In recent years, the FASB has concerned itself with simplification of accounting standards, rather than prioritizing the improvement of financial reporting for the benefit of investors. While companies grow more complex and larger, and place more investments in intangible assets, financial reporting has not kept pace. This is making financial statements less relevant than ever. In its nearly 50-year history, FASB has responded well to the needs of investors when circumstances demanded an effective response. This was evidenced by its relatively speedy, experimental approach to inflation accounting in the late 1970s. Contrast that to its slow-motion response on intangible asset recognition and disclosures, a project languishing over 20 years. FASB's agenda has become clogged as the board devotes more of its attention and resources to the Private Company Council's needs. An open question: can the FASB regain its former intense focus on investor needs and put aside simplification efforts?
I began my career as a buy-side financial analyst in 1985, when financial statements were still printed only on paper and faxes were state-of-the-art “instant communication.” Earnings calls didn't exist, and newswire services were the most important means of disseminating earnings news; there was no internet. Neither did the statement of cash flows. All companies were allowed 90 days for filing 10-Ks, and 45 days for filing 10-Qs. They were delivered by snail mail, or in a real hurry—by overnight delivery services.
It was a lazier time, to be sure, and market inefficiencies abounded. For its part, FASB did much to improve financial reporting for at least the first 15 years of my career. Consider what changed in that period: the statement of cash flows was added to the reporting package. Pensions and other postretirement benefit obligations were calculated and reported more consistently. Segment reporting became more consistent with managements' discussions and analysis of operations. Debt and equity securities were reported at fair values, and so did derivative instruments. The reporting of stock-based compensation found its way into footnotes, and after the turn of the century, the reporting found its way into the income statement. The early part of the new century brought other improvements: business combination accounting was reformed and made sensible. Intangible assets appeared on balance sheets—at least, when a business combination occurs. Asset retirement obligations were recognized. Accounting for exit and disposal activities was made rational. None of those standards were perfect, yet they all resulted in financial reporting improvements for financial statement users to employ. The FASB was unafraid to try something big and new in each of them. Curiously, most of those standards were issued when the FASB still lacked independent funding—while it was still funded by contributions from its constituents, including financial statement preparers. For those first 15 years of my career, the FASB had its mojo working.
By the mid-2000s, had accounting reached a state of nirvana, with no need for further improvement? Hardly. Even now, analysts still need the FASB to improve their lot by tackling big, bold projects after a time when that body seems to have concentrated on less-striking “simplification” projects. The FASB seems to have lost its mojo.
Are there still big, bold projects that would improve the work of investors? Certainly.
Financial Statement Presentation
In the last couple of decades, non-GAAP reporting by companies has exploded. There's an underlying suspicion among investors that companies are selecting the reporting that makes their results look best, without the drag of impairment and restructuring charges, without the amortization of intangibles or the reporting of stock compensation, or without the dozens of other assorted add-backs to net income. Why do investors go along with it? Partly because they have little choice when companies present earnings this way. Companies guide analysts in their estimates according to their own recipe for earnings, and sell-side investors face shunning if they don't comply. That's not the whole reason, however. I think investors accept it because they are trying to find a core operating result, or they are trying to arrive at a very simple cash generation figure—even if those measures are flawed. Often, they believe that they are improving comparability among companies.
In 2007, the CFA Institute issued a white paper presenting their view of a comprehensive business reporting model.1 That model presented operating results isolated by current-period transactions, accruals, changes in estimates, and changes in fair values of assets and liabilities. While it has languished for 14 years, the reporting model still provides useful clues about the way investors view performance reporting and could provide significant input to a FASB project on performance reporting. When it was issued, the FASB considered its suggestions without going very far. The Great Financial Crisis began shortly afterward and diverted its attention elsewhere.
The accruals research literature has grown exponentially over the last 30 years, and it is one accounting research discipline that many analysts incorporate into their practice of financial analysis. They analyze accrual earnings versus cash flows, study accruals for evidence of undue growth, or simply use pre-packaged databases that show ready-made “Sloan ratios” for quick check on accruals chicanery. Has the work been incorporated into financial reporting? Not yet. Consider this to be a subset of the presentation issue.
