An information highway in need of capital improvements.

External reporting is an information highway that should serve the needs of those who use it. This has been the guiding principle of the American Institute of CPAS special committee on financial reporting, which is putting together its final recommendations for improving external reporting. The committee was established in 1991 by the AICPA board of directors to recommend the nature and extent of information management should make available to others and the extent to which auditors should report on the elements of that information.

In November 1993, after two years of research into the needs of external reporting users (investors, creditors and their advisers), the committee published a summary of its initial findings, The Information Needs of Investors and Creditors (see "AICPA Issues Report on Information

Needs of Investors and Creditors," JofA, Jan.94, page 21), in which it said the critical information needs of external reporting users were not being met. The committee observed that over time a financial reporting process that failed to meet investors' and creditors' information needs would result in less effective capital markets, which could misallocate and misprice capital--to almost everyone's detriment.

The consequences of a failing reporting process are severe. When their ability to make informed capital allocation decisions is limited by a lack of information or by poor information, investors and creditors may increase the cost of capital or reduce their market participation. Deserving companies may be unable to obtain capital or may be able to obtain it only at excessive cost. A thinner capital market decreases opportunities for risk-sharing and reduces capital market liquidity. Companies find it more difficult to grow and remain competitive, causing overall competitiveness and the economy as a whole to suffer.

This article is intended to provide an understanding of the special committee's deliberations and the significance of its work. A second article later this year will discuss the committee's recommendations and focus on their implications for the future of external reporting.

EXTERNAL REPORTING A BIRD'S--EYE VIEW

Some argue the external reporting highway is in crisis and dangerously close to collapse. Many have voiced serious concerns, including accountants, business professionals, academics, study groups in both the United States and abroad, members of Congress arid certain regulators.

Others argue that while there may be a few bumps, the external reporting highway is fundamentally sound and meets the needs of those who use it. Any past problems were caused by factors currently being addressed by standard setters, regulators and businesses; such problems are not evidence costly construction of a new highway is necessary.

The committee's charge requires that in developing recommendations it determine how information currently provided by financial statements is understood and how assurances provided by auditors are perceived. This charge has resulted in an extensive effort to understand users' information needs and their perceptions of external reporting.

CHANGES IN THE BUSINESS ENVIRONMENT--USERS' PERSPECTIVES

In an age characterized by rapid change, increased globalization of the economy and business and constant technological and financial innovation, the information needs of investors and creditors are evolving.

Rapid change. Perhaps the most challenging factor today is the accelerating rate of change. Such change requires perceptive, knowledgeable, creative and flexible management and a work force capable of responding quickly. It also requires a flexible capital market capable of allocating and reallocating capital on a timely basis.

In an era of rapid change, reporting that focuses primarily on past history no longer provides an adequate basis for predicting future results. Some therefore argue a fair value accounting model is more responsive to users' needs. The committee's research, however, suggests otherwise. Users say that while fair value information is useful, particularly for certain types of assets and liabilities and in certain types of industries, they oppose replacing the mixed-attribute accounting model with a fair value model. They say the mixed-attribute model provides a stable and consistent benchmark they can rely on to establish historical trends. They also are concerned about the subjectivity and potential volatility in reported results of a model based entirely on fair value.

Nevertheless, users need more forward looking information, particularly more meaningful historic indicators of future performance. But they do not want management to present financial projections and forecasts. Users believe making projections and forecasts is their responsibility and better forward-looking information will enhance their ability to do so.

Timeliness of information also has been redefined. Advances in technology and telecommunications, combined with other changes, have increased both the speed and volume of business transactions and enhanced businesses' ability to report on them. These developments, together with changes in the speed with which market transactions are executed, make rapid communication of business information critical. Investors can react almost instantaneously to corporate communications. Thus, any unwarranted delay on the part of a business to disclose information essential to users' investment or credit decisions could have serious implications for investors, creditors and the market.

Some expected this situation would bring about a desire for on-line, "real-time" reporting, perhaps even on-line access to a company's books and records; however, users say that, as a practical matter, expanded quarterly reporting is optimal--except for information about critical transactions and events, which they need immediately.

