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DELOITTE, KEY FACTORS SHAPING FINANCIAL REPORTING: THE DECADE AHEAD

Submitted by: Ozan Karan

Deloitte & Touche LLP
Copyright 2011 Deloitte Development LLC. All rights reserved.

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In the United States and other major economies, the rst decade of the 21st century ended with a global credit crisis and a number of highly stressed or failed nancial institutions. A major concern raised by these events is the ability of nancial statements to warn users of the risks of failure, even when the statements are prepared according to current nancial reporting frameworks. It appears that nancial information provided by some institutions did not alert users of the extent to which the institutions were vulnerable, even when the information complied with applicable accounting guidance. As Hans Hoogervorst, incoming chairman of the International Accounting Standards Board (IASB), noted in a recent speech, Huge risks were allowed to build up on and off balance sheet without being noticed.1 Indeed, the reported positions of some institutions, the limited transparency regarding certain areas (as discussed in this paper), and the often incomplete portrayals of risk suggest ways in which nancial reporting might be improved. In addition, there have been calls from various quarters for increased regulation, as well as efforts to strengthen nancial reporting, for the benet of investors and other stakeholders. In this paper we explore several nancial reporting challenges and trends that have emerged over the past few years, focusing on the following three key qualitative characteristics of useful nancial reporting: Relevance: Reported information must be relevant to investors and other users as an aid in making decisions based on an entitys nancial position, performance, risks, and business prospects. Understandability: Financial reports must be clear and avoid unnecessary complexity or inconsistency that may limit the ability of users to comprehend the information. Timeliness: In todays fast-moving markets, information must be communicated quickly if it is to be useful in supporting investors decisions.

These characteristics have long been recognized as essential qualities of information that aim to support nancial, investment, and other economic decision making. Similarly, the chief objectives of nancial reporting will largely remain the sameto portray the position and performance of the entity in question so that investors in equity and debt, among other stakeholders, can make decisions based on accurate information regarding potential risks and returns. The perceived lack of relevant, understandable, and timely information may contribute to the low use of nancial reports, as indicated by a survey of investors conducted in 2008 by the Ofce of Investor Education and Advocacy of the U.S. Securities and Exchange Commission (SEC).2 The survey suggests that many investors do not actually read disclosure documents and that respondents indicated that too much legal or technical jargon gets in the way of clarity, the documents can be too long and wordy, and information is sometimes hard to nd in the reports. William Lutz, director of the SECs 21st Century Disclosure Initiative, also cited these ndings in a speech at the National Investor Relations Institute in 2009, noting that a majority of those investors surveyed never actually read the various reports.3 With all thisand the lessons of the recent pastin mind, we examine how changes to nancial reporting might help to address these challenges.

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Relevance of financial reporting

Investors and other external stakeholders want information that is relevant to the decisions they face. For investors, relevant information can help them to answer two questions: What is the expected return on an investment, and what is the potential risk associated with that return? Despite the vast amount of information included in todays public company lings and reports, this information does not always help investors to answer these fundamental questions. It seems clear that the risks associated with some of the investments and the funding strategies of some institutions were not apparent to readers of their reports. The reported information may not have been clear enough to provide users with an accurate picture of the true position of some institutions or certain information that would enable them to form such a picture may have been missing (or both). In addition, nancial statements prepared according to U.S. Generally Accepted Accounting Principles (GAAP) may not fully portray potential exposures arising from certain assets, liabilities, and transactions. For instance, rules regarding consolidation and leasing that allow for off balance sheet treatment of related assets and liabilities may generate different exposures. Finally, nancial statements measure the nancial results and position of an entity, but typically provide relatively little information regarding the drivers of value and performance. A detailed management discussion and analysis (MD&A) may provide information on those drivers. However, the MD&A is not closely governed by GAAP and it does not necessarily relate directly tonor can it necessarily be directly reconciled withthe values in the nancial statements. This can make it difcult to form judgments about future nancial results. Accounting bodies, such as the IASB and the U.S. Financial Accounting Standards Board (FASB), have attempted to address specic issues through ongoing standardsetting projects in areas such as leases, pensions, and consolidation. Also, the SEC continues to work toward enhanced disclosures in certain sections of annual reports. We expect these efforts to continue. Nevertheless, providing investors with deep insight into the operational reality of an entity may require an effort that extends beyond what is currently considered the scope of nancial reports. Many business leaders and accounting professionals want at least to clarify and, preferably, reconcile differences between performance as measured by operational metrics and by nancial reports. Many want to focus more on the information that management actually uses to run the business. This calls for clarifying the nature and purpose of performance metrics and nancial reports and the proper relationship between the two. This may also call for developing nancial reports that capture operational reality, which may entail reporting more non-GAAP and non-nancial information. For instance, measures such as economic net income are now increasingly used in nancial statement footnotes to help management get its story across.

