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Reflections on Changes in the Financial Reporting Environment

Larry Smith, CPA

The following is taken from remarks made at the end of a speech Larry Smith made on September 21, 2016, at the AICPA's 2016 National Conference on Banks and Savings Institutions in Washington, D.C. At this point in time, FASB has completed many of the major projects it has been working on for the past decade. In light of that unique position, and, realizing that this was probably the last of his major speaking opportunities, Smith decided to dedicate the final part of his talk to his personal views of the current environment of financial reporting, how things have changed over his 15 years at FASB, and how those changes should, in his view, influence the board's priorities going forward.

I've decided to end my talk today with some final reflections following almost 15 years in standards setting, since I now have less than 10 months left until they throw me out of my office in Norwalk.

The financial reporting world is markedly different than when I left public accounting to join FASB as a staff director and EITF [Emerging Issues Task Force] chair over 14 years ago. Enron and WorldCom had just occurred; FASB was in the process of receiving comment letters on its original proposal to interpret ARB 51 regarding the consolidation of special purpose entities, which eventually became FIN 46; Sarbanes-Oxley [Act of 2002] was being debated in Congress, and the PCAOB did not exist; the infamous “Norwalk Agreement” between the IASB and FASB did not yet exist; and the Accounting Standards Codification was considered a fool's dream by many in Norwalk.

A lot has happened since then. Much of my nine-plus years as a board member has been spent addressing issues that were added to our agenda when it appeared as if we might be moving towards the adoption of IFRS. The movement to IFRS was thought to be inevitable by some at the time, yet as we all know, at least for the foreseeable future, that is no longer the case.

Critics might then question whether FASB was misguided in addressing the agenda topics established during our push for convergence. I would answer those critics by saying, “Absolutely not.” A world of financial reporting in which the standards are closer than they used to be is an improvement in worldwide financial reporting. While you may not agree with some of the individual conclusions in all of the standards we've issued, it's time to move on.

We have completed, or have made significant progress on, many of the major projects that have faced us over the last 10 years. Revenue recognition, financial instruments, credit losses, and leases—they're all done. And we've proposed a significant improvement in hedge accounting and will soon be proposing an improvement in long-duration insurance accounting. Despite this, there are still some significant challenges facing FASB in the future, and some of those challenges cannot be solved by FASB on its own, for they relate to challenges created by changes in how financial information is being reported.

Various changes in the financial reporting environment lead me to this view. I'm going to mention just a few so you understand where I'm coming from, and they are in no order of importance, nor are they necessarily interrelated. First, the length of financial reports in the United States is out of control. I recently printed the 10-Ks for three major financial institutions, and the average size of them was about 450 pages. Do we really believe people are using, or even reading, all of that information? I read recently that the size of a typical 10-K filing today is over 10 times the length of a typical 10-K filing in the 1950s. The person who cited this increase posed this question: “Is business today really 10 times more complicated than it was back then?”

Several years ago, we added the disclosure framework project to our agenda, which has the objective of ultimately adding a chapter to our conceptual framework that addresses how the board should think about disclosures for specific topical projects. While we clarified that the objective of the project was to help improve disclosures, many people, including some board members, were hopeful that it would result in the removal of many unnecessary disclosures. We issued an exposure draft, which fundamentally consists of a series of questions for the board to consider in determining the disclosures for a specific project. Now, when these questions are evaluated in relation to a specific topic, they invariably suggest adding to existing disclosures and rarely suggest deleting any disclosures. At least that is what has happened to the four areas of accounting for which we have tested the proposed framework: fair value, pensions, income taxes, and inventory. But when we evaluate those additions together, along with all of the existing GAAP disclosures, it becomes apparent that the totality of disclosures is just getting more overwhelming. Bottom line, it's difficult to delete individual specific disclosures. The challenge to FASB is to find a better way to evaluate the totality of disclosures. For example, should we work on the development of disclosure objectives and then let the individual companies determine the specific disclosures to meet those objectives, or does this introduce too much optionality and variability in the types of disclosures companies will make?

