Financial Statements: Who's In Charge?
By David Harper
In the United States, a company that offers its common stock to the public typically needs to file periodic financial reports with the Securities and Exchange Commission (SEC). We will focus on the three important reports outlined in this table:
|Filing||Includes||Must be filed with SEC|
|10-K Annual Report||Audited financial statements, management discussion & analysis (MD&A) and schedules||Within 90 days of fiscal year end (shortens to 60 days for larger companies, as of Dec. 15, 2005)|
|10-Q Quarterly Report||Unaudited financial statement and MD&A.||Within 45 days of fiscal quarter (shortens to 35 days for larger companies as of Dec. 15, 2005.)|
|14A Proxy Statement||Proposed actions taken to a shareholder vote, company ownership, executive compensation and performance versus peers.||Ahead of the annual shareholders\' meeting, filed when sent to shareholders.|
The SEC governs the content of these filings and monitors the accounting profession. In turn, the SEC empowers the Financial Accounting Standards Board (FASB) - an independent, nongovernmental organization - with the authority to update U.S. accounting rules. When considering important rule changes, FASB is impressively careful to solicit input from a wide range of constituents and accounting professionals. But once FASB issues a final standard, this standard becomes a mandatory part of the total set of accounting standards known as Generally Accepted Accounting Principles (GAAP).
Generally Accepted Accounting Principles (GAAP)
GAAP starts with a conceptual framework that anchors financial reports to a set of principles such as materiality (the degree to which the transaction is big enough to matter) and verifiability (the degree to which different people agree on how to measure the transaction). The basic goal is to provide users - equity investors, creditors, regulators and the public - with "relevant, reliable and useful" information for making good decisions.
Because the framework is general, it requires interpretation, and often re-interpretation, in light of new business transactions. Consequently, sitting on top of the simple framework is a growing pile of literally hundreds of accounting standards. But complexity in the rules is unavoidable for at least two reasons.
First, there is a natural tension between the two principles of relevance and reliability. A transaction is relevant if a reasonable investor would care about it; a reported transaction is reliable if the reported number is unbiased and accurate. We want both, but we often cannot get both. For example, real estate is carried on the balance sheet at historical cost because this historical cost is reliable. That is, we can know with objective certainty how much was paid to acquire property. However, even though historical cost is reliable, reporting the current market value of the property would be more relevant - but also less reliable.
Consider also derivative instruments, an area where relevance trumps reliability. Derivatives can be complicated and difficult to value, but some derivatives (speculative not hedge derivatives) increase risk. Rules therefore require companies to carry derivatives on the balance sheet at "fair value", which requires an estimate, even if the estimate is not perfectly reliable. Again, the imprecise fair value estimate is more relevant than historical cost. You can see how some of the complexity in accounting is due to a gradual shift away from "reliable" historical costs to "relevant" market values.
Financial Statements: The System
The second reason for the complexity in accounting rules is the unavoidable restriction on the reporting period: financial statements try to capture operating performance over the fixed period of a year. Accrual accounting is the practice of matching expenses incurred during the year with revenue earned, irrespective of cash flows. For example, say a company invests a huge sum of cash to purchase a factory, which is then used over the following 20 years. Depreciation is just a way of allocating the purchase price over each year of the factory's useful life so that profits can be estimated each year. Cash flows are spent and received in a lumpy pattern and, over the long run, total cash flows do tend to equal total accruals. But in a single year, they are not equivalent. Even an easy reporting question such as "how much did the company sell during the year?" requires making estimates that distinguish cash received from revenue earned. For example, did the company use rebates, attach financing terms or sell to customers with doubtful credit?
(Please note: throughout this tutorial we refer to U.S. GAAP and U.S.-specific securities regulations, unless otherwise noted. While the principles of GAAP are generally the same across the world, there are significant differences in GAAP for each country. Please keep this in mind if you are performing analysis on non-U.S. companies. )
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