Investors and other external stakeholders want information that is relevant to the decisions they face.
Expected return on investment To evaluate expected return on investment, investors need information that helps them to estimate future earnings and cash ows. A number of challenges may impact the usefulness of nancial reporting to investors who are making those estimates. First, the information in nancial reports is principally backward looking, with few forwardlooking elements. Second, current accounting standards use a mixed attribute model, with some elements recorded at historical book values and others at fair value. Regardless of the value recorded, some items are accounted for in ways that may not, in an analysts opinion, reect the underlying economics of an entitys nancial position or performance. Thus, to account for various accounting treatments that may affect their view of the value of the business, analysts typically make adjustments to reect their assessments of the value of items such as pensions, inventories, research and development, and certain nancial instruments.

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To what extent should nancial reporting aim to capture and present non-nancial measures? Some would argue that non-nancial information lies beyond the purview of nancial reporting and should be excluded from nancial reports, and that such information can be disclosed elsewhere, either on an entitys website or in special reports aimed at specic audiences. Others argue that useful non-nancial information can only enrich the picture of the entitys nancial performance and prospects. In practice, organizations increasing use of non-GAAP measures indicate that some believe that GAAP nancial measures may not always provide the most relevant (or even the most reliable) information for investors. That increasing use also indicates that non-GAAP and non-nancial information might also help readers to understand the key drivers of the business and better gauge future returns. Risks associated with returns Much of the relevant information concerns risk measures associated with expected returns. Currently, such information is typically included in the MD&A. Relative to the reporting of an entitys nancial performance and position, reporting about risks has recently started to receive signicant attention.

Risk information is designed to capture the potential variability of prospective outcomes. Current disclosures about risk may include only certain information, may be incomplete, or may be less formally structured than other key areas of nancial reports. The SEC and U.S. GAAP require certain disclosures, ranging from disclosure of risk factors to sensitivity analysis of nancial instruments to potential variations in currency and interest rates to value at risk (VaR). However, these disclosures can fall short in various ways. They are often limited to specic risks, such as currency or interest rate uctuations, and may not provide a comprehensive analysis of broader risks within and across organizations, industries, and market segments. Risk disclosures might be more useful if the starting point would be to identify the most signicant risks the organization faced across its operational, investing, and nancing activities. Organizations could then present an aggregated picture of the potential impact of risks on the entitys nancial position and performance. For example, an entity might provide an enhanced analysis of its sales and cost of sales by addressing questions such as: Which factors drive sales and cost of sales? What is the impact of the general economic environment on sales? What drives demand from our customers and from their customers? What are the chief costs and what drives them? What are managements views of the future of the drivers of costs? What is the entitys ability to meet growth in demand? How can costs be managed when demand drops more than planned? Currently, the answers to such questions are not required and are rarely provided in nancial statements. Indeed, a company so inclined could limit itself to describing how sales and cost of sales changed without providing much information about the reasons for the changes, and still be in keeping with current disclosure requirements.

Providing investors with deep insight into the operational reality of an entity may require an effort that extends beyond what is currently considered the scope of financial reports.

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Understandability
Two main issues typically affect the understandability of nancial statementscomplexity and inconsistency. Complexity and inconsistency in nancial reporting may contribute to investors low use of reports and high reliance on other sources, which often simplify the information and render it more comparable. To some extent, the issues of complexity and consistency led to the creation of the SECs Advisory Committee on Improvements to Financial Reporting (ACIFR),4 whose goal is reducing unnecessary complexity and making information more understandable for investors. Complexity in reporting may make it difcult for investors, lenders, and creditors to understand an entitys nancial position and performance, and may present challenges to preparers, auditors, and other stakeholders. The ACIFR recognizes two types of complexity: unavoidable and avoidable. Unavoidable complexity arises from the sophistication and intricacy of todays business environment and the transactions or activities of the enterprise itself. Avoidable complexity arises from other sources. According to the ACIFR, sources of avoidable complexity include unnecessary difculties imposed by a nancial reporting regime that creates uncertainty in identifying, interpreting, and applying the relevant GAAP. The ACIFR also sees the reporting regime as generating difculties in evaluating the information and applying the relevant GAAP. These sources of complexity emanate largely from the sheer volume and pace at which guidance is issued under GAAP. Avoidable complexity also arises from the incomparability of nancial statements. Ironically, under GAAP, incomparability often stems from bright line rules that are intended to increase comparability. In practice, economically similar transactions can result in dramatically different accounting, because small details put similar transactions on opposite sides of a bright line. In fact, such rules might lead companies to structure transactions so as to achieve certain reporting results, which can generate inconsistency in the reporting of similar transactions. Thus, interpretations of accounting principles and rules may contribute to inconsistency, even in accounting for similar transactions within an industry or a country. Last, but not least, global comparability has not been achieved due to the large number of accounting frameworks that are still in use around the world. This has been an issue of growing importance as trade and capital markets have continued to globalize at an increasing rate in the last decade.

