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Sept 1993

Special Committee on Financial Reporting: interim report. (Accounting)

by Holder, William W.

    Abstract- AICPA's Special Committee on Financial Reporting undertook a program of research and inquiry to be able to make well-founded recommendations on how to improve financial reporting. A major research project studied the types of information that users of financial statements require from companies, aside from those included in audited financial statements. Another research work focused on the types of information provided in reports written by financial analysts about industries and companies that determine investment or lending decisions. The Committee also made an extensive literature review and has developed a sizable computer database of information. It was also involved in in-depth discussion with academicians, investors and creditors. These activities are geared toward finding the appropriate changes needed in improving financial statements.

After its formation, the Committee considered how other groups approached the goal of developing ways to improve financial reporting. We quickly decided that to be able to make informed recommendations based on sound evidence, a program of research and inquiry was necessary. Most importantly, we believed we should seek information about the nature of information that is useful to those making investment and credit decisions and about how information is used in decision making processes.

Commissioned Research Projects

The Committee commissioned two separate research projects, both of which involved obtaining the services of independent researchers.

The first project was mentioned in last year's article. That project was conducted by Paul Healy of MIT and Krishna Palepu of Harvard. The project involved examining types of information financial statement users request from companies in addition to those provided in audited financial statements. The researchers are attempting to identify and categorize the nature and extent of information that analysts and others request from the investor relations offices of the companies subject to the research. In this way the Committee may be able to identify certain information that is useful in decision making but that is not routinely disseminated in the broad fashion as is true for publicly available financial reports.

Another research project commissioned by the Committee was designed to study the types of information supplied in reports written by financial analysts about industries and companies that influence, determine, or suppport investment or lending decisions. Researchers Gary John Previtts of Case Western University and several associates developed a frequency analysis of key terms and phrases in those reports to assess what information figures most prominently in the analysts work. The information generated by this project may also assist the Committee in identifying the nature of information that is commonly used in investment and credit decision making.

Other Research Activities

Although not commissioned by the Committee, a FASB research report, Reporting Diaggregated Information, published d in February 1993 is being used to consider how financial reports can be improved by providing better and different segment information. This research report, written by Paul Pacter, addresses an extraordinarily improtant topic that analysts and other users have identified as crucial to their work. That research report is available from the FASB.

The Committee performed an exhaustive search of the literature and have developed a large computer data base of information for users' needs. The result of that literature search indicates there is much information with respect to what other (e.g. practicing accountants, preparers, and academics) believe financial information users need but very little direct information from users themselves as to what they need.

Other research literature has, however, been quite helpful in a number of respects. Examples of research literature that has been found to be of particular value to the Committee includes that dealing with the predictive validity of selected accounting numbers (e.g., net income, cash flows from operations, and other intermediate operating measures as predictors of future cash flows from operations) and about the usefulness of various accounting measurements (e.g., free cash flow and core earnings).

The Committee has also found particularly useful business and investment models including those proposed by Michael Porter, Rappaport and Graham, and Dodds. Those models are generally used to analyze companies and evaluate and measure shareholder value. While not directed primarily toward accounting information, those models provide useful insights as to the nature of information that might be useful in evaluating overall business enterprises, including their prospects for future success.

The Committee is holding a series of indepth discussions with groups of equity investors and a parallel series with groups of creditors. Those meeting are designed to explore the needs of both groups for specific information and how they use that information. We have found those meetings to be of great use in assessing the findings and positions of others, in considering the results of other research efforts, and in developing fresh insights based on information generated in the discussions.

Finally, the Committee plans to conduct a broad-based survey of financial information users to confirm their information needs and determine whether our tentative recommendations can be expected to be responsive to those needs. Of particular concern will be the completeness of the survey and the neutrality of the questions posed.

