POLICY - Extreme Makeover

Accounting rulemakers are revamping how companies present financial reports. Will investors benefit?

Financial statements are the lifeblood of capital markets. Companies seeking to raise money from investors must disclose their true financial condition so the market can properly value their securities. But too often the 10-Qs and 10-Ks that companies churn out are imperfect, subject to everything from subtle spinning to outright manipulation by savvy managers.

Accounting regulators are trying to do something about that. The U.S. Financial Accounting Standards Board and the International Accounting Standards Board are about to undertake a major overhaul of corporate financial statements. The goal: to present a broader, clearer and more detailed view of corporate performance that is less subject to obfuscation, be it purposeful or inadvertent.

“The aim is to reduce the flexibility that companies have in presenting their financials and improve the consistency of financial statements,” says FASB chairman Robert Herz.

Officials have yet to settle on specific proposals, but one possibility they will explore is forcing companies to classify all items under three broad headings: operating, financing and investing. Cash flow statements already are broken down that way; FASB may extend the scheme to the two other components of financial reports -- the balance sheet and the income statement. Another option is to force finer disclosure of broad line items, such as “cost of sales” and “selling, general and administrative” expenses. Taxes would be relegated to a separate section, so the main financial statements would deal with pretax numbers.

One potential consequence is that investors, with so much additional information at their disposal, might deemphasize traditional valuation benchmarks like net income -- a long-standing barometer of financial health that is subject to both misinterpretation and manipulation. Net income could become more frequently used in conjunction with other metrics, such as operating cash flows, to provide investors with a more complete picture. “This project offers the possibility of spreading investors’ attention beyond just net income,” says Gregory Jonas, head of the accounting specialists group at Moody’s Investors Service. “It will be controversial.”

Presenting alternatives to earnings per share and more clearly separating nonoperating items from those directly related to everyday business might also encourage investors to consider long-term performance and prospects instead of what has happened in any given quarter. That, in turn, stands to change corporate behavior, removing the incentive for executives to actively manage earnings.

Much about the overhaul is up in the air. FASB plans to release preliminary proposals in the third quarter for public comment. Those recommendations will likely change, following two more drafts and rounds of comments. New rules will come in 2009 at the earliest. Regardless of how the current proposals evolve, financial statements will look very different.

“It would drastically change what people are used to,” says Christine DiFabio, director of technical activities at Financial Executives International, a professional organization for CFOs and treasurers. “It would definitely take a while to get used to this.”

Companies are likely to put up a fight. Some are bound to argue that additional disclosure will force them to release proprietary information, putting them at a competitive disadvantage. And many companies, already weary from costly, time-consuming postbubble reforms like the Sarbanes-Oxley Act, are likely to oppose proposals that would require even more work. One such change being explored by FASB would require issuers to produce cash flow statements by adding inflows and outflows line by line; today companies get to the same numbers simply by removing noncash items from net income. Critics say the hassle would outweigh the benefits.

“If all we do is add 45 lines to each statement, we’ve failed,” says Kenneth Kelly Jr., controller at spice maker McCormick & Co. and a member of a task force advising FASB on this project. “The objective is better information, not just more data.”