Globalization of the economy and business. The interdependence of the world's economies is not new, but because of advances in technology and transportation, they have become even more integrated. For U.S. businesses, globalization provides increased opportunities, but it also requires gaining access to foreign markets, establishing customer bases and forming reliable business alliances to sustain these new markets. Political sensitivity, particularly in areas characterized by long-standing political and social tensions and instability, also is needed.

Users need information about globalization's effect on individual businesses so they can assess the opportunities and risks of these enterprises. For example, users say they need more information about opportunities and risks in general and need disaggregated information on an industry and geographic basis. However, the committee is looking at the cost of providing such information--including the competitive cost of disclosing information that might be disadvantageous to a company. In general, users may be satisfied with disaggregated information by industry limited to a few key items along the lines of the information companies use to manage their business segments. Similarly, geographic information may not always be important. The key is whether the information is useful in assessing opportunities and risks. A flexible approach seems appropriate.

As access to foreign capital markets expands, the absence of an international reporting framework becomes increasingly troublesome. It contributes to a lack of comparability among reports issued by companies around the world and is especially burdensome for those who must understand and analyze financial statements prepared on a variety of accounting bases. Here, too, valid concerns are raised about the competitive cost of providing additional and better information to assess opportunities and risks. When competitors outside the United States have access to information they do not have to disclose themselves, U.S. companies perceive a disadvantage. Both the committee and subsequent standard setters must be sensitive to this issue.

Leaps in technology. New technology and telecommunications have changed the way users access and analyze business information. They also have changed products, customer and intercompany relationships and purchase and delivery methods. They have created new risks and new ways to hedge these risks. Each of these developments has affected users' information needs.

New technology and telecommunications have enabled financial institutions to develop a broad array of financial instruments, financial instrument derivatives and other products that allow businesses to finance operations and capital expenditures and to arbitrage, hedge and invest in unprecedented ways and with unprecedented speed. From a reporting perspective, such products test the limits of an accounting model developed to address the tangible products of the industrial age.

Increased risk, combined with changes in product technology, has created new relationships among vendors and among vendors and suppliers. Such interdependent relationships affect the success of both. For example, the products of some businesses are highly interdependent with the technology and products of other businesses, as in the relationships between software developers and computer hardware manufacturers or microchip producers and hardware manufacturers. In addition, the technological requirements for innovative products have fostered new business alliances to develop new products and market them effectively.

Users are anxious to know about the effectively such factors and have expressed a need for increased nonfinancial disclosures about the activities, events and relationships affecting businesses.

EXTERNAL REPORTING DISPLAY AND DISCLOSURE ISSUES--USERS' PERSPECTIVES

Although some display and disclosure issues relate to changes in the business environment, some simply reflect a desire for improved display and disclosure in general. For example, users want a clearer delineation between nonrecurring, unusual and infrequent items and those events that represent a company's ongoing activities. Current reporting does not identify a sufficiently broad range of nonrecurring, unusual or infrequent items and the descriptions and details of items identified sometimes are insufficient to determine their nature. The need for more information in this area also ties into users' concerns about credibility of reporting; they believe nonrecurring losses more often than not are disclosed separately while nonrecurring gains are included in continuing earnings, with no separate display or disclosure.

IMPROVING THE EXTERNAL REPORTING HIGHWAY

Some argue that despite the shortcomings in external reporting, users somehow obtain the information they need and U.S. capital markets continue to function remarkably well. In fact, U.S. markets are the best in the world. Whatever problems exist, people are coping.

But coping imposes real costs on all participants in the external reporting process. Like a highway constructed in an era of lower speeds and fewer cars, a reporting process that falls short of meeting users' needs can cause serious problems for those who rely on it. It also may force users to detour to alternative routes to obtain the information they need--routes that may be time-consuming and costly for them to use and for preparers to maintain. These costs may be difficult to quantify, but they exist. Further, when users must detour to obtain needed information, the highway's overall value is diminished.

The committee's research does not confirm assertions that the external reporting highway is collapsing--in fact, users suggest few changes in the current standards for recognition and measurement of assets, liabilities and income. However, they express a need for major capital improvements-particularly with respect to including more nonfinancial business information to help assess opportunities and risks.

Major capital improvements cannot be undertaken without a sound budget, however. There are costs to providing more relevant information to investors and creditors. The committee is considering not only the costs of preparing and presenting the information users need but also the competitive and litigation costs associated with that information. For example, the committee believes a legal safe harbor must be in place before certain forward-looking information can be presented. It also believes nonfinancial information should be limited to that which a company already uses to manage its businesses.

