A Capital Approach for Performance Reporting
Kurt Ramin | February 18, 2016 |
Information about financial performance is useful in predicting an organization’s capacity to generate cash flows from an existing resource and capital base. Should the income statement reflect all aspects of performance reporting? This is an important question for the entire investment and stakeholder community.
It is, therefore, no surprise that projects on how to report and present financial performance have a long history, both at the US Financial Accounting Standards Board (FASB) as well as the International Accounting Standards Board (IASB).
At one time performance reporting was a joint FASB/IASB project but where do things stand now? Based on their successful joint efforts on the new revenue standard and the suggested requirements of sustainability reporting, is there an opportunity again for both boards to work together or even consider new performance reporting models?
In a recent article on the FASB website, Chair Russell Golden explained that a survey of FASB advisory group members revealed that preparers, users, and practitioners all thought financial performance reporting, pensions, and other post-retirement benefits should be top priorities for FASB. Consequently, on February 3, 2016, FASB added four financial reporting issues and two more projects to its research agenda.
The four new financial reporting topics up for research are:
- pensions and other post retirement employee benefit plans;
- intangible assets;
- distinguishing liabilities from equity; and
- financial performance reporting.
All four will be included in an Agenda Discussion Paper, anticipated from FASB in the first half of this year.
“Value is mostly determined by the income statement and the balance sheet doesn’t tell you much about the value of the company.”
That’s what IASB Chairman Hans Hoogervorst said in a November 2015 webinar, Accounting for the Future, with the Association of Chartered Certified Accountants.
There are reasons for this thinking: intangibles and weightless assets are now the major components of market capitalization for a large number of entities. Physical objects are becoming software code (software imbedded in products, 3D printing, the Internet of Things, etc.). Just-in-Time outsourcing and electronic payment systems are reducing working capital. In addition, long-lasting accounting debates on debt versus equity definitions, currency translation, inconsistent discounting and valuation methods, netting and deferred taxes, and the use of various presentation formats for the balance sheet did not help the “image” of the balance sheet either. Under the new lease standard, IFRS 16, it is now possible that the same identifiable asset (object) appears on the lessors as well as the lessees books as an asset. If this was done for other assets, we certainly would have a rich world. This is another reason to focus on object tracking and avoiding double counting and the misleading of economists and statisticians.
Currently, both FASB and IASB, are proud of their mostly converged standard, Revenue from Contracts with Customers (Topic 606 and IFRS 15), to be implemented by 2018. (The IFRS standard is effective for annual periods beginning on or after January 1, 2018. The FASB has a slightly more detailed revised implementation date provision.)
The revenue standard is an important milestone for better performance reporting and it will be interesting to watch how it is applied by various industries and supply chains. One of the main features of this product and service related revenue reporting standard is to focus on separating objects (i.e., contracts) from value (price) during the assessment using the five step model (“separate performance obligations”) outlined in the revenue standard.
The revenue recognition standard is a good starting point for continuing work by both standard setters on a new financial performance reporting standard (now called Primary Financial Statements by the IASB). The original idea for this standard was to integrate the reporting format along the lines of the direct presentation version of the cash flow statement (operating, investing, and financing). Now there are less clear objectives for a new performance-related standard. Hopefully, with further work, the standard setters will then use the opportunity to request improved reporting on people-related expenses—from salaries and benefits to share-based payments and travel expenses—supporting the unstructured reporting and disclosure requirements by various regulators, voluntary non-financial reporting standards, and management comments (Such as, “People are our most valuable assets”).
During the 32nd session of the UN Conference on Trade and Development (UNCTAD) Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (ISAR) at the beginning of November in Geneva, I had the opportunity to present my own thoughts on a new model—the Ramin-Lew model—for performance reporting. The chart below provides an overview of the proposal, as does an academic article in the Journal of Sustainable Finance & Investment.
The key feature of the model is separating objects and value for three object classes (products, people, and physical infrastructure, which we are calling 3Ps). Through various technology advancements, the tracking, recognition, and identification of objects is now possible, compared to a couple of years ago. If we know where objects are all the time, we need less value-based control mechanisms. This opens the door for a new approach and paradigm change in performance reporting.
Simply stated, the focus is on cash flow for a period and add or deduct accounting estimates (accruals) to reconcile to financial data. Data not covered by the 3Ps (e.g., taxes and deferred taxes) will be part of owner’s equity. Using a matrix presentation, we then forecast data using the same principles (3Ps and financial reconciliation). For most entities, the 3Ps cover 70-90% of the data and everybody understands at least products, people, and physical infrastructure.
The disclosure section on the data aligns the 3Ps for past and future information and comments on 3P related information, intellectual capital (intangibles), social and relational capital, and other material items, including risk assessment. The focus is clearly on sustainability performance (see the work of the Global Reporting Initiative and the Sustainability Accounting Standards Board) and not just on financial performance. This makes information more comparable on an entity and industry basis.
The proposed model focuses on entity reporting, including segments or industry data. Each entity has to define their own objects within the 3P taxonomy and can create 3P subclasses. This is similar to allowing extensions in an XBRL taxonomy. A definition and description of the business model along the lines of a Management Discussion and Analysis or management commentary should introduce general information about the entity. Entity identification and entity information repositories are important for making information accessible and keeping it transparent. For additional information, see the work of the Global Legal Entity Identifier Foundation and the global enterprise registration efforts.
Small- and medium-sized entities (SMEs) are ideally suited to apply the proposed model: they usually don’t have a complex product flow, have only a small number of employees, and usually have a service-related physical infrastructure. [We are currently looking for SMEs that are interested in further field-testing of our model—please let me know in the comment below if you’d like to help us!]
It is expected that larger companies will face considerable IT challenges implementing the new revenue standard. This might be an opportunity to take a look at the 3P model at the same time.
Separating objects from valuation will strengthen valuation standards and have a positive and overarching effect on the accounting, valuation, and audit profession. New skill sets will be required to consult on object tracking and understand an enlarged set of integrated capitals. These profiles already exist in entities that perform due-diligence work, management audits, fraud investigation and dispute services, and “agreed upon procedure” assurances and other advisory services.