Peeling away financial reporting issues one layer at a time

The “Preliminary Views” on Financial Statement Presentation: Seven Years of Deliberation for This?

This past October, the FASB and IASB issued a joint discussion paper with their preliminary views on financial statement presentation:

"[The IASB and FASB initiated the joint project on financial statement presentation to address users' concerns that existing requirements permit too many alternative types of presentation and that information in financial statements is highly aggregated and inconsistently presented…" [¶ S1]

Both boards commenced work on separate projects in 2001, and seven years later have barely anything to show for it except for this five-page document, which amounts to little more than a proposal to re-arrange the living room furniture. For the sake of completeness, I should also point out that the IASB did also make a few minor alterations to IAS 1 that mainly catch up IFRS to GAAP in respect to reporting dirty surplus – whoops, I meant "other comprehensive income."

To give you some sense of the nature of these deliberations, such as they have been, I can draw on a personal experience. After the Enron debacle, the lack of transparency afforded by the indirect method of presentation for the statement of cash flows rightly became a focus of critics. In Enron's case, it would have been kinda sorta nice to be aware of how little cash Enron was getting from its customers. Six months following Enron's implosion, I attended the annual reunion of alumni from the SEC's Office of the Chief Accountant. At a presentation to our group, the erstwhile Chief Accountant assured us that the direct method of presentation of cash flows would soon become required. Supposedly, there was a clear consensus that this was the right thing to do.

That was more than six years ago, and nothing whatsoever has changed, other than that we're knee deep in another financial debacle. The preliminary views document disingenuously continues to spout the party line in support of the direct method, and even for further disaggregation of cash flow information. If this were solely an FASB decision, and if President-Elect Obama appoints a non-partisan SEC Chair (I'm rooting for Charles Niemeier), then I might have some reason to hope. But, there's no way this sort of change will find its way into IFRS. EFRAG (European Financial Reporting Advisory Group), and perhaps China, will contrive some sort of excuse that it would harm the ability of companies in their part of the world to compete; and the proposal will fade to black yet one more time.

Another proposal that would have some merit if it weren't watered down with weasel words is, "An entity should further disaggregate its income and expense items by their nature within those functions to the extent that this disaggregation will help users in predicting the entity's future cash flows." [¶ S11, italics supplied] For example, cost of sales would be disaggregated into materials, labor and other components. But, who would decide what "will help users"? Answer: management, of course, because that is the consistent theme of IFRS – trust management to do what is right. If this were an FASB-only project, I'd bet that the document would include examples and illustrations of the principle functional categories to be disaggregated, together with the principle components of the disaggregation.

Separating Financing from Everything Else

No presentation format can be satisfactory unless it assists readers in assessing the performance of a company, independent of any decisions regarding financing that management made. That's why I am so strenuously opposed to the capitalization of interest costs in any way shape or form: assets values should be reported independent of how they are financed, and financial items affecting profitability should be separated from all other revenues and expenses.

Thus, the cockles of my heart warmed as I read these noble words:

"The proposed presentation model requires an entity to present information about the way it creates value (its business activities) separately from information about the way it funds or finances those business activities (its financing activities)." [¶ S4]

But, then, reality intruded upon my reverie as I read the following:

"The classification decision would reside with management…. The Boards support a management approach to classification rather than a prescriptive approach because they believe it will result in financial statements that reflect how management views and manages the entity and its resources." [¶ S6, italics supplied]

In other words, what constituted financing or "business activities" would be subject to the discretion of management. That's not quality financial reporting, it's farcical financial reporting. But perhaps the boards saw no other way to protect interest capitalization, that sop to the oil and gas industry. Also, don't count on management to disaggregate the interest component of cost of sales, or the cost of anything else.

The main point of this post is to demonstrate that the choice between a "prescriptive approach" and a "management approach" is a false choice. A third alternative, as always, is a principles-based approach.

The Principle of the Largest Possible Entity

The late Tom Burns, one of my mentors, once remarked that the most fundamental problem of financial reporting was choosing the entity of account: in other words, the boundaries that marked the affairs of the entity, and the affairs of others. I didn't fully appreciate that statement until too many years later. I was trying to think of a way to explain to my students in a managerial accounting course how the topics for such a course were selected. I eventually decided that managerial accounting explored decision making scenarios in which managers would decide which "real", or "productive" resources a business should acquire, and how best to put them to use. Questions of financing the resource acquisitions would be explored elsewhere in the curriculum.

