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Recommendations of the special committee on financial reporting.

To gauge the reaction to the work and recommendations of the American Institute of CPAs special committee on financial reporting, the Journal of Accountancy interviewed 10 business leaders. They represent financial report preparers, internal audit committee members, users (investors, creditors and their advisers), regulators and academicians. Highlights of those interviews appear on the following pages. Each participant was asked the same questions:

1. What do you think of the project in general?

2. What are your reactions to any of the specific recommendations?

3. Do you think the recommendations address the criticisms that have been directed at the financial reporting process: that is, lack of relevance and credibility and the perceived gap between available and reported information?

Charles A. Bowsher is comptroller general of the United States,

Washington, D.C.

On balance, it's a very good project. The financial community has been discussing these issues for some time. The commitee's recommendations certainly were needed. I commend the people who worked on the project.

Many of the recommendations--such as those to provide core, noncore and disaggregated information--are excellent. There's a very good chance they will be adopted. After all, they make good sense.

However, I have a concern about rooting everything in a current historical cost model. That model served us well from 1934 to about 1974, but now we have to deal with fluctuations in currency and interest rates. More and more, U.S. business has to question whether historical cost can continue to be the anchor of our financial reports. In fact, most large businesses today use the mark-to-market valuation. It's something the Financial Accounting Standards Board has to work on.

The issue of internal controls and systems is critical. While the yearend balance sheet is important, the efficacy of businesses' year-round systems and internal controls is every bit as important. While this subject is mentioned in the report, it's not given quite the prominence it deserves.

On risk-related derivative products: They are becoming a very big issue. Everybody in business is talking about them and we have to give a lot more thought to them.

On expanding segment reporting: This proposal is long overdue. Too often financial reports hide problems because they fail to provide enough information about segments of a business. So, while the overall financial information looks good, there may be certain weaknesses that eventually could affect a company's overall results.

On core and noncore reporting: It's important because core earnings tell you how healthy a company's overall operations really are. It's a good management exercise to develop such information. Actually, most well-run businesses already go through the exercise.

On preparation costs: I think the arguments of some--that it will cost too much to prepare--are overblown. I think people who are anxious not to change and not to make improvements simply are trying to hide behind this argument. Once you get your systems in place, providing the additional information is not that much more costly. This is basic information, and I think a lot of it already is available internally. The fact is, most well-run companies have such data. Companies that don't should collect the information for their own good.

Barbara Hackman Franklin, a former U.S. secretary of commerce, serves on

a number of corporate boards and chairs several audit committees.

I appreciate the work that went into this, but speaking as a corporate director, an audit committee chair and a former regulator, the report lacks balance. The perspectives of users--that is, investors and creditors--and of auditors are included, but those of corporate management and shareholders are missing.

I'm concerned that some might view the report as overly self-serving on the part of the accounting profession. If so, the profession's credibility can erode. That's the last thing I want--I'm a believer in the profession and want auditors to have as much credibility as possible.

On forward-looking information: This will be difficult given the litigation threat. The first time a management prediction fails to pan out, there will be a mountain of lawsuits.

On core and noncore reporting: Interesting, but the concept is not defined. Reporting on noncore assets and liabilities at fair value would be very difficult. We're all used to generally accepted accounting principles--how does this concept fit?

On differential disclosures: Given the litigation risk, this would be unfair and potentially harmful to certain enterprises and their shareholders.

On international standards: As it is now, U.S. companies are often required to carry a heavier reporting burden than companies based abroad. The United States shouldn't get so far ahead of the rest of the world that we create a "competitiveness gap" due to our reporting requirements.

On preparation costs: I'm not sure a balance has been struck between the cost of implementing the proposals and the hoped-for benefits.

James L. Cochrane is a senior vice-president of the New York Stock

Exchange in New York City.

The committee seems to have accomplished its goal of providing a broad, philosophical frame of reference for improving business reporting. But there is not much in the proposals on implementation, which perhaps was inevitable given the committee's mission.

