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Transparency
and Understandability, But for Whom?
How Different
Standards Setters Define the ‘Average User’
By
Sid R. Ewer
FEBRUARY
2007 - In June 2001, Lynn Turner, then chief accountant of
the SEC, gave a speech titled “The State of Financial
Reporting Today: An Unfinished Chapter III,” at the
Glasser LegalWorks Third Annual SEC Disclosure and Accounting
Conference:
[In
1998 in America] there were 84 million shareholders, representing
43.6% of the country’s adult population. That is a
21% increase from the number of 69.3 million just three
years earlier and a 61% increase from 52.3 million in 1989....
These stockholders come from all walks of life ... half
of those stockholders have income of less than $57,000 and
only 18% have family incomes that exceed $100,000 ... the
average stockholder today is the average American who lives
next door ... [A]verage Americans today, more than ever
before, are willing to place their hard-earned savings and
trust in the U.S. capital markets ... because they have
confidence in the integrity of those markets.
In
less than 10 years, the number of individual shareholders
had increased by more than 50%. Less than 20% of America’s
stockholders can be classified as high income, and how many
of them possess a sophisticated knowledge of accounting
matters is unclear.
Two
years after Turner’s speech, the Federal Accounting
Standards Advisory Board (FASAB) promulgated Statement of
Federal Financial Accounting Concepts 4 (SFFAC 4), “Intended
Audience and Qualitative Characteristics for the Consolidated
Financial Report of the United States Government.”
The FASAB’s action had nothing to do with Turner’s
speech, but the underlying theme of SFFAC 4—who is
the intended user of a financial report?—raises a
question: Should FASB take a cue from its federal government
cousin?
Whatever
one thinks of the federal government’s financial matters
(it has never enjoyed an unqualified opinion on its financial
statements), federal government accounting rule makers may
have been right where SFFAC 4 is concerned. With SFFAC 4,
the FASAB has signaled its intent to democratize the understandability
of the U.S. government’s consolidated financial report
(CFR). Paragraph 6 of SFFAC 4 declares:
The
CFR should be a general purpose statement of accountability
to the public. A general purpose report should be easily
understandable to the “average citizen” who
has a reasonable understanding of Federal Government activities
and is willing to study the information with reasonable
diligence.
The
author believes that the FASAB’s conceptual approach—an
understandability to average citizens—is noteworthy
in how it diverges from that of FASB, the Government Accounting
Standards Board (GASB) and the International Accounting
Standards Board (IASB). Moreover, this article will question
whether FASB and the other standards setters, perhaps without
realizing it, are moving away from transparency in financial
reporting through the specific words used in accounting
concepts and, just as important, through the words used
before in those considerations but now left out.
Characteristics
of Users
FASB’s
Statement of Financial Accounting Concepts (SFAC) 1, “Objectives
of Financial Reporting by Business Enterprises,” issued
November 1978, states in paragraph 9, while discussing the
environmental context of objectives, “the objectives
in this Statement are affected by the economic, legal, political,
and social environment in the United States.” Earlier
in the same paragraph, SFAC 1 notes that “objectives
stem largely from the needs of those for whom the information
is intended.” Paragraph 24 acknowledges that “[m]any
people ... are potentially interested in financial reporting,”
then goes on to list a multitude of potential users. Paragraphs
28–30, however, declare that the objectives of SFAC
1 are to underpin general-purpose financial statements and
that the primary “focus is on information for investment
and credit decisions.”
Thus,
FASB serves first the investor and the creditor. As for
how knowledgeable that investor and creditor should be,
paragraph 34 says: “The information should be comprehensible
to those who have a reasonable understanding of business
and economic activities and are willing to study the information
with reasonable diligence.” In paragraph 36, however,
FASB recognizes that users’ “understanding of
financial information ... may vary greatly,” and that
“financial reporting [should be able to] be used by
all—nonprofessionals as well as professionals—who
are willing to learn to use it properly [and that] efforts
may be needed to increase the understandability of financial
information.”
The
IASB says that its Framework for the Preparation and Presentation
of Financial Statements [published in 1989 by its predecessor,
the International Accounting Standards Committee (IASC)]
is “concerned with general purpose financial statements
[that are] directed toward a wide range of users.”
Paragraph 10 of the IASB Framework, however, provides that
“as investors are providers of risk capital to the
entity, the provision of financial statements that meet
their needs will also meet most of the needs of other users
that financial statements can satisfy.” The IASB almost
mirrors FASB in its conception of the knowledge base that
users possess; according to paragraph 25 of the IASB Framework,
“users are assumed to have a reasonable knowledge
of business and economic activities and accounting and a
willingness to study the information with reasonable diligence.”