That was fine and good, but I needed to have a way to explain what was "real" versus merely "financial." This is when, and I can't explain why, I came back to Tom Burns' observation. I asked myself, what would financial statements look like for the largest possible entity (LPE) – as if the universe were one big happy family? In other words, what if all the entities that existed, personal, corporate, government, etc. were consolidated/combined? This is my depiction (units of measure are arbitrary and only for purposes of illustration):

The Largest Possible Entity

Consolidated/Combined Balance Sheet

December 31, 20×1


$   100

Plant and equipment


Natural resources




Total assets






Consolidated/Combined Income Statement

Year ended December 31, 20×1

Production revenue

$ 500

Utilization of resources in production


Net income



The most important lesson from the balance sheet is that all of the assets that remain upon elimination of reciprocal accounts are the "real" assets. Therefore, financial assets and liabilities are distinguished by their absence on the balance sheet of the LPE. For example:

  • There is no cash on the LPE's balance sheet. The entity already owns and controls all of the goods and services in the economy, so cash is of no use, except perhaps for the paper it is printed on.
  • There are no receivables, derivatives of any kind, or liabilities. They all offset, or eliminate, as "intercompany" transactions.
  • There are no investments in other entities, because the LPE can't recognize an investment in itself as an asset.

The only categories of revenue and expense that can appear on the LPE's income statement are revenues from the production of real goods and services and expenses from the use of the assets as inputs to the production of those goods and services. Like all receivables and payables, financial revenues and expense are reciprocal items that cancel out.

From the above, I derive the following simple principles that can be the fundamental basis for a financial statement presentation standard:

  • Only those assets that are not eliminated in the consolidation/combination process to arrive at the balance sheet for the "largest possible entity" (LPE) are "real," or call them "operating" if you want. All other assets and liabilities are to be reported as financial in their own separate categories.
  • Operating expenses are the utilization of real assets in the production or real goods and services. All other expenses are financial.
  • Operating revenues are either (1) the measure of the assets (real or financial) that an entity becomes entitled to for having transferred real resources or for having provided real services; or (2) the measure of the reduction in liabilities that an entity is entitled to from having transferred real resources or provided real services. All other revenues are financial.

Thus, the fundamental distinction to be made in financial presentation is between those items on financial statements that are, or are derived from, real versus financial assets and liabilities. If the boards want to give management the discretion to decide what is "operating" and what is "non-operating", that would be fine with me, just so long as financial items are not conflated with real items in any financial statement. Especially after this latest financial debacle, the potential usefulness of this fundamental distinction should be more apparent than ever.

The day may yet come when we will be freed from the eccentricities of financial statement presentation foisted upon investors by managers who have no interest in giving shareholders more information about their actual performance. Sad to say, after seven years of waiting for a five-page, joint preliminary views document, that day will be no closer if the next generation of SEC leadership doesn't give the accounting standard setters a swift kick in the pants.

On that note, I even sent the gist of my LPE principle to a senior staff member of the IASB a number of years ago, not long after the IASB announced the commencement of its financial statement presentation project. His initial reaction was positive, but after I offered to help develop the idea further, I received no further response. I now invite you, kind reader, to be the judge.


  1. Reply Bob Jensen December 7, 2008

    Hi Tom,
    I’m a bit confused by a number of things in this module, including the following:
    What makes the components of the balance sheet and income statements additive?
    For example, it would seem that Knowledge has enormous covariances with the other assets.
    What makes financial reporting at this highest level of “ownership” of interest to investors?
    This level of financial reporting might be important to politicians, but investors are more interested in there small pieces of the this balance sheet.
    Thanks for making me think about such things,
    Bob Jensen
    Response from Tom:
    Hi, Bob:
    The LPE concept for distinguishing between financial and non-financial items is independent of valuation, or measurement. The concept is useful for identifying which assets would be recognized.
    I could propose any number of valuation approaches, but they wouldn’t change my conclusions with respect to what is fundamentally financial and what is not. For example, how about this approach to valuation:
    There is a Master of the Universe. Her utility for one keg of beer is set to unity. The utility of everything else is measured relative to the utility of one keg of beer.
    Also, in my system it would be perfectly OK to not recognize knowledge as an asset.

  2. Reply Independent Accountant December 8, 2008

    I have used this very example to try to explain operating and financing decisions to other accountants. Right on.

  3. Reply Robert Bloomfield December 10, 2008

    I have been doing some research on Financial Statement Presentation as part of my role as director of the Financial Accounting Standards Research Initiative. I have a couple comments.
    First, you link readers to the 7-page summary document, but there is a lot more than that. The FASB project page is
    The discussion paper is quite long and detailed, including elaborate examples of a manufacturing and a banking company.
    Also, one very interesting aspect of the proposal is a reconciliation footnote that would reconcile, line by line, the cash flow statement to the income statement. The differences are broken into various categories including accruals, fair value remeasurements, other remeasurements, etc.
    So if you are opposed to capitalized interest, you are likely to be able to undo a fair bit of that through the footnotes.

  4. Reply d4winds January 19, 2009

    The LPE concept has great utility but ignores in its aggregations one very salient aspect of financial items: their inherent limited liability (LL) nature, which has implications for the real recoverability of one entity against the operating profits of another.

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