The New Look Financial Statements

 

In an effort to improve financial reporting and provide more useful information to financial statement users, the regulatory bodies have proposed a new exposure draft on changing the format of the financial statements. The new exposure draft has many new changes to the look and feel of the financial statements.  Four significant changes that are proposed are the format of the balance sheet, the format of the income statement, reclassification of equipment in the cash flow statement, and the elimination of the indirect method for the cash flow statement.

What is changing?

The new proposed balance sheet will be broken into the three sections: assets, liabilities, and stockholders’ equity. It will no longer be in a format where all of the assets, liabilities, and stockholders’ equity are grouped into their individual sections.  Instead the new balance sheet will look more like the current statement of cash flows. It is going to be broken into four sections: operating, investing, financing, and equity. The operating section is going to include the assets and liabilities contributed the company’s normal business with a netted figure at the bottom. The investing section would include the company’s investments and the financing section would include the company’s short and long term debt.

The new proposed income statement will be similar to the new balance sheet. It will also be broken operating, investing, and financing sections.  Each section will have the income and expenses related to the company’s operating, financing, or investing operations. These income and expenses will be netted in each section so user of the financial statement will now the amount of income or loss a company has generated from each category. The three figures are netted to compute net income or loss at the bottom of the statement. A section for other comprehensive income is found after the net income figure.

Currently the purchase and disposal of long term assets such as equipment are investing activities but the exposure draft is going to reclassify them into operating activities. I believe classifying the purchase and selling of equipment in the operating section is better because for many companies equipment is a normal expenditure and part of their normal operations. Even though they do not sell the equipment, it is used to make the widget which the business sells to make money. Equipment is not necessary an investment in my opinion. Equipment depreciates over time and most of the time is not worth what you bought it for. It does not appreciate and one cannot expect to make a gain from it like securities.

Lastly, the indirect method of reporting cash will no longer be allowed.  Under the direct method, cash is reported based on how much is received or paid as a result of various activities. With the proposed changes, companies will no longer have the option to start with the net income figure and make adjustments to arrive at cash flows from operating activities. The cash flow from operating activities will include the expenditures on equipment as stated above and other cash outlays related to a company’ s core business. Cash outlays such as cash paid for goods, cash paid for pensions, cash collected from customers, and other various items. The investing section will include cash received from dividends and interest while the financing section will have dividends and interest paid.

Does it make financial statements more useful?

I believe all of the proposed changes will enhance the usefulness of the financial statement. I believe the new look financial statements will give the users of the financial statements a better understanding of each item presented on the balance sheet, income statement, and statement of cash flows. The users of the financial statements will now how many assets or income a company has generated from its core business and not from other sources.  It has increased comparability across the three statements and has made the calculation of ratios a lot simpler as well.

What are the negatives?

Although there are positives to the proposed financial statements, they do have negatives as well. Some of the negatives to the proposal are the cost of the new accounting software to companies to switch their accounting system to conform to the new format. Other negatives include the cost to restate prior year financials for comparability purposes, the new statements are more complex because debits and credits are in the same sections. Also the new statements might not be comparable across companies and will need more notes. Most importantly, assets will not equal liabilities and stockholders’ equity.

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Image Credit to Leasing News

What is an “Asset”?

“Asset” according to the FASB

The current FASB definition of an asset holds merit and has some limitations as well. The current definition is: “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” The key components of the current definition are probable future economic benefit, controlled by a particular entity, and result of past transactions. This definition holds merit because in order for an item to be considered an asset it should encompass these three components.  An item cannot be considered an asset unless it can probably bring in some kind of future benefit to the entity which holds it.  Probable means more likely than not or greater than fifty percent chance of an economic benefit being obtained in the future by the entity which controls the asset. The question of control and the beneficiary of the economic benefits being produced by the asset is the second major portion of the definition. Although it might seem straightforward, control can be ambiguous at times when it comes to certain contracts and subsidiaries. So in certain cases an entity must show some sort of legal claim or the right to receive the benefits arising from the asset if it wants to place it on its balance sheet. The last part of the FASB definition allows a user to verify an asset as a result of a past transaction.

Limits to the Current Definition

The limit to the current definition is not narrow enough and leaves room for interpretation.  It allows for certain items to be treated as assets when they should not be.  An example of this would be dry holes in the mining/drilling industry. Currently dry holes are capitalized and treated as assets on the balance sheet. Applying the definition, dry holes arise from past transactions and are obtained or controlled by an entity. According to the drilling companies, it provides a future economic benefit because it improves the company’s drilling techniques for future exploration. An asset should provide future economic benefit in the form of future cash flows which is the main purpose of an asset. Dry holes do not provide future cash flows for the entity and should not be capitalized and treated as assets. But drilling/mining companies have interpreted the current definition to include them as such.

What the definition of an “asset” should be

If I were the absolute dictator of accounting, my definition of an asset would be, “probable future economic benefits obtained or controlled by an entity resulting from past transactions which can be exchanged for cash.” By adding the “exchanged for cash’’ element it eliminates certain items such as dry holes and goodwill from the balance sheet. It only includes items which provide value

to an entity. In essence an asset is an item which provides value to companies by providing them with future cash flows. So I think the cash element should be in the definition. The rest of the definition is in line with the current FASB definition. Also my definition does not eliminate prepaids as assets because they provide future economic benefit which is in line with the current definition.

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Earnings Management

Managers are entrusted by shareholders to properly run their companies. Managers are expected to behave ethically and make decisions in the best interest of the shareholders. They are supposed to maintain the long term financial health of the organization by making strategic decisions which enhance firm value. However managers do not always behave in this manner. They make unethical, risky decisions which compromise the financial stability of the organization.  Earnings management helps explain the aberrant behavior of managers.

What is Earnings Management?

Earnings management is manipulating a firm’s accounting numbers to mislead the users of financial statements. This practice is typically done to inflate a company’s earnings to give the illusion that its value is greater than it actually is. Managers sometimes participate in this behavior to reach earnings targets so they can receive their bonus.

Causes of Earnings Management

Increase in private control benefits leads to earnings management. Strong legal systems limit insiders to gain private control benefits. If investor protection is strong, insiders enjoy fewer private control benefits which give them less incentive to manipulate earnings. But weak investor protection and an increase in private control benefits creates an incentive to manage earnings.

Ways to Curtail Earnings Management

One technique which can be employed to curtail aberrant behavior by management is to eliminate performance-based compensation.  Performance based compensation puts pressure on management to reach the projected numbers so they can get their bonus. This behavior can lead to earnings management and compromise the financial health of the organization. Instead of

Another technique which can be employed to curtail aberrant behavior is to employ stricter penalties for management who do not act ethically. By having stricter penalties and strong investor rights, it can deter management from behaving unethically. If investor protection is strong, management has less private control benefits. This decrease in private control benefits gives management less incentive to act unethically.   performance based contracts, I think companies should use outcome based contracts. The outcome based compensation better aligns the goals of management and shareholders. By better aligning the goals of the principle and agent, it well reduce the pressure for management to behave unethically.

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