The IASB thereby added “accounting” to FASB’s
presumed user knowledge base.
FASB’s
and the IASB’s initial attempt to converge conceptual
frameworks in their Preliminary Views placed equity investors
and creditors first and second, respectively, among the
seven categories of “potential users of financial
reports.” In the same section, paragraph OB6, the
boards support general-purpose financial reporting “directed
to the needs of a wide range of users rather than to the
needs of a single group,” noting, however, that “investors
and creditors ... are the most prominent external groups
who use the information provided by financial reporting.
... Thus, the primary users of general purpose financial
reports are present and potential investors and creditors.”
The boards reiterate their support for “information
that is useful to a wide range of users” (paragraph
BC1.8), but say in paragraph BC1.14 that both boards still
“designate investors and creditors as the primary
users.”
And
how knowledgeable should those designated investors and
creditors be? According to paragraph QC3, “[t]hose
users, especially investors, may have widely differing
degrees of knowledge about the business and economic environment,
business activities, securities markets, and related matters”
(emphasis added). Paragraph QC4 states, however, that “in
developing financial reporting standards,” there is
a presumption that users of accounting information “will
have a reasonable knowledge of business and economic activities
and be able to read a financial report [and] will review
and analyze the information with reasonable diligence.”
Furthermore, “one does not need to be an accountant
or a professional investor ... but it is necessary to learn
how to read a financial report.” So, the IASB dropped
“knowledge of accounting” from its users’
presumed knowledge base, but added “able to read a
financial report,” and, rather than just “study,”
the IASB expects users to “read and analyze.”
FASB agreed to this description.
Turning
from private-sector accounting to the public sector, GASB,
in its Concepts Statement (GASBCS) 1, “Objectives
of Financial Reporting,” specifies in paragraph 30
the citizenry as first among three groups of primary users;
investors and creditors were second and third. According
to paragraph 56: “Accountability is the cornerstone
of all financial reporting in government, and ... accountability
requires governments to answer to the citizenry.”
According to paragraph 8: “The Board takes a broad
view of public accountability.” Although GASBCS 1
seems to indicate that GASB has a democratic view of the
intended users of state and local government financial reports,
that concepts statement was published in 1987; in 2005 the
GASB issued Concepts Statement 3, “Communication Methods
in General Purpose External Financial Reports That Contain
Basic Financial Statements.” Paragraph 21 of GASBCS
3 states that “to effectively interpret [financial
reports,] the user is responsible for obtaining a reasonable
understanding of government and public finance activities
and of the fundamentals of governmental financial reporting,
for studying the messages with reasonable diligence, and
for applying relevant analytical skills.”
GASB,
which has offices in the same facility as FASB, where the
two professional staffs must come into close contact, has
obviously borrowed from FASB’s playbook. If GASB ever
intended to make financial reporting more accessible to
the average citizen, paragraph 21 effectively shuts down
such intentions. Indeed, GASB’s intended-user model
goes one better than FASB’s (see
the Sidebar). The bar appears to have been set
higher for users of state and local government financial
reporting than it has for readers of private-enterprise
financial reports. One might speculate whether this represents
some one-upmanship between the two standards setters.
FASAB
Concept Statement (SFFAC) 1, “Objectives of Federal
Financial Reporting,” stated that the FASAB identified
four user-groups of federal financial information, and it
repeated those users in SFFAC 4: 1) citizens; 2) Congress;
3) executives; and 4) program managers. The FASAB categorizes
citizens as an external user group and the other three groups
as internal users. The recognition of citizens as an external
group with little direct control over federal operations,
or over the form and design of financial reporting, led
the FASAB to address specifically the needs of citizens
and the purpose of the U.S. government’s consolidated
financial report.
The
FASAB promulgated SFFAC 4 because, over time, the consolidated
financial report (CFR) had become complex and voluminous,
and the FASAB recognized that the CFR was trying to serve
too many masters. Currently, the report encompasses more
than 100 pages. The FASAB decided to determine the primary
users of the CFR in order to rein in some of the CFR’s
more unwieldy features. In determining specifics of federal
financial information to provide the citizen user, the FASAB
followed the advice of the Association of Government Accountants’
1994 study “Toward a Report to Citizens on the State
of Their Nation and the Performance of Their Government.”
That study promoted a succinct yet comprehensive picture
of the U.S. government’s activities. Accordingly,
the challenge would be to make the CFR succinct while still
addressing all four objectives outlined in SFFAC 1: 1) budgetary
integrity; 2) operating performance; 3) stewardship; and
4) systems and control. The FASAB acknowledged that the
CFR would not satisfy all four objectives for all audiences,
and internal-user groups would need to rely on more-detailed
reports. The FASAB thinks, however, that users other than
citizens are often likely to employ the CFR as merely a
starting point in acquiring more financial information.