The report tries to make too level a playing field between the creditor community and the public investor community. In places it acknowledges their different needs, but overall it treats them the same. Creditors get what they need by writing their requirements into loan covenants, and the rating agencies have special access. Public investors' needs are different.

John L. Lewis, the American labor leader, had a wonderful way of describing his philosophy: "More, now." That basically is the philosophy of many financial analysts. They have a voracious appetite for information. They want more and they want it now. But should preparers be forced to provide it? We have to be careful that the analysts' own perceived needs don't drive the system.

It seems to me the committee sees the benefits to the user community a lot more clearly than it sees the costs to the providers. Also, the report focuses on the needs of intermediaries (the analysts) rather than the ultimate customers (the investors).

On asset valuation: The report implies that everyone agrees on measuring asset values historically. Both the U.S.--relying on historical data--and other approaches--those used in British Commonwealth countries, Latin America and some European countries, which permit varying amounts of asset revaluation--have shortcomings. In fact, neither is absolutely "correct." They serve different purposes. I wish the committee had addressed the differences.

On establishing international standards: I'm troubled by the committee's half-hearted approach. On the one hand it says it endorses the concept, but every sentence in the report that recommends pursuing the International Accounting Standards Committee process is qualified with a big but. The report seems to see the challenges as larger than the rewards. I think we need to move beyond the buts.

On forward-looking information: The committee has come up with a lukewarm endorsement. The report's underlying premise is: When in doubt, emphasize historical data rather than the future. I understand that, but as an investor I would have preferred more favorable treatment of the benefits of forward-looking information. Japanese businesses, for example, provide very good forward-looking information on a regular basis; it's encouraged by public policy and it works pretty well. I realize there are some dangers--people might think a forecast is an ironclad guarantee. But I think the U.S. investor is sophisticated enough to handle such information.

John C. Burton, Ernst & Young Professor of Accounting and Finance,

Columbia Graduate School of Business, New York City, is a former chief accountant of the Securities and Exchange Commission.

While I endorse many of the concepts proposed in the report, I question whether it should have been prepared under the auspices of the American Institute of CPAs. In my view, the issues addressed are the FASB's responsibility. True, the committee consulted with the board and made clear that its work in no way implies criticism of the FASB. However, the issues raised by the report are fundamental and necessarily raise questions about the adequacy of the FASB's judgment. If the FASB loses its credibility, it's likely the next step will be less attractive: government standard setting.

I also wonder whether the report goes far enough. The committee still sees auditors as auditors. There is some reasonable question about whether the attest function is a sufficient role for an independent accountant. If we are going to enhance reporting, the question arises: Who should be the reporter? Should management report on itself? I believe that CPAs should make the reporting decisions rather than simply report on them. Management should establish the information system that provides the basic data, and then the accountant should decide what information to use and how to present it most meaningfully. Walter Schuetze, the SEC chief accountant, has said the SEC sees far too many cases in which the application of accounting principles was accepted by the auditor because it was generally accepted, not because it was the right way to report.

To be sure, the idea of increasing accountants' responsibility has some problems, but it should be considered. In the audit committees on which I serve, I always ask the CPAs: If the financial statements were prepared by you, rather than by the company, what would be the difference? It stirs up quite a discussion. I try to be a little irascible by taking on the role of the creative irritant--a grain of sand in the oyster that produces a pearl.

On forward-looking information: The committee is to be commended for addressing this issue. It responds to users' needs in making educated decisions about a company. But while it's a positive step, it's dealt with only briefly. The issue of uncertainty needs more attention. I hope the committee's proposal will push the FASB to act in this area.

On differntial disclosures: The report doesn't develop this idea completely, but it's a reasonable concept. Maybe we no longer have to say that every company must follow the same rules in regard to 10-Ks and annual reports. In some cases, certain summary data would be appropriate and, in others, more detailed data would be necessary. Such a change makes sense both in terms of a cost-benefit analysis and users' needs.