Cash Flow Statements
In the last couple of decades, cash flow analysis has become a staple of investors' financial analysis, and they often use non-GAAP so-called “cash earnings” measures as well as numerous EBIT-based measures. Effectively, they concoct their own hybridized, minimalist version of cash flow. Why don't they rely more on the cash flow statement? While the cash flow statement is a quantum improvement over the statement of changes in financial position it replaced, it hasn't been reviewed for refreshment since Statement No. 95 mandated its appearance in 1988. The direct method of presenting operating cash flows was specified as preferred in the standard; today it's extinct. Yet investors would prefer the direct method. The problems with the cash flow statement are a subset of the problems with presentation and accruals: the cash flow statement does not integrate well with the income statement, and it relies too heavily on the presentation of the indirect method of reporting operating cash flows. Worse, when investors make use of the operating section of the cash flow statement, they often will blindly accept stock compensation as a non-cash charge—when it actually belongs in the financing section of the cash flow statement. This leads to investors using overstated cash from operations in their analyses.2
Benefit Plan Reporting
While benefit plan reporting has a solid grounding in the accounting standards, the choices available to companies make for tedious investor work for those who want to see consistent intercompany comparisons. Benefit plan reporting standards allow different methods of remeasurement gain and loss recognition by the employment of a corridor method of amortization—a mechanism that provides no useful information to investors. It can be bypassed through the so-called fair value method of benefit plan reporting used by some issuers—but why should choices even exist if some methods provide no meaningful information?
Investors often suspect that companies don't present as many segments as they have visible businesses. Furthermore, current segment information has little depth to it. It is not integrated with the cash flow statement. Beyond scant information (sometimes) about total assets and their geographic location, there's no balance sheet information.
Internally Developed Intangible Assets
After financial statement presentation, this is the single biggest project that the FASB could handle that would improve the work of investors. The lack of information about their unrecognized intangible assets pervasively affects financial reporting. Corporate intangible assets have become massive over the last few decades, yet they retain invisibility. This is not a new phenomenon; it's familiar to investors of all stripes and is evidenced in market valuations that don't always seem reasonable in terms of traditional valuation metrics. Some investors compensate for the lack of information by simply accepting on blind faith that such assets exist; some financial statement users create their own recipes for calculating intangible asset values. Investors might be able to trace financial statement “footprints” of intangibles intensity3, but they can't realistically devise their own values for internally generated intangible values themselves with any degree of reliability. Companies should be able to do it, however, if they were required to do so.
Contrast FASB's handling of the intangibles issue with its response to an earlier pervasive issue. As inflation ravaged the United States economy in the 1970s, the utility of financial reporting was seriously challenged. Concerns grew about the veracity of earnings reports containing inflation holding profits, the realism of corporate balance sheets, and the perverse effects of inflation on managers' decisions on capital allocation and dividend policy.
The Financial Accounting Standards Board (FASB) responded to the task of making financial reporting relevant to the investing public. Established in 1973, it began working toward a new inflation accounting standard in the following year, and issued a final product by the end of the decade. Statement No. 33, Financial Reporting and Changing Prices, was a bold experiment in financial reporting. It required disclosures never made in financial statements before, such as income adjusted for general inflation effects, purchasing power gains or losses on monetary items, and replacement cost information. The disclosures were not part of the basic financial statement package, but they were included in annual report supplementary information instead. The FASB released the standard with the promise of a comprehensive review of its provisions no later than five years after issuance.
The rest of the story needs no elaboration. Inflation's back was broken by the Federal Reserve several years after the standard became effective in 1980, making the experimental disclosures irrelevant. FASB completed its five-year review with the abolition of the standard.
The lesson here is not that Statement No. 33 was a tremendous missed opportunity. Rather, the importance of the standard is that the FASB responded to a widespread need for improved financial information with as much speed as it could muster, with inventiveness, and with boldness. Requiring the disclosures as supplementary information created a safe harbor for auditors and hastened the standard's issuance, rather than putting the Board in the position of dithering for years about including the information as part of the basic financial statement package. It afforded the Board an opportunity to learn how investors used information that might not be perfect, and to use that feedback to develop an improved standard. Alas, diminished inflation made that unnecessary.
Contrast the FASB of the late 1970s with the FASB of recent years when it comes to responding to unmet investor needs. In 2001, the FASB considered a proposal for adding information about unrecognized intangible assets to its agenda.4 After 20 years, the only place in the FASB agenda where unrecognized intangible assets appear is in the “research” section—quite far from the standards setting part of the Board's agenda. In terms of the FASB's priorities, research items have never rated speedy action.
Times have changed and intangible assets are critical for many of the largest companies in the world. Regardless, the lack of information doesn't help promote effective capital allocation within the overall economy. It is an urgent project worthy of the FASB's experimentation, perhaps in the same “supplementary information” fashion as in its approach to inflation.
