A New Vision for Accounting
Robert Herz and FASB are preparing a radical new format for financial statements.
Alix Stuart, CFO Magazine
February 7, 2008
Last summer, McCormick & Co. controller Ken Kelly sliced and diced his financial statements in ways he
had never before imagined. For starters, he split the income statement for the $2.7 billion international
spice-and-food company into the three categories of the cash-flow statement: operating, financing, and
investing. He extracted discontinued operations and income taxes and placed them in separate categories,
instead of peppering them throughout the other results. He created a new form to distinguish which
changes in income were due to fair value and which to cash. One traditional ingredient, meanwhile, was
conspicuous by its absence: net income.
Kelly wasn't just indulging a whim. Ahead of a public release of a draft of the Financial Accounting
Standards Board's new format for financial statements in the second quarter of 2008, the McCormick
controller was trying out the financial statements of the future, a radical departure from current
conventions. FASB's so-called financial statement presentation project is ostensibly concerned only with
the form, or the "face," of financial statements, but it's quickly becoming clear that it will change and
expand their content as well. "This is a complete redefinition of the financial statements as we know
them," says John Hepp, a former FASB project manager and now senior manager at Grant Thornton.
Some of the major changes under discussion: reconfiguring the balance sheet and the income statement
to follow the three categories of the cash-flow statement, requiring companies to report cash flows with
the little-used direct method; and introducing a new reconciliation schedule that would highlight fair-value
changes. Companies will also likely have to report more about their segments, possibly down to the same
level of detail as they currently report for the consolidated statements. Meanwhile, net income is slated to
disappear completely from GAAP financial statements, with no obvious replacement for such commonly
used metrics as earnings per share.
FASB, working with the International Accounting Standards Board (IASB) and accounting standards
boards in the United Kingdom and Japan, continues to work out the precise details of the new financial
statements. "We are trying to set the stage for what financial statements will look like across the globe for
decades to come," says FASB chairman Robert Herz. (Examples of the proposed new financial statements
can be viewed at FASB's Website.) If the standard-setters stay their course, CFOs and controllers at every
publicly traded company in the world could be following Kelly's lead as soon as 2010.
It's too early to predict with confidence which changes will ultimately stick. But the mock-up exercise has
made Kelly wary. He considers the direct cash-flow statement and reconciliation schedule among the
"worst aspects" of the forthcoming proposal, and expects they would require "draconian exercises" from
his finance staff, he says. And he questions what would result from the additional details: "If all of a
sudden your income statement has 125 lines instead of 25, is that presentation more clarifying, or more
confusing?"
Other financial executives share Kelly's skepticism. In a December CFO survey of more than 200 finance
executives, only 17 percent said the changes would offer any benefits to their companies or investors (see
"Keep the Bottom Line" at the end of this article). Even some who endorsed the basic aim of the project
and like the idea of standardizing categories across the three major financial statements were only
cautiously optimistic. "It may be OK, or it may be excessive." says David Rickard, CFO of CVS/Caremark.
"The devil will be in the details."
Net Loss
From the outset, corporate financial officers have been ambivalent about FASB's seven year-old project,
which was originally launched to address concerns that net income was losing relevance amid a
proliferation of pro forma numbers. Back in 2001, Financial Executives International "strongly opposed" it,
while executives at Philip Morris, Exxon Mobil, Sears Roebuck, and Microsoft protested to FASB as well.
(Critics then and now point out that FASB will have little control over pro forma reporting no matter what
it does. Indeed, nearly 60 percent of respondents to CFO's survey said they would continue to report pro
forma numbers after the new format is introduced.)
Given the project's starting point, it's not surprising that current drafts of the future income statement
omit net income. Right now that's by default, since income taxes are recorded in a separate section. But
there is a big push among some board members to make a more fundamental change to eliminate net
income by design, and promote business income (income from operations) as the preferred basis for
investment metrics.
"If net income stays, it would be a sign that we failed," says Don Young, a FASB board member. In his
mind, the project is not merely about getting rid of net income, but rather about capturing all incomerelated information in a single line (including such volatile items as gains and losses on cash-flow hedges,
available-for-sale securities, and foreign-exchange translations) rather than footnoting them in other
comprehensive income (OCI) as they are now. "All changes in net assets and liabilities should be
included," says Young. "Why should the income statement be incomplete?" He predicts that the new
subtotals, namely business income, will present "a much clearer picture of what's going on."
