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ACC 710
Reporting Financial Performance (Richard Barker)
Financial Reporting is a blueprint of recorded financial activities in which an entity’s financial position is determined from. The earnings concept cannot be defined appropriately for accounting standard and therefore, an alternative approach to reporting financial performance based on a matrix format, remeasurements. Remeasurements are a result of revisions made to assets and liabilities, resulting in predictive and feedback properties as well as other benefits like facilitating analysis of the measured subjectivity on reported financial performance.
If various transactions and events increase income and expenses with informational properties, then these can be aggregated into a subset of comprehensive income and the most important subset is “earnings.” There are two ways that these earnings can be measured. One is that certain items of financial performance can bypass the income statement and be reported depending on region, in equity (international standards), or other comprehensive income (U.S.), statement of total recognized gains and losses (U.K.). Second, may report on income statement and regarded as falling outside a measure of earnings (discontinued activities and extraordinary items).
There is a lack of conceptual clarity regarding earnings is necessary to understand because standard setting is moving towards a fair value model, making it more difficult for it to be understood what constitutes earnings. For example, companies vary with regards to impairment tests of goodwill, fair value changes for financial instruments and pension-related value changes can cause huge and fluctuating gains and losses belong in earnings or should be reported below the line. There is no universally agreed way of what’s considered appropriate.
The definitions of “core earnings” vary, AICPA calls it recurring activities, S&P calls it ongoing operations, yet it includes nonrecurring items. Alternately, AIMR has a single statement of comprehensive income that separates market value changes from operating activities, United Kingdom Society of Investment Professionals (UKSIP) separates trading performance and profit and losses on capital items. Lastly, Cearns says that both national and international standard setters have to find a way of reporting financial performance for investors to understand more clearly an entity’s actual performance.
It is understood that there is a loss of information in comprehensive income is reported without separate disclosures because the appropriate aggregate valuation multiple is a weighted average. The example is given of various entities with different outcome. Examples were given of many entities and although they may slightly vary namely that income and expenses fall in the common definitions of earnings are given higher valuation multiples and that items that are not in earnings may also be relevant to earnings. Investors benefit from having a breakdown of the variation in what may be considered relevant of each component of comprehensive income.
Current practices give three alternative approaches in excluding earning items from comprehensive income that are out of the entity’s core operations, not recurring or are not within management’s control. Each earnings concept excludes items from earnings that are less relevant in determining comprehensive income. The financial results of operating activities help predict value drivers, what makes them progress, like gross margin. However, disposal gains and losses, or nonrecurring such as discontinued operations are not as relevant if at all. Lastly, any
externally driven, not under management control should be excluded because when an investor is
choosing to invest in a company, a determining factor would be the one with better management and that is determined by past performance.
Earnings concepts include predictive and feedback concepts such as forecasting how an entity might do in the future as well as learning from previously inaccurate forecasts. For example, if an analyst consistently has overestimated sales or that they have been difficult to predict, then this gives feedback information informing the forecasting process. But there are situations that are nonrecurring or externally driven such as a natural disaster or inflation are difficult to predict, providing limited feedback value and therefore, does not enhance the ability for the analyst to forecast.
Operations as an Earnings Concept
Depending on the type of business, disposal gains and losses and fair value changes are normally classified as nonoperating, unless it’s a real estate or financial institution. Therefore, a standard cannot be applied to all businesses. Defining business activities as frequent or infrequent are also not possible so categorization is a subjective judgement. FASB states that gains and losses are separate from operating activities, but only state that revenues are “ongoing major or central operations and activities” while gains result from “peripheral or incidental transaction…” (FASB 1985, para. 78-84). The IASB also has a similar definition leaving the interpretation unclear. There is also a problem of insufficiently measuring nonoperating expenses. Depreciation and impairment of PPE are operating expenses, but disposal gains and losses are not, resulting in an inaccuracy. For example, asset is under-depreciated, disposal losses are likely, and earnings are overstated.
Recurrence as an Earnings Concept
There is an overlap of operating and recurring concepts and it is difficult to draw the line in what’s considered just operating and just recurring. Also, the reporting entity uses subjective measurement on how an entity determine if an item is frequent or infrequent and this is bases on their own view of the future as well as their willingness to inform others. Income statement consists of combinations of various transactions and events such as recurring item like employment costs and infrequent payments like bonuses, severance costs or payments to contract employees.