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Being understood To deliver nancial statements that readers understand, preparers must cope with complexity. Different constituents believe that complexity arises from different sources: Users typically believe that complexity is driven by diversity in interpretations, which can reduce comparability among companies, and by continual updates to accounting standards, which can reduce comparability of the same entitys statements from period to period. Preparers typically believe that complexity is driven by implementation challenges resulting from ambiguity in accounting standards and lack of industry understanding by standard setters. Auditors typically believe that complexity is driven by increased reliance on judgments and estimates. Standard setters typically believe that complexity is driven by preparers who often seek exceptions, additional interpretive guidance, and bright lines.

Here are twoamong manypotential examples of complexity: The mismatch resulting from accounting for derivative instruments at fair value while hedged items are carried at a different measurement attribute has to be resolved. Over the years, preparers and auditors asked for added guidance until the nancial instrument standard became the poster child for complexity. (The pre-codication 800-plus pages were slimmed down to 500 pages post-codication!) Preparers thus have signicant guidance to wade through before they can create understandable statements. Lease accounting guidance is an example of bright line rules overriding principles. As a result of this guidance, preparers often structure lease arrangements to achieve off balance sheet treatments, either by setting the lease term at slightly less than 75 percent of the estimated economic life of the property, or setting the present value of the minimum lease payments slightly below 90 percent of the excess of the fair value of the leased property. The reader is left with less, rather than more, understanding of the entitys obligations and position. Recent proposals by the IASB and the FASB to improve leasing and nancial instrument standards demonstrate how difcult it is to reach consensus and avoid the trap of merely replacing old complexities with new ones.

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IFRS to the rescue? International Financial Reporting Standards (IFRS) have been accepted at an accelerating rate around the world since their adoption as the set of standards to be used by public companies in the European Union in 2005. Although the timing is still not certain, it appears that IFRS could come to the U.S. toward the middle of the decade5 through either convergence or full adoption (and to Canada in 2011 and to Japan in 2015 or 2016). If fully adopted, IFRS will bring U.S. companies reports more in line with those in Europe and many other countries that have adopted IFRS. It is hard to argue against IFRS as a big step forward in increasing global comparability, despite certain challenges about its consistent application. However, the adoption of IFRS may also be a feasible way to consolidate, address, or replace the volume of guidance that adds so much avoidable complexity to the application of U.S. GAAP.

Although it may not be a complete solution, IFRS could reduce complexity and inconsistency in nancial reporting. Having companies in most major economies following a single set of standards may well enhance the consistency and comparability of nancial statements from a global perspective. These standards could also be expected to make the jobs of preparers and auditors a bit easier, if only because the volume of guidance provided by IFRS is less than 20 percent of that provided by U.S. GAAP. However, changing the mindset in the U.S. to deal with limited guidance and increased judgment will probably pose a bigger challenge than resolving the technical differences between IFRS and GAAP.

Although it is not a complete solution, IFRS could reduce complexity and inconsistency in financial reporting.
In general, IFRS focuses more on the economic substance of transactions rather than on achieving compliance with detailed rules. In that sense, and although IFRS also contains many rules, some observers believe that IFRS could shift managements focus away from the reporting aspects of a transaction and more completely toward its economic effects. This could reduce the role of accounting treatments in management decisions. However, other observers believe that the relative focus on principles that characterize IFRS could, at times, leave management still wrestling with the economic effects and desired accounting treatments, and could in practice generate more variability than GAAP.