Critics might question whether FASB was misguided in addressing the agenda topics established during our push for convergence. I would answer by saying, “Absolutely not.”

Some people might suggest that we should not worry about the totality of disclosures, which many today characterize as “disclosure overload.” After all, if a disclosure is helpful in understanding the particular amount or issue to which it relates, it should be required, shouldn't it? And, if an investor is not interested in the information embedded in a required disclosure, he or she can just ignore it. Yet isn't there a point at which the volume of disclosures for a particular company gets so large that it actually detracts from an investor's ability to analyze the financial statements?

The second major change in the financial reporting environment is the focus of auditing. Through the influence of Sarbanes-Oxley and the PCAOB, auditing has evolved significantly from where it was when I signed audit opinions. Today, there is much more emphasis on internal controls over financial reporting. The evolution in how those internal controls are designed, documented, and tested has resulted in dramatic improvements in the efficacy of internal controls. A major challenge facing FASB is how it should factor that change into its consideration of costs and benefits of proposed new accounting standards. Does the auditor's focus on internal controls open up new areas of financial reporting outside of the basic financial statements, for which FASB should consider developing standards? And if yes, should that influence the PCAOB's agenda as well?

Third, users focus on and react to interim disclosures of financial information that companies distribute well before financial statements are issued through the filing of Form 10-Q or 10-K. It appears that the financial statements included in the 10-Q or 10-K are effectively confirmatory in nature; that is, they serve to confirm the information included in investor packages released well before the regulatory reports are filed. Based on my discussion with preparers, the information included in these investor packages comes from the same systems, and is therefore subject to similar, or the same, systems of internal controls that exist in the preparation of the audited financial statements. Should there be any standardization of the interim information that currently is voluntarily released to investors? Again, should there be any ramifications for the PCAOB's agenda?

Isn't there a point at which the volume of disclosures for a particular company gets so large that it actually detracts from an investor's ability to analyze the financial statements?

Fourth, the reporting of financial information digitally has progressed significantly over the past 10 years, and it will continue to progress such that users of financial information will increasingly focus on tidbits of information, rather than the financial statements as a whole. This is not unlike how each of us individually digests news about current events. Let's face it, how people access information today is very different from how information was accessed 30 years ago, and it will continue to evolve in the future. This is equally true for information about a company's financial position and performance. How should FASB evaluate the fact that investors really don't digest a set of financial statements from start to finish? Are there standards-setting implications of investors' focus on just tidbits of information rather than the financial statements as a whole?

The next change in the financial reporting environment is the professionalization and specialization of investors. I've learned a lot about this from my fellow board member Hal Schroeder since he joined the board over five years ago. While Hal and I may disagree at times on individual technical issues, he's caused me to pause and consider just how financial information is digested by the investor community. Ignoring these developments creates, in my view, greater challenges to FASB in terms of the types of standards it should be issuing in the future and what the focus of those standards should be.

Finally, the proliferation of non-GAAP disclosures should cause FASB to step back and look at the big picture of financial reporting to see what, if anything, can be done to address the fundamental cause of their use. I have not always been of that view. Our own FASAC [Financial Accounting Standards Advisory Council], several years ago and again a few days ago, advised us not to worry, that the use of non-GAAP disclosures was not a reflection of shortcomings or failures in GAAP. After all, we live in a country where freedom of speech is a fundamental right. My concern is that there are non-GAAP measures being reported that, on their surface, appear to be comparable measures, when in fact there are differences in their composition which in turn makes comparisons difficult. Furthermore, the use of non-GAAP to present anti-GAAP, that is, measures different from GAAP because the issuer disagrees with the GAAP measure, is a concern that needs to be addressed.

