What today's balance sheet tilt means.

What today's balance-sheet tilt means

When we discuss the FASB and the future for that organization, we are also talking about the future for users of financial statements, financial executives, and public accountants. If there is a theme to this future, I see it summed up in two words: complexity and volatility.

Why do I think there is going to be more complexity and more volatility? A major reason is the shift that has been in process for some time and promises to accelerate--the shift in emphasis from the income statement to the balance sheet.

The FASB spent a good bit of its first decade developing a conceptual framework, and when that document was finally completed, there was a fair amount of compromise in it. To some degree, it backed off from the very strong balance-sheet emphasis that initiated the project. It still does, however, lean significantly toward the balance sheet. This balance-sheet tilt shows up in recent FASB statements such as 87 on pensions and 96 on income taxes.

We are moving toward an era in which the income statement reflects not only the operating results, but also changes in balance-sheet accounts. And the later may, of course, have very little relationship to the operations of a business for a particular period.

This shift in emphasis is not only from the income statement to the balance sheet; it's also from off the balance sheet onto the balance sheet. Thus, automotive and other large manufacturing companies that have financial subsidiaries must now fully consolidate those subsidiaries in the balance sheet. Equity accounting for those subsidiaries is no longer permitted.

Statement 94 required consolidation for the first time in this year's annual reports, but that does not mark the end of this issue. One of the FASB's major projects addresses consolidations and the issue of what is the reporting entity.

We may see future consolidation of entities that today are not consolidated because they are not controlled through stock ownership. The equity accounting method itself is being reevaluated to see if it should have a role in the way companies account for significant investments.

The FASB is also looking at control, and whether a change in control should prompt a new basis of accounting. Now, control other than through stock ownership is a very subjective term. Sometimes it has a legal meaning, sometimes a financial meaning, and certainly it could introduce volatility into financial reporting if control becomes a requirement for consolidation.

Statement 96, on the other hand, already has introduced complexity. That is attested to by anyone who has tried to extend his schedule of various timing differences for x number of years into the future in order to determine whether there is a deferred tax asset or deferred tax liability. Indeed, Statement 96 is so complex that the Board, as you know, has had to delay the implementation date. Whether the Board will seize the opportunity created by this delay to rechallenge its conclusions in the light of some unreasonable results obtained by applying 96 remains to be seen.

If the Board stays with the liability method--versus the deferred method under APB 11 which tended to normalize the impact of income taxes, particularly rate changes--we will have significant volatility in financial reporting. Under Statement 96, as soon as the tax rates change, all of corporate America will need immediately to change the deferred tax assets and liabilities that have been recorded on their balance sheets.

It seems safe to forecast that there will be some tax rate changes in the 1990s. After all, we have a significant deficit, among other problems. And President Bush wants to reduce the capital gains tax. But whenever tax rate changes occur, we will see great volatility under the current standard.

The volatility will start, in fact, even before any change in the tax rate is finalized, because analysts will start predicting what the impact will be on individual companies.

Retirement benefits

Continuing this balance-sheet focus and the resulting complexity and volatility, we have Statement 87 on pensions. Most companies by now, of course, have adopted it. In 1989, however, a minimum liability provision is phased in for the first time in the history of U.S. financial reporting. Most companies will not have a minimum liability because their pension obligation is fully funded; however, some will. Up until now, there has been footnote disclosure showing the funding status of company plans but no requirement for a minimum liability provision to be recorded.

Another reason most companies will not have a minimum liability is because tax deductibility is permitted for pension funding. That is not true, however, for other postemployment benefits. The FASB's recently proposed standard on these benefits is obviously going to introduce a good deal more complexity and volatility into financial reporting. An example is the proposed requirement to predict health-care costs 10, 20, even 30 years from today. Is that really possible to do? The FASB, of course, is taking the position that it's better to predict what such costs may be in the future, if they are indeed a liability, than to do nothing about them.

This is not just a matter of disclosure. These are costs that will be recorded in your financial statements, effective in 1992 for the income statement and in 1997 for triggering the recording of the minimum liability.

What may happen? Some groups might say, if we have to do this, why not have the federal government get even more involved with paying for health-care benefits after a person retires. Others, of course, would not like to see the government more involved. Still others may seek to permit the funding of this obligation to be tax deductible, as it is for pensions--as unlikely as that may seem to be in today's environment.

