Peeling away financial reporting issues one layer at a time

The Earnings Management is Hidden in the Details

With inspiration and encouragement from the John Hughes IFRS Blog, this post is a partial recycling from 2010 of Merrily We Roll Along — Forward and Up.   I had observed way back then that with XBRL on the rise, analysts could have a field day if only the notes to financial statements would include reconciliations (or “roll forwards”)* for all of the balance sheet accounts.

John Hughes’s resurrection of this topic was inspired by the dissent of IASB member Patrick Finnegan to the IASB’s decision to demur from acknowledging the power of disaggregated information in its revamped conceptual framework:

“Mr Finnegan believes that the Conceptual Framework should discuss the usefulness of financial information from the perspective of disaggregated information, not aggregated information. The financial statements issued by most entities report information that summarizes a large volume of detail…such summarized information cannot provide the essential information necessary for an investor’s understanding of financial performance (or financial position).

…[T]he disclosure principles …[should] include a requirement for the disclosure of entity-specific information that shows or explains changes in assets and liabilities … One way of achieving this disclosure objective would be to provide reconciliations for all assets and liabilities…” [emphasis added]

Mr. Finnegan’s dissent recalled for Mr. Hughes a more promising, albeit fleeting, moment in time when the IASB actually contemplated doing something that could actually help shareholders and potential investors.  As it has become all too common, the document in which was proferred the simple balm of balance sheet account reconciliations took seven years of “due process” to produce — as if reconciliations were some sort of great step forward instead of something that should be self-evident to an undergraduate accounting student.  But soon thereafter, the transparency scolds — i.e., the people that the FASB and IASB really listen to — consigned it to the attic with the rest of the unwanted children from the convergence era.  Out of sight, out of mind.

Thanks also to Mr. Hughes for recalling my enthusiasm at the time:

“In his blog nowadays, Selling seldom finds a reason to express such infectious excitement; neither, for that matter, does anyone else involved in IFRS. It was nice to be reminded of it by Finnegan’s dissent, even if it only seems to confirm that our socks will be staying on for the foreseeable future…”

Over the last month or so, I had been mulling over a post.  What could I add to what John Hughes wrote?  With the benefit of hindsight, it turns out that I’m glad for once that I took my time.  For a few weeks later, a case in point to buttress Mr. Finnegan’s dissent arrived in my inbox.  It came from former FASB chair Dennis Beresford, who since has served on the faculty of the University of Georgia.  By way of further introduction, I must also say that Mr. Beresford had questioned the utility — and perhaps even the feasibility — of balance sheet account roll forwards to me after reading my “Merrily We Roll Along …” post back in 2010.  This was his observation, which he shared with about 700 academics via the AECM listserv:

“I continue to see many papers (another presented at a workshop at our University this week) that rely on the Jones Model to somehow determine that companies are managing their earnings through accruals. I just don’t think it’s possible in most cases to know whether a company is more or less aggressive in managing earnings without knowing more about the details of what underlies the amounts in the financials. It would be nice to see some academics challenging the Jones Model and similar assumptions from other papers rather than continuing to build a pile of papers based on a model that may not be valid.” [emphasis and hyperlinks supplied]

Basically, Mr. Beresford proved the point I was trying to make in “Merrily We Roll Along….”  Of course, the Jones Model, and others like it (see, for example the Beneish Model of earnings manipulation) are very noisy proxies for earnings management.  But, owing to the over aggregation of financial information produced for public consumption, it’s the best information available to researchers who wish to construct predictive models from large samples of data.

As Mr. Finnegan observes, financial reporting doesn’t have to remain stuck in the early 20th Century.  Just think of all of the new and innovative metrics of athletic performance that have been developed by leveraging new data technologies.  I’ll bet that the Elias Sports Bureau accumulates more quantitative information about the 80 at-bats in one baseball game than, say, Microsoft reports in it’s 10-K from its millions of accounting entries.

So, what might investment analysts do with similar data on public companies?  Instead of plugging and chugging the Jones or Beneish models, indicators of discretionary accruals would practically jump out of a spreadsheet and into the researcher/analyst’s lap!  Even better, issuers of financial statements themselves would have to help, whether they wanted to or not.  The SEC’s MD&A rules already in effect would make it the responsibility of management to identify the significant changes made transparent by the reconciliations, and to explain the reasons for the changes.

And taking the above one logical step further, detailed reconciliations would discourage management from booking discretionary accruals in the first place.  If it is inevitable that accounting standards must leave some room for discretionary accruals, then the economic incentives to abuse that discretion matter.   As justice Louis Brandeis said, “sunlight is the best disinfectant.”  Rules that require sunlight on discretionary accruals will not only increase transparency for analysts and researchers, but they will also discourage misleading and/or manipulative accounting entries in general.

Alas, Mr. Finnegan’s dissent is an official acknowledgement that the IASB/FASB attic will remain locked, and with the lights turned off.  The data explosion in sports reporting, from leveraging state-of-the-art information technologies, will not be replicated unless stronger incentives to act in the interests of investors are forced on accounting standards setters.

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*The term “reconciliation” and “roll forward” are used by various commentators to mean the same thing in this context, i.e., starting with the beginning balance of a balance sheet account and list the increases/decreases that will derive the ending balance.

1 Comment

  1. Reply Steve M September 15, 2015

    I design financial reporting applications for large multinationals.   You are right that technology has come a long way.   It depends on the sophistication of the fp&a /reporting group at a company,  but most that I have worked with do collect a lot of roll forward data.   That being said,  usually it is more around requirements for disclosures and to facilitate automation of cash flow.   You typically see PPE,  debt,  equity.   You may also see bad debt reserves,  or some other reserves,  but not often enough.   I think most of the time the issue is the underlying technology at the ERP level,  where the movement types are not being captured,  so breaking out the movements can be very challenging.   In my business,  we can tell you that reporting is only as good as the reliability of the underlying data.   Couple that with pressure to tighten the close cycle,  and subs just cannot report that info as quickly.   We do provide the ability to see movement of each balance sheet account at a much lower level than what you typically see in financial statements. So some of the explanation can be seen at lower level of GL.   If certain accruals are broken out,  you can at least see the culprit.   The ability to use a taxonomy to tag this data is a reality today as well,  to provide xbrl docs,  but companies likely wont tag at that level unless they are forced to. 

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