Board member Thomas Linsmeier agrees. "The rationale for segregating those items [in OCI] is not
necessarily obvious, other than the fact that management doesn't want to be held accountable for them in
the current period," he says.
Whether for self-serving or practical reasons, finance chiefs are rallying behind net income. Nearly 70
percent of those polled by CFO in December said it should stay. "I understand their theories that it's not
the be-all and end-all measure that it's put up to be, but it is a measure everyone is familiar with, and
sophisticated users can adjust from there," says Kelly. Adds Rickard: "They're treating [net income] as if
it's the scourge of the earth, which to me is silly. I think the logical conclusion is to make other things
available, rather than hiding the one thing people find most useful."
It's not clear that investors and analysts are excited about the prospect of losing net income, either. "I like
having one agreed-upon number that everyone can use for comparison, so I'd be reluctant to see that
go," says Janet Pegg, senior managing director and an accounting analyst at Bear Stearns. Debt investors
are more neutral. "I don't really care if it stays or goes," says Greg Jonas, managing director for Moody's
Investors Service and a member of an advisory board to the FASB project. Moody's analysts use net
income in fewer than 5 percent of all the ratios they construct, Jonas says, so "we're already looking at
business from various perspectives."
While the threat of net income disappearing permanently is "a real one," according to Kelly, there are
several mitigating factors. Young, who is one of the stronger proponents of the move, finishes his term
this year, and other board members seem considerably more sympathetic to keeping the status quo. "If
people continue to demand a net income metric, we'll provide information to calculate it," says Herz. The
head of the IASB, David Tweedie, has also gone on record as saying he thinks net income should stay.
The official board pronouncement is that companies would still be allowed to segregate OCI items in the
short term, but that they must appear on the main income statement. Over the long term, the board
plans a separate project to evaluate each OCI item and reconsider its placement.
Going Direct
Another major shift in the new model would be to require companies to use the direct method for the
cash-flow statement, explaining cash changes from the bottom up to arrive at net income, rather than
starting with net income and making adjustments. (Currently, most companies use the latter, indirect
method.) That statement would be linked with a new form, the so-called reconciliation schedule, that
would track changes in income to cash flows or fair-value changes.
The difficulty in constructing a direct cash-flow statement largely depends on the company. As controller
for multinational McCormick, Kelly says he found the exercise "virtually impossible," with thousands of
transactions involving currency translations and so-called intercompany eliminations (what one division
charges another for a product) gumming up the works. "If I were to get a cash-flow statement from each
of my divisions around the world and try to add it up, it would never add up to my general cash-flow
number," he says.
Rickard, on the other hand, switched CVS/Caremark to the direct cash-flow method three years ago as
part of an experiment, and found it so easy he never bothered to switch back. That's in part because all of
the company's operations are stateside, and because Rickard had no intercompany eliminations.
Survey respondents were similarly split. About 40 percent said constructing a direct cash-flow statement
would require major adjustments, while it would take minor adjustments for nearly 30 percent. Given
such disparity, finance executives can expect something of a reprieve. The IASB, for one, doesn't think the
direct method should be required, and FASB members say they are looking closely at a hybrid
direct/indirect method now used in Australia and New Zealand as a compromise.
"Radical Yet Insightful"
The concept of the reconciliation schedule, on the other hand, is gaining much wider support. Young
thinks it is one of the most critical components of the new format, and more important than mandating
the direct cash-flow statement. Wall Street is pushing for it as well.
"As we see more fair value coming through the financial statements, those statements need to do a better
job of showing where the changes are coming from; this would help a lot," says Pegg of Bear Stearns.
Jonas of Moody's considers the reconciliation schedule "the most radical yet most insightful" part of the
project so far. "Many fundamental analysts are trying to understand the business's ability to generate
recurring, persistent cash flows," he says, and the schedule helps them do that.
Surprisingly, some finance executives endorse it, too. "It's the kind of schedule you do to make sure you
haven't made a mistake anyway, and to me, there's no difference if we publish it," says Rickard. More
than 50 percent of survey respondents said they thought the reconciliation schedule would help explain
revenue changes to investors; only 28 percent said it would not.