Kenneth J. Johnson is vice-president, controller and director of internal

audit at Motorola, Inc., Schaumburg, Illinois.

I think the project was worthwhile. It needed to be done simply because many people have been asking whether our present reporting system is relevant, whether it addresses users' needs and whether there is a need for fair value statements. In general, the report addresses these issues and is fairly objective. The committee reaffirmed that the U.S. reporting system is the best in the world, and it has come up with refinements rather than throwing out the whole process and starting over.

The committee members started with several preconceived notions that users wanted certain things--such as fair value statements, direct cash flow statements and the recording of stock compensation expense in financial statements. But when the members learned, on interviewing users, that such changes were not wanted at all, they wisely shifted their position. It was very helpful to get those issues behind us.

On the committee's proposal for separating core from noncore activities and the assets and liabilities associated with them, there's no question it's theoretically attractive, but it's also totally impractical. Here at Motorola we try to do this internally every quarter, but we have many disagreements among ourselves on what is core and what isn't. One of the driving reasons for considering this issue in the first place was to ensure comparability among companies. But if we can't agree among ourselves, what chance is there for success externally? In the long run, I think such reporting would confuse people more than help. We give lots of information to analysts now and I'm not sure they even know how to use it.

I don't agree with the proposal that calls for management to identify the specific things it considered when it determined the carrying amount of a liability or an asset. After all, we pay our public accountants to look over our shoulders and detrmine whether the approach we used is reasonable.

On identifying fourth-quarter results: I'd like the committee to rethink this proposal because the data already are available simply by deducting nine-month data from the year. While I agree that quarterly segment reporting is appropriate, geographic segment reporting is mind-boggling. We don't even use it to manage the company. Why would anybody need such information to make an investment decision?

On international accounting requirements: I'm certainly in favor of global harmonization, but I don't think we should impose U.S. standards on the rest of the world. We should be much more accommodating on this issue.

On flexible audited statements: I'm not sure how this would work in the real world. The SEC probably would have a difficult time with it.

James L. Gertie is a group senior credit officer of the Bank of Boston.

My overall reaction to the committee's report is very positive. It was an ambitious project and was handled very well. I am particularly impressed by the breadth of users' involvement and the genuine interest the committee took in trying to meet our various needs. The committee's work is an excellent place to start for further deliberations on these issues.

As a commercial lender, I'm happy the report is sensitive to the need to balance the cost of reporting financial information with the associated benefits. My concern is that, if the preparation costs are too high, it might discourage borrowers from preparing the full comprehensive model. But that message was heard clearly by the committee and addressed.

I also am pleased with the recommendations on core cash flows and earnings. Currently there is too much flexibility on determining those numbers for lenders to assess the forward-looking potential cash flow of a business reasonably. Bankers extrapolate such data so they can predict a borrower's future cash flow--that is, the annuity nature of the cash flow. So it's very important.

On consolidated entity reporting and disaggregation: In this case, I think lenders were not heard quite as well as was the equity community. The committee focused a great deal on disaggregation by line of business and product. Surely an equity holder finds such data important, but the commercial lender doesn't give the data as high a priority as the committee might have thought. Lenders are more interested in legal entity disaggregation than an enterprise's various lines of business. However, I recognize that these recommendations were not formulated for the convenience of the banking community.

On market value reporting: I agree with the committee that it's not as important to the banking community as some might think. Consider this: By the time I get values from a company, they are 90 to 120 days old; if I'm making a bank loan, I need up-to-date reporting so I can make my own assessments. In addition, I am pleased with the recommendation that preparers provide the assumptions behind such values; lenders then can make their own adjustments to those assumptions.

On flexible audited statements: In general I support the recommendation. However, I would have liked more auditor attestation on things such as inventories, receivables and restructuring reserves so we can make better determinations on core results.

