Views on Financial Statement Presentation - Essay Example

Preliminary Views on Financial ment Presentation Your Introduction The need to reassess the presentation of the financial statement in its current form was ignited by the misrepresentation of data to the public and regulators by various US corporations including Enron and WorldCom and later gained momentum in the wake of the dramatic fall of the seemingly ‘stable’ Lehman Brothers and other major global financial institutions when fair value accounting not reflective of existing market prices and GAAP principles were manipulated by executives to generate disingenuous financial reports (Benston, 2003). The IASB and other regulatory bodies therefore acted urgently initiating a raft of new amendments aimed at halting firms from concealing underperforming portfolios through ingenious accounting practices (Brodie, 2008). Consequently the IASB and the FASB issued amendments to IAS 39 Financial Instruments: Recognition and Measurement and IFRS 7 Financial Instruments: Disclosures that permit the reclassification of some financial instruments and require consequential additional disclosures in respect of any reclassification made.  These amendments were issued to address the current market conditions and, due to its urgency, were issued without the normal due process (IASB & FASB, 2009). The Financial Statement Presentation is one of the seven joint IASB and FASB financial accounting projects set to concluded by the year 2011 in three phases [See Table 1]. The main preposition was the introduction of a cohesive, disaggregated, and liquid and flexible. The FSP Discussion Paper (DP) – Preliminary views on Financial Statement Presentation is founded on three premises which require a presentation of the FSP in such a way that: Depicts a consistent financial representation of a firms performance; Disaggregates data in a practical and forecasted way about the firm’s upcoming cash flows; and Assists stakeholders appraise the firm’s liquidity and financial elasticity. According to a statement by the joint IASB and FASB boards the purpose of the project was: ‘establish a standard that will guide the organization and presentation of information in the financial statements...the management of an entity communicates financial statement information to users of financial statements, such as present and potential equity investors, lenders, and other creditors...improve the usefulness of the information provided in an entity’s financial statements to help users make decisions in their capacity as capital providers.’ (IASB and FASB, 2009, Pg.1) The board’s primary intention is for firms to present a singular financial statement with the objective of enhancing the financial presentation model that is analogous and uniform hence decipherable to the users. The projected presentation model necessitates a firm to present the financial information in a way that depicts how it operates its business disengaged from data on the financing aspect of its business activities. The financial statement is categorised as per the main economic activities: operations, investments, and financing aspect. The firms must present a singular statement that incorporates the financial position, comprehensive income, and cash flows. The firms are required to classify their income and expense entries into the operating, investing, and financing categories. Likewise, a firm is required to disaggregate its income and expense entries by their character including separating total revenue entries into either wholesale income or retail proceeds or disaggregating total expenditure from either material, employment, transmission, and power expenses hence assisting the shareholders predict the firm’s prospective cash flows (Ernst & Young, 2009). Among the principal proposals in the DP is that: The FS is disaggregated from its present position of grouping all assets, liabilities, and equities in separate categories but rather categorised according to their functions; either operational, investment, or financing. Additionally assets and liabilities will require to be categorised as either short-term or long-term assets while also including additional liabilities in the accompanying footnotes as well as accounting policies. The key proposals include: the categorization of assets and liabilities, income and costs and cash flows into operating and investing groupings (business) and financing; a distinct statement of all-inclusive income; exclusion of ‘cash equivalents’ from the financial position and cash flow statement; new program that resolves cash flows to comprehensive income; and Additional features on the visage of the statements. According to IASB and FASB boards’, the purpose of the updated financial presentation joint project that produced the; Preliminary Views on Financial Statement Presentation Discussion Paper was to institute a benchmark that would henceforth guide the preparation and presentation of financial statements. The project was principally aimed at providing legible financial statements to the various stakeholders which would assist them make an informed decision. Thus the FASB & IASB (2008) stated, ‘The results of this project will directly affect how the management of an entity communicates financial statement information to users of financial statements, such as present and potential equity investors, lenders, and other creditors.’ (IASB & FASB, 2009, Pg. 2). According to the IASB (2009), ‘the model would introduce a clear separation between an entity’s financing activities (how it obtains capital) and its business activities (how it uses that capital to create value).’ (pg. 5) [Table: 1] Additionally the entity would be required to disaggregate items of income and expense according to their function: either operational, investment, or financing category e.g. expenditure in sales or organizational costs and in regards to their purpose. Likewise in the statement of cash flows, an entity presents its cash flow statement in disaggregated manner whereby its operational receivables and disbursements including cash received from customers and cash paid to contractors to obtain inventory (direct method) instead of integrating net returns to net operational cash flow (indirect method) commonly or currently applied by majority of entities. The current International Financial Reporting Standards (IFRS) allow an entity to categorize costs either by outlook or by application. Table 1 Source: IASB & FASB, 2008 This segregation of entity performance and financing was initially proposed by Modigliani and Miller (1958) hypothesising that the value of an entity is derived from its prosperity rather than its assets. Although most financial entities have welcomed the proposals, there have been reservations particularly in regards to the cost incurred in preparation of the documents. The Basel Committee on Banking Supervision (2009) alleged that the ‘the proposed financial statement presentation would complicate the calculation of key ratios used in the analysis of financial results for financial services entities which could lead to less transparency, comparability and comprehensibility’ (Basel Committee on Banking Supervision, 2008, p. 2). One of the major areas of concern is the costs envisioned in the implementation of the new direct cash flow statement. Although the joint committees consider this feature will accentuate the prominence or the liquidity of the entities, it’s uncertain how the information will be useful to the stakeholders as rarely used by management in their regular operational activities. This may eventually lead to more incremental costs to the shareholders during the implementation process of this direct method. The integration of the financial statement may provide a more cohesive statement along with the newly stated disaggregated standards. The incorporation of the statement of financial position is beneficial to the user rather than the cash flows to the comprehensive income statement since it would integrate more cohesive, perceptible, superior, and candid in the FS construction. The cash flow statement is usually prepared through the indirect method whereby data from the income statement and balance sheet are utilised to create the statement. In the direct method as proposed by the joint boards’ discussion paper, the data utilised is sourced from transaction accounts or direct cash flows to back into the cash flow statement. The perception of the income statement as the most crucial document among the financial statement however lacks any theoretical backing for the argument. The balance sheet, the primary FS document cannot be disregarded in view of the precarious nature of the global financial recession and the performance of various entities consequently. Nonetheless studies by the CFA-Institute reveal that most entities apportion differing statements equal prominence [See Table 2] (McEnally, 2009). The proposed presentation format also does not distinctively depict the difference between the commercial and funding segments and the classification contained in the business segment between operational and outlays aren’t distinguished significantly. A study by Beltratti & Stulz (2006) on global banks, having excess assets worth $50 billion revealed that, ‘banks with the highest returns in 2006 had the worst returns during the crisis’ (pg.3). Thus poor performing banks at crisis period average returns were -87.44 percent while the thereafter registered 33 percent after the crisis. Conversely, the best performing banks averaged -16.58 percent during the crisis and 7.8 percent thereafter. Table 2 Advantages Classification between operating and investing activities The DP definitions of business, functional, venture, and funding are practical hence enable entities categorise items in accordance o their business operations thus allowing entities to distinguish items that conform to their line of business. The suspended operations are segregated from the active processes and investment activities within the statement of comprehensive income. Company’s ability to present or allot income taxes between active operations, suspended operations, and components of other wide-ranging proceeds will be advantageous to the entities. Disadvantages Diverging of internal management reports including the