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By Larry Smith
Larry Smith is a Senior Managing Director in FTI Consulting’s Forensic & Litigation Consulting segment serving as a member of FTI Consulting’s National Office, consulting with engagement teams and clients on complex accounting issues and as a testifying expert in litigation matters involving the application of GAAP. On June 30, 2017, Larry completed his second five-year term as a member of the Financial Accounting Standards Board.
From 2002 to 2017 I had the pleasure of working as a technical director and a Board member at the Financial Accounting Standards Board (FASB). During that time, the Board worked on a number of significant projects.
This article focuses on one specific project, performance reporting, and the recent Board decision about the direction of that project and its relationship to a current significant topic in financial reporting, non-GAAP performance measures.
Financial performance reporting is not something that FASB only recently considered as an area of generally accepted accounting principles (GAAP) requiring improvement. It has been the subject of various agenda and research projects for well over 15 years, including joint efforts with the International Accounting Standards Board (IASB).
In October 2008, FASB and IASB issued a Discussion Paper that asserted the wide array of reporting formats that are permitted under both GAAP and international financial reporting standards (IFRS) impede the ability of users to compare financial statements of different entities. Additionally, the paper asserts that the lack of specific guidance about the level of detail that should be presented in financial statements “creates difficulties for users who want to understand and analyze an entity’s activities.”
Among the various sweeping changes proposed in the Discussion Paper was the requirement to disaggregate information so that it is useful in assessing the amount, timing, and uncertainty of an entity’s future cash flows.
One potential way to disaggregate information discussed in the paper is to disaggregate functional information into its natural components.
For example, “selling, general, and administration” expense would be broken out into its natural components such as payroll costs, supplies, utility costs, depreciation, etc. Of course, even the “natural” components I listed can be divided further.
For example, payroll costs can be broken down into salaries, pension, vacation, etc. And, each of these can be broken down further, by types of employees, into permanent, temporary, exempt and non-exempt, etc. One person’s interpretation of a “functional” item can very well be the next person’s interpretation of a “natural” item.
More than 200 comment letters on the Discussion Paper were received from constituents across the globe. Financial statement preparers, in addressing the requirement to disaggregate functional expenses by nature, questioned the importance of the resulting information since, in their view, they don’t use that information to manage their businesses, and they currently lack the systems to enable them to compile such information. Consequently, a requirement to report such disaggregated information could be very costly to implement.
FASB and IASB considered the feedback received from the comment letters as well as from other outreach to constituents in response to a staff draft of final decisions. Both boards then reassessed their respective agendas (at the time they were jointly deliberating major projects on revenue recognition, financial instruments, leases, and insurance) and decided that the project on Financial Statement Presentation was a lower priority.
Eventually, FASB took the project off of its active agenda; yet the project didn’t die. Instead, FASB renamed it “Performance Reporting” and placed it on its “research” agenda. Unlike some projects on the research agenda that receive little attention, two staff people were dedicated to research performance reporting issues.
The staff evaluated a variety of potential ways to improve how companies report their performance, including defining operating income, changing the fundamental structure of the statement of income, and requiring different aggregated sub-totals in reporting comprehensive income.
The staff also explored different ways the income statement can be disaggregated, including the disaggregation of infrequent and unusual items and functional amounts into their natural components. Additionally, to gain insight as to what investors want and currently use, the staff evaluated what many companies are disclosing as “non-GAAP” measures.
The topic of non-GAAP reporting has received much attention in recent years as the use of non-GAAP measures has increased substantially. It is generally acknowledged that companies resort to the use of non-GAAP measures because these measures allow management to report a company’s performance through the eyes of management. There have been numerous studies about the use of non-GAAP. Many reports suggest that the primary types of non-GAAP adjustments relate to the exclusion from performance measures items that are considered non-operating and items that are considered nonrecurring.
With that in mind, one might have expected FASB to add a project that would have defined either (or both) operating income and infrequent and unusual items (beyond the existing definitions). However, that is not what the Board decided. While I haven’t spoken to FASB members since their agenda decision, I believe I understand why they didn’t choose to address either a definition of operating income or infrequent items. As a part of the research project on performance reporting, the Board explored each of these in great detail during my last three years at FASB. During that time, no consensus could be reached by FASB members on either a definition of operating income or on setting parameters for defining what is infrequent or unusual. I suspect that, when asked to make an agenda decision, the Board saw the handwriting on the wall in terms of its inability to reach any consensus about these terms. So, instead, in September 2017 the Board decided through a 4-3 vote to add a project to require disaggregation of functional lines into their natural components. Even when voting to add that project, some Board members acknowledged that the project may result in further disaggregation of only one to three lines in the income statement: selling, general and administrative costs, cost of sales, and research and development expense.