Implementing the changes needed to improve external reporting will require planning and ultimately will depend on the collaborative efforts of all participants in the reporting process. Ignoring the need for change will leave preparers, auditors, professional organizations, standard setters and regulators to develop ad hoc solutions as problems arise; the result may well be a variety of solutions that fail to address the most important underlying problems. Further, in today's litigious environment, such solutions may be subject to legal challenges that ultimately could prove costly to all involved.

The better alternative would be a reporting model that provides relevant and reliable information, one that supports an active and effective capital market and contributes to the competitiveness and growth of individual companies and the economy as a whole.

EXECUTIVE SUMMARY

* THE AMERICAN INSTITUTE OF CPAs special committee on financial reporting is developing its final report on improving external reporting. The committee believes critical information needs of users--investors, creditors and their advisers--are not being met.

* THE CONSEQUENCES OF A financial reporting process that does not meet users needs are severe. Investors and creditors may increase the cost of capital or reduce their market participation. Companies may be unable to obtain capital and economic growth may suffer as a result.

* THE INFORMATION NEEDS of investors and creditors are evolving. In an era characterized by rapid change, increased globalization and technological innovation, users need more nonfinancial disclosures about the activities, events and relationships affecting business.

* DESPITE THE SHORTCOMINGS of external reporting, users are somehow obtaining the information they need. But making do imposes costs on all participants in the reporting process. The real solution is to make the necessary capital improvements so the external reporting highway serves everyone's needs with relevant and reliable information.

THE SPECIAL COMMITTEE

The American Institute of CPAS special committee on financial reporting was formed after a troubling decade that included the savings and loan crisis, highly publicized business failures and a tort system spinning out of control. Although it has no standard-setting authority, the committee was created to respond to increasing concerns about the relevance and usefulness of external reporting.

In its June 1993 report, Meeting the Financial Reporting Needs of the Future: A Public Commitment From the Public Accounting Profession, the AICPA board of directors observed: "This is a time of exceptional challenge for the financial reporting system and, hence, for the accounting profession. The challenges come both from the economy itself and from the concerns of the public .... To stay the best, our financial reporting system must be as dynamic as the financial markets themselves .... No matter how sound the financial reporting, however, it is without value if the user does not perceive it to be sound."

The committee's work is a cornerstone of the AICPA reform program, but it does not stand on its own. Other parts of the program are critical to effective implementation of the committee's recommendations. The report describes five goals of the program:

* Improving the prevention and detection of fraud.

* Enhancing the utility of external financial reporting to those who rely on it. a Ensuring the independence and objectivity of independent auditors.

* Discouraging unwarranted litigation that inhibits innovation and undermines the profession's ability to meet evolving external financial reporting needs.

* Strengthening the accounting profession's disciplinary system.

DETERMINING THE INFORMATION NEEDS OF INVESTORS AND CREDITORS

In considering potential recommendations, the American Institute of CPAS special committee on financial reporting focused its efforts on learning directly from users the information they need to make investment and credit decisions, rather than inferring it from what others believe. The depth and breadth of this effort are unique.

The committee's research efforts included

* Studying and analyzing the writings of investors and creditors and the writings of others about their research into investors' and creditors' information needs.

* Studying and analyzing the types of information included in analysts' formal reports about companies.

* Meeting with discussion groups that included portfolio managers, analysts and bankers from large and small institutions.

* Meeting with the financial accounting policy committee of the Association for Investment Management and Research and the accounting policy committee of Robert Morris Associates.

* Meeting informally with other investors and creditors.

* Surveying financial information users. The survey was conducted by a nationally recognized research organization.

The committee also maintained contact with standard setters, regulators and financial statement preparers. In particular, the committee learned from preparers about their concerns and the costs of meeting users' information needs.

These efforts led the committee to a new and deeper understanding of users' needs and a conviction that external reporting must be changed to be responsive to those needs and to keep pace with a rapidly changing business environment. At the same time, discussions with preparers heightened the committee's sensitivity to costs and other potential constraints on meeting users' information needs.

EDMUND L. JENKINS, CPA, is a partner of Arthur Andersen & Co., Chicago. He is chairman of the American Institute of CPAS special committee on financial reporting.