required cash flow elements (direct and reconciliation disclosure requirements) Expensive to implement new cash flow system insignificant to management but useful to the shareholders in discerning the company’s liquidity position since most firms generally utilise functional earnings metrics in concurrence with balance sheet data metrics and indirect cash flow systems. Within the projected statement of financial position, the manifold desegregations may lead to even greater consumer or shareholder confusion as the integrated financial statement tend to oversimplify the general financial circumstances and liquidity of the entity encompassing its operational resources. The provision to categorise cash equivalents like short term investments may be erroneous as they may be deemed as investments within the cash flow statement. This will not reflect the actual position of how entities utilise their cash flow hence will be ambiguous to the investing public. The de-linkage of the balance sheet from the operational aspects may derail the perception of the investor as well as mislead credit and other equity analysts as exemplified in the current global turndown. Summary Decision usefulness The proposed amendments can be termed as useful to the users to make better equity and credit decisions as opposed to the current ambiguous financial reports that are subject to manipulation hence the IASB/FASB suggestions are an improvement to the existing guidelines. However the decision to incorporate the data in one statement will clog and make it more complex and incomprehensible to the respondents. Enhancement of Comparability Features In terms of comparability, the proposals of classifying entries as per their functionality or operations will make it easier to contrast entities within the same industry or differing industries as well as appraising the performance across differing time periods. This management approach enhances the various disadvantages particular the cost of implementing the direct method in the financial statement presentations. Subjectivity and Expenditure Although the proposed presentation format will be tedious and costly to implement in the short-term, the proposals are beneficial to the ultimate users both investors and creditors who will be able to make a more informed equity or credit decision. The rather explicit comprehensive statement might not be as readily useful to the management of the company as it will involve incorporating some ineffectual cash flow data extraneous to their operations. Conclusion The proposed amendments in the discussion paper will go along way in enhancing the reporting function of business entities. The use of direct method in presenting cash flow statement may enhance transparency however may be costly to the entities in the short term but largely beneficial to the other stakeholders who need a more explicit financial statement not open to abuse. The new presentation format will ease the comparability factor to other similar entities or functions. Although costly to our firm, we believe the proposed format will assist both the firm and our shareholders as wells as contractors. References Basel Committee on Banking Supervision (2008) Discussion paper - Preliminary Views on Financial Statement Presentation: Comment Letter. Basel, Switzerland: Basel Committee on Banking Supervision. Beltratti R S (2009) Why did some banks perform better during the crisis? Retrieved from Havard.law.edu: Benston G (2003) The Quality of Corporate Financial Statements and Their Auditors before and after Enron. Cato Institute: Policy Analysis , November 6, 2003; Policy Analysis no. 497. Brodie C (2008) Financial Reporting Standards Board Developments. Retrieved December 3, 2009, from New Zealand Institute of Chartered Accountants: FASB & IASB (2009) Financial Statement Presentation—Joint Project of the IASB and FASB. Retrieved December 1, 2009, from IASB Online: Glickman Murray (1996) Modigliani-Miller On Capital Structure: A Post-Keynesian Critique UEL Department of Economics Working Paper No. 8. IASB (2008) Snapshot: Preliminary Views on Financial Statement Presentation. London: International Accounting Standards Board. IASB & FASB (2009). Preliminary Views: Conceptual Framework for Financial Reporting- The Reporting Entity. International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) , NO. 1580-100 MAY 29, 2008. IASB FASB (2008) Preliminary Views: Conceptual Framework for Financial Reporting: The Reporting Entity. File Reference No. 1580-100: Financial Accounting Standards Board: of the Financial Accounting Foundation. McEnally R (2009) Preliminary views on Financial Statement Presentation. Norwalk, CT: CFA - Centre for Financial Market Integrity. McKinney M C (2008) FASB and IASB Issue Discussion Paper on Financial Statement Presentation. Accounting Standards & Communication Group - Deloitte: Deloitte & Touche LLP: Audit and Enterprise Risk Services. Verret J W (2009) Treasury Inc.: How the Bailout Reshapes Corporate Theory & Practice. Washington DC: George Mason University Law and Economics. Ernst & Young (2009). Insights on International GAAP: IFRS Outlook. London: Ernst & Young Read More