Complexity in Financial Reporting: Impact on Financial Statement Preparation and Analysis

1. Self-Inflicted ComplexityFederation of Schools of AccountancyMay 2015Katherine Schipper Duke University

2. Starting point • Starting point: Complex accounting adds to the difficulty of financial statement preparation, auditing, financial statement analysis, valuation • Complex accounting has few/no defenders and many critics • Example 1: SEC Advisory Committee on Improvements to Financial Reporting (2008) • Example 2: ACCA member survey on Complexity in Financial Reporting (2009) • Example 3: KPMG/FERF report on Disclosure Overload and Complexity (2011) • Example 4: Australian Financial Reporting Council Managing Complexity Report (2012) • Example 5: December 10, 2013 speech by Chairman of the FASB • Example 6: EFRAG Conceptual Framework Bulletin on Complexity (2014) • Example 7: CFA Institute, Addressing Financial Reporting Complexity (2015) • The reports attribute financial reporting complexity to several factors • Complexity of the arrangement being accounted for • Regulatory frameworks, including litigation • Complexity of financial reporting standards themselves • Examples: measurements; disclosures; asset derecognition; distinguishing liabilities from equity

3. Starting point—Questions to consider • What are the characteristics of a complex accounting standard? • Scope complexity : Standards are vague, overlapping, possibly inconsistent • Application complexity • Preparers cannot understand how to apply the standard, or face too many decision points in applying the standard • Voluminous record-keeping • (Very) difficult measurements, including hard-to-obtain inputs • Usability complexity: Financial reporting information is hard to understand • Is accounting complexity sometimes self-inflicted? • If yes, why would this be the case? • How is accounting complexity related to the idea of “non-distortion” of income? • Is complexity reduced when standards are closely tied to the conceptual framework? • My focus: the calculation/presentation of comprehensive income and of earnings/income/profit (or loss) • Complexity of preparation • Complexity of analysis

4. Overview—income statement complexity • Two fundamental questions that arise in teaching financial accounting, auditing, financial statement analysis and valuation: • Why create a separate income statement* instead of showing comprehensive income (or loss) as a single component of the change in shareholders equity? • Conceptual basis • Practical value • What should an income statement show? • Earnings (income; profit/loss) vs comprehensive income vs something else • A brief historical digression • How many subtotals, and which ones? • Examples of accounting complexity and links to presentation of earnings, comprehensive income and other comprehensive income (OCI) • Concluding comments and questions to consider • *Sometimes called a statement of profit and loss or a statement of operations

5. Conceptual basis and practical value of an income statement* • Conceptual basis for an income statement (U.S. GAAP) • “…reflect the extent to which and the ways in which the equity of an entity increased or decreased from all sources other than transactions with owners during a period” (para. 30, Concepts Statement 5, emphasis added) • Equity = assets - liabilities • Extent to which equity changed => comprehensive income • Amount could be shown in a statement of shareholders equity • Ways in which equity changed => changes in assets and liabilities • Statement with line items that display changes in assets and liabilities • Practical value of an income statement • Assess performance • Input to valuation • Prediction (including revisions of expectations) • *However “income” is defined, and however the statement is titled

6. Example of a statement of operations, showing net income (loss)

7. Example of a statement of comprehensive income Displays Net income (loss) and Other Comprehensive Income (OCI) • Comment and questions to consider: • The apparent purpose of the statement of comprehensive income is the presentation of OCI components • Does the two-statement display of income and OCI components meet the conceptual criterion described in Concepts Statement 5? • Does the two-statement display provide practical value?