In my view, I believe this project could further delay any significant improvement in financial reporting for another two or more years.
First, there appears to be lukewarm support for the project on the part of the FASB members. Two of the Board members who voted to add the project indicated they had significant concerns about the potential cost to preparers to provide such information, because their systems are not geared to gathering information about the nature of expense items. Another Board member who voted to add the project warned that he didn’t believe it would be possible to disaggregate cost of sales by the nature of the cost. He suggested that any “cost” that was previously an asset (be it, depreciation for self-constructed assets or cost of sales for inventory) will be very difficult to disaggregate into the natural components of that cost. So, three of the four FASB members who supported adding the project voiced significant reservations about it prior to having any substantive deliberations about the topic.
Perhaps more important than the concerns about the cost to disaggregate functional lines into their natural components are my concerns that, even if it was possible to provide the information in a cost-effective way, does that information supply what the users of financial statements really want? As discussed earlier, most companies are now reporting non-GAAP financial information, and, many of those non-GAAP measures seek to remove non-recurring items and items that are considered as non-operating. Many non-GAAP measures are being reported in response to requests from users of financial statements. Does breaking out a functional line into its natural component address the real needs of users of financial statements?
So, what then can FASB do? I already indicated that the Board (at the time) seemed to acknowledge that trying to define what is operating, or what is infrequent and/or unusual, would be an exercise in futility. Some have suggested that FASB should expand the scope of guidance it issues to address information that is disseminated outside of financial statements. To date, FASB has written standards that relate only to items included in financial statements, yet clearly financial reporting goes well beyond what is reported in financial statements. Some people have argued that financial statements merely confirm or corroborate information that has already been reported publicly through press releases and investor packages. If that is true, should FASB get into the business of issuing standards on non-GAAP measures, effectively rendering them to be another measure, or level of, GAAP? But then, if the FASB couldn’t agree on defining operating and infrequent before, what are the prospects of it being able to agree on commonly used non-GAAP measures? Having sat through many Board meetings, the issues that will need to be addressed for many non-GAAP measures are not dissimilar to those the Board struggled with when it discussed its alternatives in the performance reporting project.
In May 2016, the Securities and Exchange Commission issued updates to its Compliance and Disclosure Interpretations regarding the use of non-GAAP measures. The updates were issued to better ensure that non-GAAP measures are not being used in a manner that could be misleading to their users. The attention drawn to the use of non-GAAP measures as well as the interpretive guidance issued by the SEC has changed the landscape of reporting non-GAAP measures. It appears that there is much more attention devoted to the use of non-GAAP measures than before the issuance of the SEC’s interpretive guidance. So then, is the problem solved?
I say no. I believe there may be a role for FASB to define what is in, and what is not in, certain common non-GAAP measures, to better ensure consistency in their use. Now, I realize that this will not prevent companies from reporting adjustments to those measures, effectively creating a non-non-GAAP measure; but at least there may be greater clarity of the differences in the use of the starting point for measures that appear to be the same today based on what they are called.
I also believe there is an important role for the Public Company Accounting Oversight Board, which has acknowledged this through the creation of a research project to address the “Auditor’s Role Regarding Other Information and Company Performance Measures, including Non-GAAP Measures.” One potential path for this project would be to require the auditor to extend its report on internal controls to the controls around the creation of non-GAAP measures and/or information that is included in press releases and related information included in investor packages, thereby extending some credibility over information that is reported outside of the financial statements.
I have argued elsewhere that it is time for FASB to team up with the SEC, the PCAOB, as well as the Auditing Standards Board of the American Institute of CPAs, to consider what changes, if any, should be addressed by the various standard setters and regulators responsible for overseeing our financial reporting system. Quite frankly, given recent changes in: (1) how financial information is reported (electronic versus paper, press releases and investor packages versus complete financial statements, non-GAAP based vs. GAAP), (2) how financial information is being consumed (reliance on key measures or specific aspects of financial information vs. reading complete financial statements) and (3) how investments are managed (quants vs. fundamental analysis), I believe a comprehensive study should be performed to determine what information is actually being used to make investment decisions, and then evaluate what implications the results of the study have on our financial reporting system. But that is a topic for another article.
In my view, FASB should use the information it has learned from studying the use of non-GAAP measures to either address directly what it can do and/or influence other standard setters and regulators to pursue courses of action that can be of greater benefit to users of financial statements. This can be achieved by improving the clarity and comparability of information through more standardized definitions of commonly used measures or through standards that enhance the credibility of that information.
The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
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