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Timeliness
No matter how relevant, reliable, simple, and consistent entities make their nancial reports, if they are not delivered in a timely manner they will not be of much use to stakeholders. When the SEC instituted EDGAR6 in the early 1990s it was a major attempt to improve accessibility, and in recent years ling timelines have been shortened. The timing and manner in which nancial information will be delivered in the future may represent the most profound change ahead. We see the trend in reporting as moving away from providing reports and schedules that were developed before the current technology platforms, and toward a demand-driven model where users will receive and retrieve the information they deem most relevant, and on a more real-time basis. To the extent possible, information should be made available for users to access and retrieve in a manner that meets their needs and, when possible, in real-time or close-to-real-time. Technologies such as XBRL7 may well make customizable or self-customized information a near-term reality, while true real-time reporting may remain more elusive and controversial. Real-time reporting Financial reporting involves a closing process that can range from two days to a few weeks, depending on the entity. Given the existence of potentially enabling technologies, the notion of real-time reporting is gaining broader appeal. It does raise the issue of the continuous controls monitoring and continuous auditing that would be required to ensure the accuracy of the reported data. However, real-time reporting to investors and other stakeholders may remain a goal, which poses a host of questions ranging from the practical and technical to the philosophical and psychological: Can corporate intranets and the Internet be harnessed to enable real-time internal accounting and external reporting? What information should be made available and at what level of detail? Will detailed information be relevant without the context of the bigger picture? Does this information obviate the need for nancial reports as currently presented? Should users be left to compose reports as they see t? What controls and procedures can be put in place to ensure accuracy and completeness of information retrieved by users? What are the resource and other costs of real-time reporting in comparison to the potential benets? Accounting systems, skills, and processes will likely need to evolve to keep pace with demands. Organizations that can more successfully adapt may gain a competitive edge in capital markets. Even if true real-time reporting, or anything close to it, remains elusive, many believe that the current state of affairs can be improved on. The better and more timely the nancial information developed by the enterprise, the more effective and efcient its operational, risk management, and funding efforts should be. This implies that whatever initiatives nancial reporting functions undertake in the years ahead, and whatever principles, standards, and systems they adopt or develop, they must make the relevance, understandability, and timeliness of reporting high priorities.

Risk, regulation, competition, globalization, and investors demands will continue to fuel changes in financial reporting.

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What might the future hold?

Risk, regulation, competition, globalization, and investors demands will continue to fuel changes in nancial reporting. Given this and the factors and trends identied above, there are several guiding principles for accounting and nancial executives to consider in the years ahead, regardless of the actual developments that emerge: Create exible nancial information systems that can adapt to change rather than try to achieve a static state of perfection. Focus on user needs and, to the extent possible, go beyond the current focus on compliance to develop systems with the ability to meet those needs. Adopt an integrated approach to governance and risk management, and develop human and IT systems that support a comprehensive approach to providing nancial and non-nancial information to users. Accounting professionals, particularly preparers, auditors, and standard setters, will continue to strive to meet the needs of investors and other users of nancial reports through relevant, understandable, and timely reporting. For investors, this means reports that portray the position and performance of each entity in ways that enable them to weigh the risk/return tradeoffs they face when making decisions. With IFRS on the horizon and an increasing recognition that current reporting practices may not completely satisfy investors needs, nancial executives may face signicant challenges. Chief among these may be improving nancial reporting while managing costs, interpreting standards, and addressing risks. The decade ahead does not appear any less challenging than the last. However, with a focus on improving nancial disclosures to enhance relevance, understandability, and timeliness, the hope is that nancial statement preparersand userswill be equipped to better navigate the challenges ahead.

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Endnotes 1 The objectives of nancial reporting, a speech by Hans Hoogervorst at the European Commissions Financial Reporting and Auditing A time for change? conference on February 9, 2011
2

Contacts For more information on how Deloitte can help your company address its most pressing nancial reporting issues, contact any of the individuals listed below. Tom Omberg Partner Leader, Financial Accounting & Reporting Services Deloitte & Touche LLP +1 212 436 4126 tomberg@deloitte.com Sherif Sakr Partner Financial Accounting & Reporting Services Deloitte & Touche LLP +1 212 436 6042 ssakr@deloitte.com Sachin Sethi Partner Financial Accounting & Reporting Services Deloitte & Touche LLP +1 212 436 5052 ssethi@deloitte.com Brian Murrell Partner Financial Accounting & Reporting Services Deloitte & Touche LLP +1 212 436 4805 bmurrell@deloitte.com Alfred Popken Partner Accounting Standards & Communications Services Deloitte & Touche LLP +1 212 436 3693 apopken@deloitte.com

Toward Greater Transparency: Modernizing the Securities and Exchange Commissions Disclosure System, 21st Century Disclosure Initiative: Staff Report, January 2009 Speech by SEC Staff: The Future of Financial Reporting, William Lutz, Director, 21st Century Disclosure Initiative, U.S. Securities and Exchange Commission, at National Investor Relations Institute, New York Chapter, January 15, 2009 For information on this committee, visit http://www.sec. gov/about/ofces/oca/acifr.shtml See Commission Statement in Support of Convergence and Global Standards issued on February 24, 2010, and the SECs progress update issued on October 29, 2010, and staff paper issued on May 26, 2011 for further details Electronic Data-Gathering, Analysis, and Retrieval System of the SEC eXtensible Business Reporting Language, an open, global standard for the electronic exchange of business information

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As used in this document, Deloitte means Deloitte & Touche LLP, a subsidiary of Deloitte LLP. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting. This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, nancial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualied professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.

Copyright 2011 Deloitte Development LLC. All rights reserved. Member of Deloitte Touche Tohmatsu Limited

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