Distinctions
Between the Standards Setters
The
four standards-setting boards’ understandings of the
external user’s sophistication in financial reporting
usage appear imperceptibly different, yet examining how
each board describes its constituents’ characteristics
reveals significant distinctions. FASB, in paragraph 34
of SFAC 1, states that “[financial] information should
be comprehensible to those who have a reasonable understanding
of business and economic activities and are willing to study
the information with reasonable diligence.” The FASAB
acknowledges that it bases its definition of a general user
on FASB’s definition in SFAC 1; paragraph 6 of SFFAC
4 as noted above, declares:
The CFR should be a general purpose statement of accountability
to the public. A general purpose report should be easily
understandable to the “average citizen” who
has a reasonable understanding of Federal Government activities
and is willing to study the information with reasonable
diligence.
The
words “easily” or “average citizen”
do not appear in FASB’s definition of the abilities
of the external user. Moreover, FASB notes that the primary
external user is one who is interested in investment and
credit decisions. Although FASB is inclusive in its notions
of those interested in investment and credit decisions,
the ensuing discussion of them implies a level of cognizance
in financial reporting topics that exceeds the typical vision
of the “average citizen.” The IASB echoes FASB
in targeting investors and creditors first, although the
IASB uses the words “wide range of users,” which
FASB did not use until 2006, in the Preliminary Views. But
absent from FASB’s Preliminary Views are the SFAC
1 words “understanding of financial information,”
“may vary greatly,” and “efforts may be
needed to increase the understandability of financial information.”
Both
GASB and the FASAB designate citizens as the primary user
group of financial reporting. GASB, however, demands more
financial analysis acumen from its users than does the FASAB.
GASB has actually ratcheted up its expectations of users
over those expected of business accounting standards setters.
The Exhibit,
which compares key terms of each of the boards’ notions
of user characteristics and the year such characteristics
were published, indicates a trend of rising expectations
of users. After 1978, except for the FASAB, each board added
to “understanding of ... and willing to study ...
with diligence” words that required additional competencies
or efforts from users.
Understandability
In
its SFAC 2, “Qualitative Characteristics of Accounting
Information,” issued in 1980, FASB asserted (paragraph
40) that “understandability of information is governed
by a combination of user characteristics and characteristics
inherent in the information.” Paragraph 41 states:
Understandability
and similar qualities of information ... are closely related
to the characteristics of particular decision makers
as well as classes of decision makers ... The Board establishes
concepts and standards for general purpose external financial
reporting by considering the needs of broad classes
of decision makers and cannot base its decisions on the
specific circumstances of individual decision makers. [emphasis
added]
In
the hierarchy of qualitative characteristics accounting
information (SFFAC 2, Table 1), FASB declared that all characteristics
must meet the test of understandability before they can
be useful information for making decisions.
Paragraph
25 of the IASB Framework defines understandability at the
same time and with the same sentence it uses to address
user characteristics: “[U]sers are assumed to have
a reasonable knowledge of business and economic activities
and accounting and a willingness to study the information
with reasonable diligence.” Thus, the IASB couches
understandability of accounting information in terms of
presumptive users with a certain level of knowledge in,
and willingness to study, accounting information. This may
appear only superficially different from the intent of FASB
in SFAC 2, but SFAC 2, paragraph 41, declared: “The
Board establishes concepts and standards for general purpose
external financial reporting by considering the needs of
broad classes of decision makers” (emphasis added).
Note FASB’s use of the plural “classes,”
presumably meaning more than just the investor and creditor
classes.
However,
in the Preliminary Views, paragraph QC39, both FASB and
the IASB explain succinctly that understandability can be
accomplished only by presumptions of a user’s knowledge
and willingness: “[U]nderstandability is the quality
of information that enables users who have a reasonable
knowledge of business and economic activities and financial
reporting, and who study the information with reasonable
diligence, to comprehend its meaning.” FASB and the
IASB (paragraph BC2.39) concluded that “the framework
needed to clarify both the qualitative characteristic of
understandability and the characteristics and responsibilities
of users of financial reports ... by incorporating into
the definition of understandability the responsibility of
users to study information with reasonable diligence rather
than only being willing to do so.”
The
boards also rejected displaying a chart similar to SFAC
2’s chart of “A Hierarchy of Accounting Qualities.”
That chart positioned “understandability” as
the focal point through which all other accounting-quality
descriptors must pass. According to FASB and the IASB in
the Preliminary Views, paragraph BC2.61: “To include
such a chart in a chapter focusing solely on qualitative
characteristics would be premature.”