Again, though, the appropriate level of detail remains an open question. The basic categories that FASB is
contemplating right now are: cash flows not affecting income, accruals and systematic allocations,
recurring valuation changes, and remeasurements other than recurring valuation changes. Beyond that,
the number of columns and precision of reconciliation vary greatly among the drafts. In some scenarios,
the reconciliation schedule would replace the cash-flow statement (since it would contain it).
Inside Info
A potentially explosive change that is still only a twinkle in standard-setters' eyes is expanded segment
disclosure. Last September, FASB said it was asking the IASB to sign off on the view that companies
should have to classify segment as well as corporate data into operating, financing, and investing buckets.
How much detail will be provided within those buckets remains to be seen. The alternatives FASB
proposes range from including only significant line items to including enough segment data to total the
general financials.
FASB members, particularly Young, are eager to push this part of the project forward. "I'm beginning to
believe that's where some of the greatest payoffs are," he says. And it's hard to find an investor or an
analyst who would turn down such plum information. Jonas, for one, is clamoring for it. "For a complex
business, the unit of analysis is often the segment," he explains. "When we're analyzing GE, for example,
we do look at GE consolidated, but only after we analyze each segment. But yet we don't get nearly the
info in segments that we get at the consolidated level."
Finance executives so far are fairly relaxed about this proposal, largely due to Financial Accounting
Standard 131, which says they don't have to report externally anything that is not used internally.
McCormick, for example, doesn't keep some of the items that would likely be requested, such as balance
sheets for each segment, but Kelly doesn't expect that will be a problem if those parts of FAS 131 stay in
place. "And if we have it within the company, I'm fine with reporting it," he says.
Pie in the Sky?
Given that FASB has so many big-picture projects on its plate these days, it is tempting to dismiss the
financial-statement project as just another pie-in-the-sky idea that will get bogged down in procedure. But
with a joint FASB/IASB draft due out for comment in mid-2008, "hard decisions" could be made by 2009,
says Young, with implementation to follow by 2010 at the earliest, if not several years after that. FASB
members say that finishing this project isn't contingent on finishing any others on its ambitious agenda,
including its efforts to hammer out a conceptual framework for accounting and to redefine notions of
revenue and fair value.
Assuming the change happens, the full impact of the new format remains difficult to gauge. Viewed from
one perspective, the new GAAP could be incredibly disruptive. It would require huge changes, from
revising accounting textbooks and curriculums to changing IT systems to constructing new earnings
metrics (and selling investors on them).
Take a different viewpoint, though, and the change is marginal. Companies would mostly be reporting
data they already collect. Analysts already manipulate data in the ways that make sense to them; the new
format would just save them a few steps. Meanwhile, XBRL, which could be mandated before the new
format takes hold, could make the project irrelevant, some say, since in theory it would allow anyone to
assemble his own customized financials based on standard data tags.
To be sure, CFOs will need to follow the project and comment when appropriate. In the long run, though,
neither FASB nor companies, analysts nor investors, are likely to be the final arbiters of how onerous or
easy the new approach is. The ease of conversion in many cases "will depend on how much I can
estimate," says Kelly, "and that will come down to, 'What do the auditors think?'"
Alix Stuart is a senior writer at CFO.
What about Private Companies?
The new GAAP format may be just the inspiration private companies need to push for their own separate
version of accounting standards. "It would appear from this project that the purpose of financial reporting
is the valuation of publicly traded equities," says John Hepp of Grant Thornton, on the grounds that the
structure is designed to clarify the persistence of earnings into the future, rather than the historical facts
of the past period. "If that's the case, it may not make sense to apply it to companies that aren't publicly
traded."
While the Private Company Financial Reporting Committee (PCFRC), which is part of the Financial
Accounting Standards Board, has not formally decided to lobby for a "little" GAAP, as companies in Canada
have done, it is considering it more intently these days. "From what I've seen in the preliminary formats,
[the new financial statements are] probably overly complex for the needs of most private companies,"
says Judy O'Dell, head of the PCFRC. Bankers and other lenders on the committee "are very concerned"
about what the lack of net income and traditional subtotals on balance sheets would mean for the ratios
they traditionally use in making lending decisions, she says.
Any effort on behalf of a separate GAAP is likely to meet with resistance from FASB chairman Robert Herz,
however. He says he wants to stick with one GAAP because "users don't want to have to learn two
languages," and because many private companies ultimately go public. However, Herz concedes that the
new GAAP format "may have to be simplified" for private companies. — A.S.