Why can't today's FASB accelerate a project on information about unrecognized intangible assets? Why can't it take on the wide issue of financial statement presentation, incorporating better segment information, accruals information, and improvements in cash flow reporting? I don't think there's a good reason they can't. Today's FASB is better-funded and better-staffed. It needs the willpower—the mojo—to take on these projects.
It's true the FASB has tackled wide-sweeping projects in the last seven years on revenue recognition, lease accounting, and credit losses. All of those standards, however, can trace their genesis to the now-defunct program of convergence with International Financial Reporting Standards in the early 2000s, a program which was effectively imposed on the FASB by the Securities and Exchange Commission. Those standards were brought to completion with the most copious transition and adoption guidance ever executed by the FASB, resulting in numerous modifications to each original standard as the FASB listened and learned.
While the FASB labored mightily on these three standards, it never seeded the agenda with any similarly profound projects—and keep in mind that those projects emanated more from the SEC than from the FASB. Given the length of time it takes the FASB to complete major projects, it should have been important for them to seed the agenda with new ones while they were undertaking these three efforts.
Instead, the FASB pursued an agenda of minutiae: its “simplification” program. In the eight years from mid-2013 to July 2021, the FASB issued 124 Accounting Standards Updates (ASUs); about 30 percent of them related to “simplification” efforts, codification improvements, practical expedients, technical corrections, or delays for implementing standards. Another 19 percent of the total ASUs were adoptions of Emerging Issues Task Force Consensuses, usually narrow in scope and usually added to the FASB agenda to address preparer concerns. ASUs addressing the needs of not-for-profit entities composed another 5 percent of the total output. ASUs issued for meeting the needs of private companies, as determined by the Private Company Council (PCC), amounted to another 4 percent, leaving about 42 percent of the ASUs issued during this period as stand-alone FASB projects that should have related primarily to publicly traded companies for the benefit of the investing public.
FASB's simplification efforts were narrow projects resulting in reporting relief for financial statement preparers, dealing with such limited topics as presentation of debt issuance costs, inventory measurement, accounting for income taxes and goodwill impairment testing. Had the FASB been truly ambitious and bold in its efforts to simplify accounting, it would have tackled the multitude of measurement and presentation choices that are available within the accounting literature. Apart from the benefit plan reporting choices already mentioned, choices exist in the presentation of restructuring charges, share-based payments, and cash flow statements to name just a few other examples. If comparability could be improved among all financial statement issuers, capital allocation would be improved within the entire economy.
Instead of going big on simplification, the FASB chose to go small—an opportunity squandered. A factor that may have pushed them in the “small” direction was the creation of the PCC in 2012. It may not be mere coincidence that the FASB's recent output focused on simplification as the PCC grew its own muscle.
The PCC was ostensibly created with two responsibilities. From the Financial Accounting Foundation report establishing the PCC:
First, the PCC will determine whether exceptions or modifications to existing non-governmental U.S. Generally Accepted Accounting Principles (U.S. GAAP) are required to address the needs of users of private company financial statements. Second, the PCC will serve as the primary advisory body to the Financial Accounting Standards Board (FASB) on the appropriate treatment for private companies for items under active consideration on the FASB's technical agenda.5
The PCC functions almost like a standard setter of its own within the FASB. According to the PCC's page on the FASB website:
The PCC will review and propose alternatives within GAAP to address the needs of users of private company financial statements. The PCC will vote on proposed alternatives, which must be approved by a two-thirds vote of all PCC members.
Proposed alternatives to GAAP approved by the PCC will be submitted to the FASB for a decision on endorsement. If endorsed by a simple majority of FASB members, the proposed alternatives will be exposed for public comment. Following receipt of public comment, the PCC will consider changes to the original decision and take a final vote. If approved, the final decision then will be submitted to the FASB for a final decision on endorsement …
For projects under active consideration on the FASB's technical agenda, the PCC will advise the FASB about the implications for private companies. The PCC will work actively and closely with the FASB during its deliberations on projects for which the FASB and/or the PCC believe the private company perspective is important.6 (emphasis added)
This is an incredible amount of involvement for the private company constituency; it's practically a live seat at the standard-setting table for private companies. Yet there's even more integration into the FASB's processes. Again, from the same PCC page on the FASB website:
The FASB Technical Director will assign specific members of the FASB's technical and administrative staff—some of whom will be dedicated, some of whom will be assigned as needed based on their specific technical expertise—to support the PCC. In consultation with the PCC Chair, the FASB Technical Director will identify additional technical staff with specific subject area expertise for particular agenda projects as determined necessary. The assigned FASB technical staff provides assistance and support to the PCC that includes, among other things, the following:
Performing research and outreach
Preparing and providing appropriate reference and background materials
Identifying various stakeholder views
Developing possible alternatives for consideration in addressing technical issues
Participating in meeting discussions
Analyzing and summarizing public comments and other stakeholder input
Drafting due process documents.