Control as an Earnings Concept
Similarly, income and expenses cannot be defined because they are exposed to external factors; however, there is internal control over the use of financial instruments in managing exposure to external factors such as change in interest rates. The management control limitation is unclear, thus difficult to measure. The overall effect on the financial performance cannot be measured reliably, and the external effects are objectively measured only by management estimates. However, management-controlled changes in estimates have a dramatic influence on reported financial performance. Management has control over on financial instruments. They dictate what consist the income and expenses. They declare the price of the company’s products, wages paid to employees, and technology employed in its operation. The management has a high influence
other disclosure in line of presentation of information. Third, there is still, to an extent, an
inherent problem of subjectivity. Finally, it is difficult to reliably measure remeasurements.
Understandability and timeliness of financial reporting can help improve crucial decision
making when determining what and how financial activities are reported. The main objective of any entity is to an effectively manageable cash flow that can serve its main purpose which is monitoring incoming cash receipts, debt, availability of assets for future endeavors and the most important is confirmation of income without having to rely on outside support. This is the reasoning behind the FASB releasing their recommendations to ASU (Accounting Standards Update) which can be very helpful in simplifying cash receipts and payments and how they should be recorded on financial statements. Reporting earning has been updated on the FASB in order for all entities to comply with that standard. The outcome of accurate reporting is to be able to determine financial standing of an entity and whether or not guidance would be needed in order to improve their financial position. Standardizing the makings of financial reporting is the goal in order to be able to follow inputs in an integrated and sensible way. All financial statements apply to a period of time whereas the distinction of a balance sheet is a single moment in time. The importance of financial reporting is the following:
- Helps an entity follow and comply with any requirements, statues and accounting principles according to GAAP, ASU and FASB.
- Assists with financial planning, analysis and decision making of regular business operations.
- Audit by independent auditor in order in order to determine accuracy and correct reporting of financial activities.
- Notes to financial statements is for additional information that help explain specific activities or items on statements and offers a more thorough appraisal financial condition.
- Accounting standards are intended to enforce transparency within an entity.
- Provide more significant information in a practical form.
- For the readers to have pertinent information that will help with decision making of future investment purposes, the public to see how their taxpayer money is being spent and for “watchdogs” to ensure that laws and accounting standards are being followed.
A major scope of accounting is based on its operating activities and that is how financial activities is reported, having an income-based model would be ideal but also realizing not only income and assets, its debt and liabilities need to also be recognized. Accruals also will have a significant impact on financial statements when it comes to decision making. Accruals can be relevant to revenue, operating and capital expenses, especially when closing the books on any given month. You want to be able to capture any income that has come in, but information is not readily available, so you would usually accrue an estimation by analyzing the amounts received to date and creating a percentage based on that or when you have a payroll coming due, but it is between reporting periods or months. Accruing for last minute invoices received but will not be able to cut a check or make a payment until after closing of that month, so you accrue the liability to get a close enough estimate of an entities net cash.
Example of an accrual example:
Initial journal entry:
04.01.18 Prepaid Rent $18,000 (this is based on an annual payment)
Cash $18,
Adjusting journal entry:
04.30.18 Rent Expense $1,500 (you take annual x 1/12= $1,500 per month)
Prepaid Rent $1,
On the conceptual foundations of financial reporting (Ilia D. Dichev)
Standard setters (FASB and IASB) adopted the balance sheet approach to financial reporting putting the primary attention on assets and liabilities, leaving income as the secondary consideration because it’s just a change in net assets. To answer to the conceptual framework reconsideration, professor Dichev proposed that income-based approach is better than the balance sheet approach. His argument has invited setters to put more attention on income in financial reporting in the sense that income is the adjusted net cash flows and reflects the success of advancing cash to earn more cash. This translate the natural foundation for financial reporting because income is precisely determined and provides clear valuation on a company’s cash flows. In addition, it serves to adjust raw cash flows to better show current success of investing cash to earn more cash.
Observations on the current conceptual model
According to professor Dichev, the balance sheet approach is flawed in the sense that:
- The essential features of financial reporting model do not reflect the essential features of the underlying business model.
- The concept of income is clear and practically useful than the concept of assets.
- The continual expansion of the balance sheet approach is eradicating the forward-looking usefulness of earnings.
- More and more valuation’s estimates in financial reports create redundancy and dangerous feedback loops between financial markets and the real economy.
A “good” model of financial reporting needs to reflect a sharp theoretical and practical distinction between operating and financing-type activities and assets in all financial statements. Moreover, the accounting for operating activities needs to reflect the matching principle of expenses and revenues (Dichev, 2015).
Sources
Barker, R. (2004). Reporting Financial Performance. Accounting Horizons, 151-172.
Dichev, I. D. (2015). On the Conceptual Foundations of Financial Reporting. SSRN Electronic Journal. doi:10.2139/ssrn.