One of the greatest challenges facing the Committee is assimilating, organizing and synthesizing the substantial amount of information that has been gathered by these procedures and processes. This will be possible only due to the relatively large and capable staff that has been assembled to assist the Committee in its activities. While the AICPA has provided essential staff support for our efforts, a large number of other knowledgeable, seasoned accountants has also been assembled to provide essential support.

In addition, a number of respected academics have also provided invaluable contributions to our work. Those individuals have attended committee and subcommittee meetings and have served in a variety of other ways. For example, the New Model Subcommittee has established a group designed to consider future needs of what the world of business and commerce may be like in 20 years and envision how the system of financial information dissemination may be affected by those changes. The group includes accounting practitioners and academics, futurists, information technologists, and economists.

Changing Financial Reporting

The Committee believes financial reporting should enhance users' ability to predict future cash flows of the reporting enterprise. In that sense, the Committee has not viewed financial reporting as a "search for truth" but rather as a utilitarian tool whose characteristics and structure could possibly be changed to substantially enhance its value. That set of beliefs has served to steer the committee to the process of information and evidence collection that was described earlier and has, at least as importantly, allowed us to frame our discussions and deliberations in a more productive manner. For example, we have spent little time debating accounting for goodwill and other intangibles in terms of various theoretical accounting models. Rather, our dicussions have focused on what accounting methods, policies, measurements, and disclosures might provide better indicators of future cash flows than is the case with current generally accepted accounting principles. These processes and methods have provided a basis for evaluating ideas and proposals for improving financial reporting.

In addition, the Committee has identified a number of "screens" through which any recommendations for changing financial reporting must pass. Those screens include such considerations as cost/benefit relationships, whether the company is the best source of the proposed information, and a number of other related factors.

As a result of these activities and beliefs, the Committee has identified several ways financial reporting might change in the future to be more responsive to the needs of information users. At this writing the Committee has nsot reached any conclusion or developed any specific recommendations. Nevertheless, several themes are evident from the information that has been developed in our efforts.

Given the criticisms evident about the current state of the financial reporting art, it seems that a number of changes may be desirable in the nature and type of information communicated and in the speed and frequency of its transmission. That nature of some of the changes that might be recommended by the Committee are described below.

Perhaps financial reporting should focus more on forward-looking information. Historic financial statements tend to report transactions and events that occurred in that past. Certain aspects of the historic financial reporting process are future oriented or require estimates of future events such as estimating and accruing for a variety of contingent losses and accruing revenue on long-term construction contracts. The focus of financial statements presented in comformity with GAAP, however, remains the past.

Examples of forward-looking information that might be useful to decision makers include information focusing on a business's ability to compete, innovate, adapt and continuously improve its operations and products and services. Much of this information may be nonfinancial in nature and be able to substantially enhance the value of business reporting.

Reporting information about evolving business risks, uncertainties, and opportunities also may hold great potential to enhance the usefulness of financial information. A recent ex-posure draft of a proposed Statement of Position of the AICPA's Accounting Standards Executive Committee provides a good example of some of the information that might be included in such expanded reports.

Identifying methods and processes to tailor and speed the communication of business information and provide it immediately as conditions change may provide considerable opportunities to increase its value. The available technologies have not been adapted to the financial reporting process as well as they might have been. Technology may facilitate the communication of flexible or customized reports better tailored to the needs of specific information users.

Changes in the auditor's report may also hold opportunities to enhance the value of the business information as it is relied on and used by decision makers. Richer, fuller, and more tailored audit reports may allow the auditor to express more understandably the results of audits and the impressions gained by the auditor.

All of these ideas are currently being considered in some detail by the Committee and whether the final recommendations and findings of the committee include them is unknown. Nevertheless, some of the changes in business reporting being addressed and considered by the Committee are profound and would consitute substantial changes for financial reporting, auditing, and other accounting services. The goal of the Committee is to develop a set of sound, well supported recommendations that can serve as a basis for improving accounting and business reporting and meet the challenges of a rapidly changing economic environment.

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