Jean Head Sisco is a member of a number of corporate boards of directors.

She also chairs some audit committees.

As a long-time corporate director who serves on audit committees, I approve the thinking behind the report. The project is very well intended and certainly begins to ventilate some of the problems of great concern to me. As chairperson of the National Association of Corporate Directors, I perhaps am more aware than most people of some of the financial reporting problems users face. I hope the committee's efforts don't stop with this.

I totally concur with the emphasis on segment reporting. There should be distinct enumerations of segments. There can be great differences in the prosperity of various segments--and even their potentials and risks. On all my audit committees we work to define and report on the segments.

I like the emphasis on fourth-quarter reporting. In some cyclical businesses the fourth quarter is key to their success. Also, many businesses make significant financial moves as the year comes to an end. Shareholders would find that information useful.

The committee did well to focus on the issue of core and noncore activities. After all, when a company has a windfall, investors and others should be made aware of it.

I'm a little concerned about companies' being given a choice on the depth of their financial reports. While I like the idea, I can't imagine how it would be implemented. I worry about the responsibility of the audit committee, which ultimately is to instruct management on how deep disclosures should go. I'm very tempted, as a corporate director, to require financial reports to delve deeper so shareholders really can understand an issue. But doing so would raise so many questions: Do you have to do it all the time? Are you held up as being exemplary because you've gone into great depth? Would the depth of reporting be conditioned on how much we want to spend to accomplish it?

I like the idea of speaking up to the SEC and legislators and pointing out areas where the rules are getting a bit obsolete. With a little less legal risk, we would be able to do a much better job of reporting--especially in the area of long-term analysis.

On addressing financial reporting criticisms: The committee made a good start in dealing with the criticisms that financial statements lack relevance and credibility. But I'm not satisfied with the way it responded to the perceived gap between available information and reported information--although I'm not sure how I'd improve it.

On differential disclosures: I wish I knew a way for a board to share more information with shareholders without giving away the house secrets.

On international accounting standards: They're absolutely essential.

Frank Borelli is a senior vice-president, chief financial officer and a

director of Marsh & McLennan, New York City.

I give the committee high marks for working hard on such a difficult subject, but if the recommendation on segment reporting means another layer of reporting on top of what we have already, we aren't forging ahead but, rather, going in reverse. The SEC already requires a fair amount of such information.

I'm strongly opposed to the recommendations on providing forward-looking information. Current disclosures already provide users with the tools necessary to make informed projections. This proposal is going to meet resistance from virtually every company because of the legal implications.

The committee is asking for companies to disclose "high-level operating data and performance measurements that management uses to manage the business." Every company manages its business differently, so it would be very difficult to get a standard set of data on which everyone agrees. In fact, much of the information being sought already is provided by companies.

I agree with the proposal to make it easier for investors to determine the trends of a business. Such information probably is the most important data for making an investment decision.

On off-balance-sheet financing: Information certainly should be disclosed--but only if it really is significant.

On core and noncore reporting: It's very difficult to define core and noncore operations and then measure a fair value for noncore assets and liabilities.

On auditor responsibilities: I think expanding the present set of standards may be counterproductive in terms of litigation. The more auditors get involved, the more responsibility and legal risk they take on. I would tiptoe in this area.

Peter Lincoln is a vice-president of U.S. Steel & Carnegie Pension Fund,

New York City.

I was one of the people invited to comment on the committee's work before it finalized its work. The committee did an excellent job of eliciting analysts' comments, and there's ample evidence it responded to our needs. However, many users will not agree with some of the recommendations.

I am puzzled, for example, by one of the proposals on core earnings. I think the committee is going far beyond where most analysts might want them to go. Analysts certainly want to know what items in an income statement are unusual, and they want those items to be identified fully. However, if the committee advocates a new concept of core earnings, it will have a very difficult time coming up with a definition that satisfies everyone. Lacking such common ground, it would be very difficult for analysts to compare results from many companies. I believe it would be enough just to identify the unusual items in a financial statement and then let management amplify this information in the management's discussion and analysis comments.