In
GASBCS 1 (paragraph 63), GASB gave its position on understandability:
Information in financial reports should be expressed as
simply as possible. Users ... tend to have different levels
of knowledge and sophistication about governmental accounting
and finance. To be publicly accountable, a government should
issue financial reports that can be understood by those
who may not have a detailed knowledge of accounting principles.
Those reports should include explanations and interpretations
that help users understand the information provided.
This
was almost 20 years ago. In 2005, GASBCS 3, paragraph 21,
made users “responsible for obtaining a reasonable
understanding of government and public finance activities
and of the fundamentals of governmental financial reporting,
for studying the messages with reasonable diligence, and
for applying relevant analytical skills.”
The
FASAB’s Framework, paragraph 15, notes that citizens
“may not have the knowledge or desire to take the
time to understand more sophisticated reports [and thus
the FASAB] should focus on meeting the basic needs of citizens
for highly summarized information.” Beyond this highly
summarized information, the FASAB emphasized the ability
of individual user groups to easily find more detail if
they desire it. GASB seems to have abandoned its notions
of accountability to the citizenry—except for those
citizens who can apply relevant analytical skills. The FASAB
still keeps words of democratization that GASB has discarded.
Has
FASB forsaken the words “efforts may be needed to
increase the understandability of financial information”?
Even more important is whether FASB has abandoned the idea
expressed in 1978 with SFAC 1, paragraph 9: “[T]he
objectives in this Statement are affected by the economic,
legal, political, and social environment in the United States
... [and] ... objectives stem largely from the needs of
those for whom the information is intended.”
Current
Contexts
Environmental
contexts change, and while many users of financial information
today possess similar cognizant characteristics envisioned
by FASB almost 30 years ago when it issued Concept Statement
1, many capital-market participants are a different breed
of investor. The accounting profession ignores at its peril,
or at least its discomfort, the fact that, in the current
political and social environment, investors in the capital
markets today are a more varied bunch than capital-market
participants 30 years ago.
FASB
consistently recognizes changes in the economic and legal
contexts of the reporting environment and strives to force
transparency into complex accounting matters. To quote Lynn
Turner further: “[A]lmost all of the financial instruments
used today had not been created [years earlier]” and
“special purpose entities [SPE] ... have been specifically
designed ... to reduce transparency to investors.”
The profession seems willing to handle the increasing complexity
of technical accounting matters, but does it address adequately
the changing demographics of users of financial information,
or, perhaps more appropriately put, of potential users of
financial information if such information were made more
transparent to a democratized capital marketplace?
Whether federal financial managers will be able to structure
the CFR to make it meaningful yet understandable to the
average citizen remains to be seen. Concurrently with SFFAC
4, FASAB issued Statement of Federal Financial Accounting
Standards (SFFAS) 24, “Selected Standards for the
Consolidated Financial Report of the United States Government.”
SFFAS 24, paragraph 8, notes that “SFFASs apply to
all federal entities ... as a whole and to component units”
(“component units” refer to individual federal
agencies and departments), unless an SFFAS eliminates a
provision. SFFAS 24 eliminated for consolidated financial
reporting certain information required of component unit
financial reporting, but instituted two other reporting
requirements specific to consolidated financial reporting:
A financial
statement that reconciles net operating revenues/costs with
the annual unified budget surplus; and
- A financial
statement that reconciles the annual unified budget surplus
or deficit to the change in the government’s cash.
The
appendices to SFFAS 24 illustrate these two statements using
line-item descriptions such as “components of net
operating revenue not part of the budget surplus.”
The FASAB acknowledged that even the phrase “budget
surplus” could be misleading to the average reader,
but also declared, in paragraph 27, that these statements
were designed with SFFAC 4 and the needs of the average
citizen in mind. The FASAB also acknowledged that bringing
additional clarity to the consolidated financial statement
would be an ongoing matter.
A
Laudable Goal
The
FASAB venture, although difficult, is laudable. Just as
actual and potential investors and creditors are stakeholders
in a business enterprise, citizens are the stakeholders
in government activities. Democratizing financial communication
to the citizen stakeholder is a goal worth pursuing.
FASB
might take more than a passing notice of the FASAB’s
efforts. The profession that FASB serves seems to believe
that, for the most part, its public-interest responsibilities
begin and end with helping to ensure effective capital markets.
The recent problems in the capital markets, however, were
caused, or at least exacerbated, in no small measure by
the unprecedented numbers of novices—“average
citizens”—participating in a booming capital
market. Had these novice investors had a better handle on
financial reporting matters, perhaps some of the problems
would have been avoided.
Sid
R. Ewer, PhD, CPA (inactive), CMA, CIA,
is the BKD Professor of Accountancy at Missouri State University,
Springfield, Mo. |