8. Observation and questions to consider • If the purpose of an income statement is to present information about changes in assets and liabilities, what is the reason for a Statement of Income showing Net income (or loss) and a separate Statement of Comprehensive Income that shows OCI components? • Are some changes in assets and liabilities different from other changes, so that two distinct statements that provide information about two types of changes in assets and liabilities are needed? • Some changes in assets and liabilities => Statement of Income • Other changes in assets and liabilities => Other comprehensive income • If so, what is the source of those differences? • Observation: There is nothing in OCI that cannot be in income, under certain conditions • Foreign currency translation effects (depends on what is being translated) • Unrealized gains/losses on certain financial assets (depends on a management designation) • Unrealized gains/losses on certain derivatives (depends on accounting designation as a certain type of hedge) • Certain pension liability adjustments (some components of pension expense increase the pension liability) • Why are some changes in assets and liabilities shown first in the Statement of Comprehensive Income (as OCI) and later in the Statement of Income?

9. A brief historical digression • The “questions to consider” are linked to, and derive from, longstanding accounting debates that reappear in different forms over time • The debates concern criteria for including changes in assets/liabilities in income • 1933-36: SEC requires an income statement and supports the AAA’s view that favors showing “all inclusive” income • 1947-51: Committee on Accounting Procedure supports “current operating performance” income that excludes certain extraordinary and nonrecurring items to avoid distortions (emphasis added) • Example: ARB 32, 1947, reporting income and earned surplus* • APB Opinions 9 and 30: established “unusual nature” and “infrequency of occurrence” criteria for reporting extraordinary items separately within net income • SFAS 12 (1975, marketable securities) and SFAS 52 (1981, foreign currency translation): established the precedent of including changes in certain balance sheet items directly in equity, without establishing a criterion for doing so • *Earned surplus = retained earnings

10. Earnings vs comprehensive income • Earnings (Concepts Statement 5, para. 36,38) • A measure of performance during a period • Concerned primarily with the extent to which asset inflows associated with cash-to-cash cycles completed or substantially completed during the period exceed or are less than asset outflows associated with those inflows • Focuses on what the entity has received or expects to receive for its output, what it sacrifices to produce and distribute that output andincidental or peripheral transactions and some effects of other events and circumstances (emphasis added) • Comprehensive income (Concepts Statement 5, para. 39) • Changes in net assets during a period except from transactions with owners Observations: • Income, whether earnings or comprehensive income, is intended to convey information about an entity’s performance during a period. • Comprehensive income is well-defined in terms of changes in assets and liabilities • Earnings is a component of comprehensive income but is not itself well-defined • Concepts Statement 5 contains no meaningful guidance for distinguishing earnings as a component of comprehensive income

11. Evaluating entity performance • What accounting metric is used to evaluate performance? • Accounting researchplus observation of capital markets and financial intermediaries indicates that components of earnings, such as operating earnings or EBITDA, are used (among other measures) to evaluate performance • Adjustments to earnings appear to derive from a wish to calculate an amount that is recurring/sustainable/normalized/non-distorted or an amount that is more nearly controllable by management • Regardless of the reason, adjustments to reported earnings are common • The adjustments result in ad hoc amounts, known by various names Observations: • Accounting standards specify required or permitted adjustments to comprehensive income that result in an ad hoc amount, known as earnings • One result of the adjustments is complexity • Adjusting comprehensive income to create earnings does not prevent or preclude users of financial reports from making their own adjustments • One way to reduce complexity is to present a single statement of comprehensive income without an earnings subtotal; financial statement users will adjust comprehensive income to calculate a performance metric

12. Complexity in other comprehensive income (OCI) Observations and questions to consider: • The FASB’s reasoning (para. 47, SFAS 130) is: “…it is appropriate and consistent to include some gains and losses in net income and to exclude others from net income….” (emphasis added) • By default, excluded items are included in other comprehensive income (OCI) • The characteristic of these items is not specified, nor is the benchmark for “appropriate and consistent” • Constituent comments include the following reasoning (para. 60, SFAS 130) that might suggest the characteristic or the benchmark • OCI items are not performance related • OCI items are volatile in ways not controllable by management • Question 1: What is the meaning of “performance” that would exclude from a performance statement information about changes in recognized items that qualify as assets and liabilities regardless of their volatility and controllability? • Question 2: What is the conceptual basis for including or excluding items from a performance measure based on a combination of volatility and controllability? • Question 3: What is the conceptual basis for reclassifying (recycling) items out of OCI into earnings?