For example, there is one tech company that presents its earnings excluding charges related to stock compensation, and it justifies that practice because GAAP permits the use of different methodologies to calculate the amount of stock compensation, thereby, in this company's view, rendering any comparison of earnings among companies misleading. Well, I can cite numerous measurements in GAAP that permit the use of different measurement methodologies. So shouldn't they all be excluded from the final anti-GAAP number? I mean, look at CECL [current expected credit loss]. We don't prescribe how to do the estimate, so then should all financial institutions report their earnings without the charge for bad debts? Or should the balance sheet be presented without the allowance for doubtful accounts? I'm sorry, but to me, there's a difference in presenting a non-GAAP number that excludes certain infrequent or unusual charges and presenting an anti-GAAP number that just says “the heck with GAAP.”

I am encouraged by the SEC staff's recent guidance that may result in a reduction of anti-GAAP reporting measures. But there still remain challenges in the lack of comparability that may exist between non-GAAP measures that have captions that appear very similar. Is this an area FASB should address, and, if yes, how?

FASB's mission statement says that our mission, and I quote, “is to establish and improve standards of financial accounting and reporting that foster financial reporting by nongovernmental entities that provides decision-useful information to investors and other users of financial reports.” In my view, the term “financial reporting” as used in the mission statement is not just referring to standards for the preparation of financial statements. I believe it is referring to how an entity reports its financial status and results to investors, regardless of the vehicle through which such information is distributed. I believe the challenges facing FASB cannot be solved by FASB alone. It's time for the various parties—that is, the SEC, the PCAOB, the AICPA's Auditing Standards Board, and FASB—to put their heads together to critically evaluate how entities are disseminating financial information, what users use to make investment decisions and how those decisions are made, and whether changes to our existing financial reporting system are warranted.

I don't have the answers, for I haven't concretely defined just what the fundamental problems are. That would be the first issue this group would need to attack. But I think it's time for the various regulators/standards setters to collectively think out of the box.

I'll just throw out one potential change; many of you might cringe when you hear it. But, if my assertion is true—that many of the real investment decisions are being made well before the financial statements are available, and that those statements are basically just a confirmation of what investors already know—then why isn't audit work of some sort being performed on the information investors are using? Remember what I said earlier about the increasing emphasis on internal controls over financial reporting? Well, perhaps the auditor could issue a simple report indicating that the amounts appearing in the package of information provided to investors before the financial statements are filed are subject to the same internal control system applied in the preparation of the financial statements, which is subject to an annual audit. And, let's think out of the box a little more—and this one some of you actually may like—if we find that the regulatory filings are really just of confirmatory value, perhaps the SEC can consider loosening the timing of the required filings to take some of the pressure off the system, or go even further and just require one semiannual interim report.

The proliferation of non-GAAP disclosures should cause FASB to step back and look at the big picture of financial reporting to see what, if anything, can be done to address the fundamental cause of their use.

Of course, that then raises other questions, such as, will standards be necessary to address whether there should be required minimum information that is included in those investor packages? If yes, what should that information be? Are all non-GAAP measures that meet current SEC rules acceptable, or are more stringent rules required? Are anti-GAAP measures appropriate? Should FASB “standardize” some typical non-GAAP measures so they are comparable from entity to entity? And the list goes on and on.

The point is, these are the types of issues I believe should be addressed, yet they can't be addressed by FASB by itself. Our financial reporting system is like a four-legged stool, with the SEC, the PCAOB, the ASB [Auditing Standards Board], and FASB being the four legs. All four legs must work together to address these issues.

The former chairman of Deloitte, who for over 10 years has been an audit committee member for major corporations, frequently describes the financial statements as the “caboose” of the financial reporting train—the implication being that all of the “important” cars precede the caboose, and that after the rest of the train passes, there is little interest in that caboose. I believe there is some real truth to this metaphor, which is why I think something needs to be done. To me, other than liabilities and equity, these are the important issues and challenges that face FASB after I leave.

Larry Smith, CPA is a FASB board member. He is currently the board's point person working with the Transition Resource Group formed on FASB's new rule on credit losses/impairment of financial instruments.

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