On the issue of nonfinancial performance information: I think information on customer satisfaction or the speed with which new products move from the development stage to the marketplace, for example, would be very helpful to investors and analysts. All companies should report such information to provide a complete picture of their objectives and determine how well they are implementing them.

On core and noncore reporting: The proposal to state noncore operations at fair market value and core at historical cost seems unworkable. I think a better way to provide information on a company's different operations is segment reporting--both by product and by region. Segment reporting could pick up enough information about a noncore business element to satisfy most analysts. But flexibility is needed. There definitely are times when segmentation should be by region and other times when it should be by product.

On auditors' responsibilities: I would be very concerned if auditors were directly responsible for providing additional information. Much of this added information is very subjective and it's really management's responsibility to provide it. The information can't be audited in the conventional way. The committee appeared uncertain about the future role of auditors. Clearly, auditors should stick to only verifiable data. If they get into this judgmental area--in which they would be assessing less quantifiable information--they would need more and quite different training. That would add to the expense of providing such data, and I question its cost-effectiveness. I realize that auditors must make judgments on the soundness of a business. To date, however, I don't believe auditors have always fulfilled that function very effectively. That's because at times they have failed to truly understand the businesses they audit.

Baruch Lev is the E. R. Niemela Professor of Business Administration and

Law, University of California, Berkeley.

I think the committee has discharged its task in a really admirable way. It would have been easy to provide an abstract, unrealistic wish list of financial items. The committee didn't do that. Rather, it provided a well-balanced set of recommendations with the right mix of realism and vision.

People who read the report should realize the committee was operating within an extremely complex web of institutions involving agents with all kinds of conflicting preferences. I view the report as a beginning--a very successful first effort--and not the end. Financial reporting is evolving continually and it needs a standing committee to address these issues. I basically support most of the report's recommendations with a few exceptions.

The role of research in financial reporting is not sufficiently addressed. For example, the committee proposes the reporting of new items, such as elements of risk and uncertainty, but it does not suggest ways to measure these elusive attributes. Research can play a key role in coming up with measurement techniques.

Research can and does provide insight into the effectiveness of financial regulations, too. It can, for example, consider whether new required data are relevant (for example, do the data affect securities prices?) and determine who is using the data and under what circumstances.

Another aspect of financial reporting not adequately addressed, in my opinion, is the strategic role of managers. The committee appears to believe that all that is required is for managers to be informed about users' needs and they will wholeheartedly provide for these needs. But we know that managers have their own objectives and preferences regarding financial reporting and sometimes even window-dress the reports.

The crucial issue is how to elicit from managers high-quality, relevant and objective information. Managers' roles as strategic players in financial reporting must be addressed.

A third issue is the committee's conclusion that accounting for intangibles (capitalization) is not currently of considerable importance to users. Frankly, I find it inconceivable that in this day and age, with the rise of science-based industries and the ever-increasing importance of intellectual property, accounting for intangibles is deemed not important to users.

My guess is that whoever expressed this opinion to the committee was not uninterested in research and development or goodwill; but rather was concerned with the earnings-management opportunities created when capitalization of intangibles is allowed. If this indeed is the case, the committee should have tackled earnings management head-on rather than relegated intangibles to a minor role.

Last, the committee believes that users' express needs should play a dominant role in regulating financial disclosure. I believe they have to play a role, along with other means of determining relevant information, such as considering the implications of economic and decision-theory models.

All in all, I reiterate my agreement with most of the committee's statements and conclusions and hope to see a continuation of this endeavor.
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Title Annotation:business leaders respond to AICPA committee recommendations
Author:Lev, Baruch
Publication:Journal of Accountancy
Date:Oct 1, 1994
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