What is already happening is that some companies are studying whether other postemployment benefits may be legally reduced or even terminated. Other companies may not effer these benefits to employees hired in the future, e.g., those hired after January 1, 1989.

As a result, the question many people are asking is: should the FASB issue an accounting statement like this--even when there is accounting support that a liability does exist--when it may well trigger significant societal change?

If corporations are going to be required to record a liability on an accrual basis for those benefits that they have promised their people, predicting health-care costs 25 years ahead probably is not the best way of doing it. It would make more sense to make projections based on today's costs. Then annually, if the costs change, revise your estimates, just like many other estimates that are revised when preparing annual financial statements. It seems to me that we should not have our financial statements relying on the extreme subjectivity and uncertainty that would result from predicting health-care costs decades ahead.

Financial instruments

Returning to the new emphasis on the balance sheet and on the resulting complexity and volatility, I want to talk about the financial instruments project, as it is one of the major items on the FASB's agenda.

The term "financial instruments" does not mean just bank debt or loans receivable. It covers almost everything that is not a property account or inventory, including a company's own receivables.

This project was added to the FASB agenda at the request of the SEC and others who were concerned about the explosion of different types of financial instruments, particularly those that attempt to reduce risks, such as hedges, swaps, or futures. It makes sense to study these instruments and such issues as when to offset assets and liabilities. Indeed, the multi-billion dollar industry for the securitization of various assets has flourished since the FASB issued a standard (No. 77) that permits sales treatment when receivables are sold, but the seller retains all the risk of credit losses and interest rate fluctuations.

With the significant amount of LBO and MBO activity going on, there are also a number of securities that have both debt and equity characteristics. Something needs to be done about deciding how they should be accounted for.

As you may recll, a project dealing with stock compensation was on the Board's agenda for many years. That is, should there be different accounting for stock options, restricted stock, phantom stock, stock equivalents, and other types of stock rights? The project was not received with a great amount of enthusiasm by those companies issuing those types of stock arrangements or by the officers receiving them. Many thought this project had died, but, instead, it has been added to financial instruments.

The trend for the financial instruments project seems to be toward more market-value accounting and reporting--which is a continuation of the conceptual framework in many ways. The result, in any event, will be to introduce more volatility into financial reporting in addition to the obvious complexity.

Two new agenda items

Two recent subjects that the Board added to its agenda are discounting and impairment.

There is no question that an accounting standard that requires discounting will have a major impact on corporate financial statements. Even a slight change in interest rates could produce a rather dramatic change on both sides of the balance sheet--particularly in a period like the recent one, which saw a 30-percent increase in the prime rate. The result could be significant changes in a company's financial statements that are unrelated to results of operations.

The question of impairment has arisen following the considerable corporate restructuring that took place in the first half of the eighties. Very large charges were recorded, reflecting the writing down or writing off of plant, equipment, product lines, and the related employee costs. Even though that period appears to be substantially behind us, there is still concern that there should be some uniform guidance on when and how to measure those charges.

A pendumum

The theme of complexity and volatility is reflective of the society in which we live. It is an increasingly complex world in which money moves in different forms very quickly. Obviously, given this volatility, our financial reporting does have to mirror what is going on, whether it's in the economic environment or the political environment. Some believe that we should be very exacting in how we do that. But the result can be technical purity and not enough useful information.

What we need is realistic and useful financial information that is complete but not as complex as it could be, and is subject to change but not as volatile as it could be. We need financial information that will serve us well in recessionary times as well as inflationary times. We have an accounting model that, with continual improvements, will achieve just that.

In the view of some, the emphasis today on balance-sheet accounting recalls a similar emphasis of 50 years ago, until the shift began toward the income statement. Today, there is a feeling that changes in valuation of assets and liabilities should be reflected in the financial statements, regardless of whether there has been a transaction that causes that change. The result is more value-based thinking than cost-and transaction-based thinking.

What we are seeing is a shifting of views over a period of time. One day the emphasis will shift back to the income statement. The point is that the pendulum should not swing one way and then all the way back the other way. The swing should be within a narrower range.

This article is based on a March, 1989, address by Mr. Groves to the Detroit chapter of FEI.