Peeling away financial reporting issues one layer at a time

Making Financial Statement Presentation Simple: Mandate Account Reconciliations

Following my most recent post on financial statement presentation, Eddie Thomas, a frequent commenter of this blog, wrote: "Wouldn't investors be better off pushing for a more robust XBRL so that they can make their own decisions about what is relevant information and what is not? It seems like an effective end run around the politics of the FASB and the IASB."

I agree with Eddie to a point, but I am afraid he may be discounting the "garbage in, garbage out" rule of data processing. The information value of "robust XBRL" heavily depends on the granularity, uniformity and quality of inputs. As to whether GAAP or IFRS has attained a quality level even approaching 'satisfactory' is, as Eddie implies, highly debatable. With respect to granularity and uniformity, it's not even a close call — hence the financial statement presentation project in the first place.

But, what I am about to suggest can make Eddie's wish to "end run" politically motivated accounting standards come true: balance sheet account reconciliations. In that last post, I suggested that one of three important things that the Boards could do would be to provide reconciliations of the beginning and ending balances of all balance sheet accounts. The other two were to mandate a direct-method statement of cash flows and to maintain a strict separation between financial and operating items. Upon further reflection, the reconciliations would be the single most important thing the Boards could do. It would also be the simplest and most logical way to do raise the level of financial reporting on all dimensions. Here are just three examples.

Example #1: PP&E

A reconciliation of PP&E can provide a separation of depreciation charges by function, and highlight the effect of discrete events hitting the income statement that are widely regarded to be of interest to investors: e.g., business combinations, restructurings, discontinued operations and impairments.

Perhaps some of this information can be teased out by the FASB/IASB proposal, but certainly not all of it. But, the FASB/IASB proposal would subject much too much to management's whim; and without detailed mandates it would be difficult to develop consistent XBRL tags.

The last two items in the reconciliation example clearly go beyond the FASB/IASB proposal: the effect of capitalized interest, and changes in the balance due to "translation" of accounts on the books of foreign subsidiaries at current exchange rates. The transparency of capitalized interest is essential to investors whose first analytical objective is the isolation of the effect of financial decisions on "operating" profits. The effect of foreign currency translation allows the investor to unwind the purely random effect on comprehensive income from multiplying a historic cost by a current foreign currency exchange rate.

Example #2: Inventories

The inventory example has a couple of extra twists. First, methinks it is not well-known that U.S. GAAP permits the capitalization of interest costs in inventory (IFRS does not). Also, "fair value hedge accounting" under both FAS 133 and IAS 39 permit the historic cost of certain inventories to be adjusted by gains and losses due to certain "hedged risks." The result of fair value hedge accounting on the carrying amount of inventories (and other assets/liabilities) is a process that I heard Tom Linsmeier refer to (prior to his being appointed to the FASB, of course) as "mutt" accounting – i.e., neither historic cost nor fair value. If comparability is truly the key reason for U.S. adoption of IFRS, then the Boards should be seeking to enhance comparability generally, and not merely through IFRS adoption. This should mean that investors are entitled to data for unwinding the effect of hedge accounting, a free choice creating lack of comparability, whenever it is applied.

The IASB/FASB proposal calls for disclosure of expenses by "nature" if management deems it to be significant information. Instead, I would require, where applicable, a statement of cost of products manufactured (i.e., a reconciliation of production costs and changes in inventory balances to cost of sales). The components of cost of sales could be highly informative, and, like reconciliations of balance sheet accounts, they are already being prepared for internal control purposes. Besides, undergraduate accounting students learn how to prepare a statement of costs of goods manufactured in their second semester!

Example #3: Trade Receivables

I include this example in part to illustrate that some legitimate foreign exchange losses are hidden in other comprehensive income (i.e., the translation adjustment). These gains and losses, which are derived from assets and liabilities held on the books of foreign subsidiaries (whose functional currency is not the dollar), are no different in their economic substance from other foreign-currency-denominated accounts receivables on a domestic subsidiary's books. Yet, by a 4 – 3 vote, the FASB decided that they should be presented differently.

Reconciliations are a No-Brainer: That's why Investors Can't Have Them

Imagine having those reconciliations along with programs that can read XBRL data! Service providers would be competing with each other to create the very best 'out of the box' analytics, and just as Eddie predicts, users won't even bother glancing at the financial statements as presented by management and the sleep-inducing narrative disclosures written to obfuscate rather than enlighten. The oil and gas industry could stuff their cherished interest capitalization where the sun don't shine, and multinationals could do the same with their foreign exchange translation gyrations.

But, the reasons why we don't currently have reconciliations are the reasons we won't get them. Managers must continue to make value-destroying choices for the sake of the accounting results that, with reconciliations, could be easily unraveled and even prevent fraud. Even though S-OX essentially requires that these reconciliations must exist somwhere in the bowels of each issuers' accounting system, auditors could not abide the prospect of providing each and every investor with the opportunity to perform its own 'analytical review' from which its own could be second-guessed. 

So, there you have it: the result of a couple of days of talking to myself, as opposed to millions of dollars spent by the FASB and IASB to solemnly deliberate for seven years such weighty issues such as whether the direct method for the statement of cash flows should be required, and a bunch of ad hoc ideas like separate identification of recurring and non-recurring revaluations.

If there is hope for improved financial statment presentation, it may be with new leadership of the SEC.  Historically, disaggregation has been under the purview of the FASB or the SEC. For example, SEC Regulation S-X is the main repository of presentation guidance for public companies. About a dozen years ago, the SEC, as a favor to issuers, eliminated supplemental schedules set forth in Reg. S-X that required details on the movements in long-lived assets. But about eight years ago, it also proposed to augment disclosures of the movements in so-called "valuation and qualifying accounts." The proposal was never acted upon, with the advent of S-OX serving as the official excuse. But, intense lobbying against the proposal by the usual suspects is the only plausible scenario.

I am not necessarily saying that the SEC should be taking over this project, but presentation has long been the purview of the SEC, and the FASB is falling way short. The purpose of S-OX in providing an independent funding source for the FASB is to free the FASB from undue influence, so as to carry out its mission in an unbiased and timely fashion. How could something as straightforward as financial statement presentation take seven years (and counting), if it were not for the meddling of special interests? Intentionally, or not, the FASB has neutered itself, and harmed the interests of U.S. investors by agreeing to join forces on the project with the IASB – which is not independently funded, and more than ever appears to be under the thumb of the European Union.


  1. Reply Eddie Thomas January 4, 2009

    Another great post. I have some questions about the psychology of some of the players:
    Why don’t companies with strong fundamentals support this kind of disaggregation? Wouldn’t the exposure of the weakness of their competitors be advantageous?
    Also, I wonder if investors are uniformly supportive of clarity in financial information. Wouldn’t greater clarity level the playing field more? I would think that those who put the most resources toward financial analysis would be happy with the opportunities that arise from accounting confusion.

  2. Reply Pauline Sallee June 1, 2009

    The problem with what you propose above is that you have illustrated a “Roll forward” which unfortunaley too many accountants think is actually a reconciliation. A roll forward of the account is not a Balance Sheet account reconciliation.

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