. Is it the activity or the net financial effect which must be large? Can any "unusually large" transaction be excluded from core? If an unusually large natural disaster causes bankruptcy, it seems odd to report healthy core earnings.
I. Financial and Non-financial Data
Adding more Band-AidsTM to the GAAP corpus won’t help, can’t disguise the fundamental illness, and may wind up suffocating the patient. The arguments against core/non-core stand on their own, but AFTF provides some additional help. AFTF will, I believe, satisfy the intent of the core/non-core approach.
With AFTF there is no need for detailed data, in particular for the core/non-core separation.
Example 1, Sale of Real estate: A building occupied by the company was purchased 30 years ago for $1,000,000, has a current depreciated book value of $100,000, and has a current market value of $10,000,000. Traditional accounting would value the building and not necessarily the future cash flow consequences of the sale. Under traditional accounting an extraordinary profit of $9,900,000 would be realized upon sale. This profit would disturb the normal earning pattern and under MOBR this profit would be segregated.
Under AFTF the value of the building is the entity-specific value or value-in-use. That value is likely to be approximately $10,000,000 so that no extraordinary gain will be realized upon sale. Actually, under AFTF tangible (and intangible), assets have no value except as cash flow generators from use or sale. AFTF values are associated with decisions or alternatives. AFTF does not assign values in a vacuum so that the value of the sale is compared with the value of not selling. In this case the choice may be to retain the building, or sell and lease comparable space. Since the market value is the general value-in-use, the general cost for use (lease) will be comparable, so that little extraordinary AFTF gain can be expected. Another phrasing is that AFTF is anticipatory so that abrupt value changes are theoretically impossible.
Example 2, Discontinued Operations: With traditional accounting there is a natural reluctance to discontinue unprofitable operations (those not meeting the cost of capital) since an accounting loss is generated. Under MOBR this loss would be a non-core item. With AFTF the value of that continued operation will be negative. The value of discontinued operations will be a smaller negative. The value of the decision to discontinue will consequently be positive. The valuation is aligned with the decision; positive results are reported positively.
More important, since AFTF is decision oriented and anticipatory the company should never be in the position of having to absorb even a traditional accounting loss. Each year, each significant operation is evaluated; when the value is decreasing, action is indicated. Losses may not be completely avoidable, but significant losses could only occur through mismanagement.
These two examples show that, under AFTF, extraordinary items are unlikely to develop; AFTF eliminates the problem that the core/non-core distinction was designed to correct. Note also the generally superior treatment under AFTF for these two examples.
In addition to the detailed reporting cited above, there are more suggestions that "Companies should increase the amount of detail in the statements …" and expand disclosures. There is a call for more high-level and qualitative information. This call for more, more, and more data is a well motivated, but misguided, attempt to correct basic deficiencies. It is well motivated since this information ultimately determines a company’s value. It is misguided in that the end-user simply can not utilize great detail. It is not relevant to the end-user and, worse, it benumbs and obscures. This data should be processed by the accounting system before being reported as high-level shareholder information. The highest level of information is what AFTF provides, namely, shareholder value and value added.
II. Management’s Analysis of Financial and Non-financial Data
Many of the points raised here apply equally well to AFTF, except that AFTF analysis would revolve around macro information rather than micro data.
III. Forward-Looking Information
It is stated that,
"Although prospective financial and non-financial information is often useful for financial analysis, user often prepare it themselves and it is not a required part of the reporting model for cost-benefit reasons."
It would be far easier, more reliable, more disciplined, and less costly for the company to assemble prospective financial information than for a multitude of users to attempt to do the same. The cost-benefit argument is false if total costs are measured and is doubly false if total benefits are measured, since company produced information would be available to all. I don’t want to repeat too much of the text, but AFTF only requires what management already does or should do. Also the unification and simplification of accounting systems should reduce costs. On the benefit side, AFTF produces relevant information, which should help management, the shareholder, and capital market efficiency. The cost-benefit argument favors AFTF.
AFTF is a prospective system based on expected values; there is no better model for evaluating opportunities and risks
AFTF captures and measures the financial impact of management decisions.
C. Comparison of Actual Business Performance to Previously Disclosed
Opportunities, Risks and Management Plans
The AFTF actual-to-expected report is such a comparison. It is phrased quantitatively in shareholder value terms. Consecutive company valuations and value added provide more comparisons.
IV. Information About Management and Shareholders
This fits well into the AFTF scheme or vice versa.
V. Background About the Company
AFTF would require and provide less information than suggested because much of the suggested information is incorporated into expected cash flows and the company valuation.
Conclusions
The Committee on Business Reporting is to be commended for their work and recommendations. It is clear that they understood the deficiencies in accounting and reporting. Unfortunately they directed solutions to fundamental accounting problems at reporting, not surprising given the constraints they worked under. One such constraint was the committee’s name and presumably its charge: Business Reporting. Another constraint was the apparent decision not to disturb the basic GAAP model. Another constraint appears to be the absence of a clear and feasible alternative to GAAP. This text may provide an alternative and I hope that the Committee and the standard setters will look at the Committee’s recommendations in light of AFTF and vice versa.
It is my opinion, that much of the added detail and complexity of the MOBR will not of positive value and should be deferred. It is well motivated, but misguided, at least from the AFTF perspective.
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