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Article Excerpt
Financial statements provide the raw data for analysis and valuation exercises. In fall 2005, the CFA Institute's Centre for Financial Market Integrity issued for comment an important new monograph, A Comprehensive Business Reporting Model: Financial Reporting for Investors. Published in July 2007, this elaborate, formal portrayal of professional investors' information needs appeared after a joint Financial Accounting Standards Board (FASB)/International Accounting Standards Board (IASB) project on income statement display began in April 2004. That joint effort quickly became the Financial Statement Presentation Project, a comprehensive consideration of the form and content of a complete set of business enterprises' general-purpose financial statements described most fully in a 2008 FASB Discussion Paper, "Preliminary Views on Financial Statement Presentation." We examine these developments and relate them to business valuation. We also examine several alternatives for reporting disaggregated financial statement data, including some voluntary public company disclosures that disaggregate reported data in innovative ways relevant to the valuation process. In addition, we provide an assessment of the formal proposals and the voluntary disclosures in a valuation context and suggest priorities to be pursued going forward.
The principles underlying business valuation are well-founded in discounted cash flow techniques: analyze the historical operating performance of the target company, project future operating cash flows after considering anticipated operating enhancements, and discount those estimated flows at the firm's cost of capital. Acquisition value is driven by the projected performance of the underlying business--revenue growth, operating margins, operating tax rates, working capital needs, and capital investment requirements. Companies' general purpose financial statements provide the starting point for most valuation data-gathering exercises that forecast cash flow or residual income. We examine the extent to which recent financial reporting display proposals and other innovative voluntary disclosures offer improved information for business valuation. This should be of interest to professional investors, financial statement preparers, and standards setters committed to the usefulness of financial statement information.
FINANCIAL REPORTING OVERHAUL?
A May 12, 2007, front-page article in The Wall Street Journal alerted many readers to a potential "accounting overhaul" with far-reaching implications for financial reporting by businesses and for users of financial reports. That article, "Profit as We Know It Could Be Lost with New Accounting Statements," discussed the ongoing activities of the joint FASB/IASB Financial Statement Presentation Project. Our review of two project-related documents--a March 29, 2007, Project Update (UPDATE)(1) and a more detailed working document discussed at a Financial Accounting Standards Advisory Council (FASAC) meeting on March 20, 2007 (2)--points to several ideas first advanced in 2005 by the CFA Institute's Centre for Financial Market Integrity. Its 59-page monograph, A Comprehensive Business Reporting Model: Financial Reporting for Investors (CBRM), is a current, comprehensive, and formal portrayal of professional investors' information needs. (3) The most recent document, the October 2008 FASB discussion paper, "Preliminary Views on Financial Statement Presentation," develops these ideas further. (4)
Although none of these documents specifically cites the valuation process as driving its proposals, the FASB discussion paper observes in paragraph S4: "The proposed presentation model requires an entity to present information about the way it creates value (its business activities) separately from information about the way it funds or finances those business activities (its financing activities)."
We see improvement in analysts' valuations as an important justification for modifying financial reports. That such modifications should be responsive to the information needs of valuation models dovetails with the FASB's emphasis on user needs driving financial reporting. (5) Better valuation estimates improve the security market efficiency that helps direct capital resources to their most productive uses.
Robert J. Bloomfield states, "Statistics that are more costly to extract from public data are less completely revealed in market prices." (6) To the extent that enhancements in the form and content of corporate financial statements make the underlying drivers of economic activity and profit more evident, analysts' ongoing valuation processes should become more accurate, less noisy, and more tightly linked to formation of market prices. In a related vein, Christine A. Botosan and Marlene A. Plumlee report evidence that firms with higher levels of voluntary disclosures tend to have lower capital costs. (7)
We next discuss the CBRM's principal proposals and relate several of them to the joint FASB/IASB project on financial statement presentation, now fleshed out in the 2008 discussion paper. Then we consider the responsiveness of these proposals, and some innovative voluntary public company disclosures, to the demands of the business valuation process for financial information.
THE FINANCIAL REPORTING USERS WANT
To some extent, the CFA Institute's 2007 "Comprehensive Business Reporting Model" builds on a monograph by its predecessor, the Association for Investment Management and Research (AIMR). The earlier monograph, Financial Reporting in the 1990s and Beyond, was primarily aimed at fixing shortcomings existing at that time. (8) Although the CBRM repeats many earlier concerns that remain outstanding and proposes several innovative improvements to help investors unravel the economic signals that either are--or should be--embedded in public financial reports, it offers its own rationale and conceptual framework.
One can hardly disagree with the proposition that, to be effective, security analysts must be able to discern the nature and extent of economic activity underlying a firm's accounting reports. Thus one must understand how a company achieved its reported performance. For example, did sales revenue grow because of rising volume, price increases, adjustments in mix, exchange rate movements, acquisitions, or new accounting policies? In seeking answers to such questions, the CBRM's specific proposals flow from 12 concepts:
1. The primary financial statements must provide the information needed by suppliers of risk capital.
2. In financial reporting, the company must be viewed from the perspective of an equity investor in the company.
3. Fair value information is the only information relevant for financial decision making.
4. Recognition and disclosure must be determined by the relevance of the information to investment decision making and not based upon measurement reliability alone.
5. All transactions and events must be recognized in the financial statements as they occur.
6. Investors' information requirements must determine the materiality threshold.
7. Financial reporting must be neutral.
8. All changes in net assets, including fair value changes, must appear in a single financial statement, the Statement...
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