While the FASB has staff dedicated to investors and sponsors outreach programs for them, investors don't have it quite this well. Furthermore, public company investors are unlikely to realize the extent to which the tapeworm-like PCC saps FASB resources away from projects that would benefit them. If public company investors are digging into FASB activities at all, they are probably not going to spend their time learning about the projects and processes of something called the PCC, and so remain ignorant of its effects on the work the FASB could otherwise do for them.
Given the apparent effect this body has had on standard-setting in the United States, it might be a suitable time for a complete review of the PCC. It was created nearly ten years ago and has had little reevaluation since then. It underwent a three-year review in 2015 which resulted in the establishment of working groups within the PCC for active FASB projects; mechanisms to increase the transparency of the PCC's discussions and views; and the creation of a PCC Technical Agenda Consultation Group. In 2019, the Financial Accounting Foundation trustees increased the maximum length of a PCC member's second term from two years to three years. There has been no apparent review of the PCC's effect on standard setting, ever.
Private companies are not all corner barbershops and florists. In today's world, a private company may be owned by a private equity firm and is likely to be a very substantial company. As the private equity world continues to grow and develop, and private companies contained in the portfolios of these firms are traded back and forth among participants, one might be entitled to wonder just how much relief is needed from large public firm accounting standards—if it's needed at all.
Before the PCC came into existence, the FASB issued accounting standards primarily for the benefit of investors in publicly traded companies, and such standards applied to private companies as well. The standards flowed downward: standards that applied to large publicly traded companies did not always apply to private companies, but the companies with the greatest exposure to investors set the tone for all of the corporate world. With the coming of the PCC, the model seems to be reversing: the private companies standard-setting agenda is working its way into the public company agenda, evidenced by the simplification output in the last eight years. The FASB's current re-examination of the goodwill impairment model and the possible reintroduction of goodwill amortization is another direct contamination of the public company agenda by the private company agenda.
The question remains: Can the FASB regain its mojo? Or has the PCC, with its fixation on simplification which seeped into the FASB's agenda, dealt it a death blow after the IFRS convergence effort weakened the FASB's attention span? It matters, and not just because public company investors might feel jilted. Like it or not, the FASB is in competition with the International Financial Reporting Standards of the International Accounting Standards Board (IASB). While it's unlikely that many countries around the world will further adopt our accounting standards, FASB standards will affect capital raising and the cost of capital in the United States. The IASB literature is still not as comprehensive as FASB's literature and is still evolving—and the IASB standards are still being adopted around the world. If the IASB standards develop to the point where the information they provide will lower the cost of capital for issuers elsewhere in the world, then the United States' markets—and industries—will suffer.
The FASB has issued an Agenda Consultation to the public at large, in which it seeks input on how it should allocate its resources for agenda projects, with comments due to the Board by the end of September. Once the Board evaluates those comments and charts its course, it should reveal whether the Board intends to regain its mojo—or if it intends to pursue the minutiae of simplification for more untold years. Academics can help the FASB regain its mojo through their research. I have found academic research interesting and useful in the area of intangible assets, which the FASB has long neglected. Yet this research hasn't prodded them into convincing action. What additional research could be done to get them to act in this area? Coming from another direction: could there be research that quantifies the decision usefulness effects, or a lack thereof, from their recent efforts? Additionally, can academic research demonstrate greater investor utility derived from improved cash flow statements and accruals information? Can academic research demonstrate a link between attention given to private companies and a change in investor attitudes toward public company financial reporting?
The academic community is always looking for fresh topics to study. It's time to search for research issues that can help the FASB regain its mojo.
See “Stock Compensation Expense, Cash Flows and Inflated Valuations,” by Sanjeev Bhojraj: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3503684
See “Equity Investing in the Age of Intangibles,” by Amitabh Dugar and Jacob Pozharny, Financial Analysts Journal, Second Quarter 2021: https://www.cfainstitute.org/en/research/financial-analysts-journal/2021/0015198X-2021-1874726
See “Proposal for a New Agenda Project: Disclosure of Information About Intangible Assets Not Recognized In Financial Statements”: https://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175819439149&blobheader=application%2Fpdf
See “Financial Accounting Foundation Board of Trustees: Establishment of the Private Company Council, Final Report”: https://www.accountingfoundation.org/cs/ContentServer?site=Foundation&c=Document_C&pagename=Foundation%2FDocument_C%2FDocumentPage&cid=1176160066778