CFA Institute proposes changes to financial reporting standards

“The timing is right for moving forward. Progress is already underway by the Financial Accounting Standards Board (FASB), the International Accounting Standards Board (IASB), and other standard setters,” says Rebecca T. McEnally, CFA, Ph.D., project director of the comprehensive business reporting model and director of the capital markets policy group for the CFA Centre. “They have made many improvements such as in the areas of stock option expensing, derivatives accounting and pension disclosures. Let’s build on this momentum to overhaul financial statements and serve investors’ needs.

“Investors worldwide are too often in the dark about the true value of companies because accounting practices fail to reflect the economics of today’s business operations.”

The authors of the paper say financial reporting must evolve to keep up with changing business practices and that opportunities exist to make significant improvements which will enhance the usefulness of financial disclosure documents for investors.

“The ability to make high quality, independent, objective and reliable investment decisions depends not only on our expertise in the use of analytical and valuation techniques, but also on the quality of the information available for us to collect, analyze and incorporate into our valuation models,” they said. “Investors will be best served if the revisions to the financial reporting model involved fundamental reforms, rather than superficial, cosmetic changes. We will work with purpose and determination to assist standard setters to address the underlying problems of an antiquated accounting model, one that was originally designed for manufacturing and merchandising companies.”

Among the list of recommendations, the paper, released this morning at a joint meeting of the FASB and IASB, points out that service sector makes up a major part of the global economy, and derives a substantial amount of revenues and earnings from activities like the purchase and sale of cash, or commitments to engage in similar transactions.

“Today, many companies in global markets are driven by the creation and use of intangible assets,” say the report’s authors. “Much of the major economic growth worldwide is attributable to such assets. The current reporting model is deficient in its requirements for transparent recognition and disclosure for these assets.”

The report calls on companies to report fair value information rather than historical data or estimates; material assessments based on what would affect an investors’ decision making processes; major claims against company resources — such as pension liabilities — and revenue generating assets that are currently allowed to “escape complete and clear recognition in financial statements” under existing rules.

The CFA Institute also says financial reporting should be neutral and not influenced by the outcomes or effects that the reporting might have on other interests.

The reports calls for changes in net assets must be recorded in a single statement of changes, rather than scattered throughout financial, income, and cash flow statements, balance sheets and changes in shareholders’ equity. “The extensive aggregation and netting in financial statements make analyses of the numbers all but impossible.”

Similarly, another proposal calls on companies to report and explain changes on a disaggregated basis and report line items based on the nature of the items. For example, aggregating costs such as pensions, labour, raw materials, energy and overhead mixes items of very different economic characteristics and trends.

“Aggregation of information with different economic attributes, different measurement bases, different trends and from very different operations results in substantial loss of information.”

Finally, the report says companies must provide all additional information like financial reporting methods used, models used for estimation and measurement, assumptions, information about risk exposures, information explaining why changes in important numbers have occurred and other details that investors require to understand items recognized in financial statements.

“If investors are to understand the numbers reported in the financial statements, they must have sufficient supplementary disclosure to evaluate the numbers,” the report concludes. “In short, the statements are not interpretable without them.”

A copy of the complete report can be found at the CFA Institute website, www.cfainstitute.org.

Filed by Kate McCaffery Advisor.ca, kate.mccaffery@advisor.rogers.com

(10/24/05)