13. Complexity in other comprehensive income • Example 1: fair value changes of available-for-sale (AFS) securities • Designation as an AFS security is largely a management choice and has little economic significance. • Complexity issue 1: Reclassification (recycling) • Show changes in fair value twice, in two different locations, based on a management decision to realize existing gains/losses • SFAS 115 (para. 79) cites “concerns about the potential volatility…from reporting the [unrealized] fair value changes of only some assets, and no liabilities, in earnings…” (emphasis added) • Complexity issue 2: Tax effects can be shown for OCI as a whole or for individual components, such as gain/loss on AFS securities • Management is permitted free choice in this display, subject to meeting certain disclosure requirements (SFAS 130, para. 100-105) • Pre-tax display of a component => similar to many earnings items • After-tax display of a component => show effect of the OCI item on equity

14. Complexity in defined benefit pension plans combined with other comprehensive income • Example 2: using expected returns on plan assets to calculate periodic pension cost for a defined benefit pension arrangement • Complexity issue 1: what to do with differences between expected returns and actual returns? • SFAS 87 as issued provides for free choice between immediate recognition or deferral of differences, subject to certain constraints (e.g., amortization of a gain/loss exceeding 10% of the assets or the obligation); deferred amounts are included in AOCI • SFAS 87 (para. 122) cites “respondent arguments that immediate recognition [of the difference between expected and actual returns] would produce unacceptable volatility…” (emphasis added) • Complexity issue 2: how to present the amortization (out of AOCI) of actuarial gains/losses related to defined benefit pension plans? • Complexity increases if the reclassified amounts appear on the balance sheet first (refer to ASU 2011-12; the Exposure Draft issued August 16, 2012 and ASU 2013-02 issued February 5, 2013)

15. Complexity in subsequent measurement of asset retirement obligations (AROs) • Example 3: how to reflect the effects of changes in interest rates in subsequent measurement of AROs • Complexity issue: calculate accretion expense using the interest rate applicable at the time a specific portion of the obligation was initially recognized (that is, a historical interest rate) • Entities keep records of “layers” of the liability so that each layer is discounted by the applicable interest rate • Basis for conclusions of SFAS 143 explains this requirement • Both a fair value remeasurement approach and the required approach require revised cash flow estimates each period • Under a fair value remeasurement approach, all the cash flows are discounted at the same (current) rate • Reasoning: the fair value remeasurement approach is “somewhat less burdensome” to apply but there is an “overwhelming disadvantage resulting from the volatile expense recognition pattern created by…recogniz[ing] period-to-period changes in interest rates through accretion expense.” (SFAS 143, para B51, emphasis added)

16. Complexity in accounting for debt issuance costs • Example 4: ASU 2015-03 requires that debt issuance costs be deducted from the carrying amount of the related debt and amortized as a component of interest expense • Complexity issue: comingles a cash transaction cost paid to financial intermediaries with interest paid to creditors • Distorts any metric that includes interest, for example, times interest earned • Basis for conclusions of ASU 2015-03 explains this requirement • Project is intended to reduce complexity as part of the FASB’s Simplification Initiative (para. BC2; capitalization in original) • Reasoning is that (1) debt issuance costs are not an asset; (2) debt issuance costs are like a discount in that both reduce the proceeds of issuing debt; (3) the required treatment of equity issuance costs is similar (emphasis added) • Comment: Both US GAAP and IFRS require that transaction costs of business combinations be expensed as incurred

17. Complexity in accounting for warranties • Example 5: ASC 606-10-55-30 to 35 specifies two accounting treatments for warranties (part of the 2014 revenue standard) • Complexity issue: two types of accounting for obligations to repair/replace sold items under certain conditions • Service-type warranty => performance obligation • Assurance-type warranty => recognize expense and warranty liability following current practice • Basis for conclusions of ASU 606 explains this requirement (para BC 368-76) • The exposure draft proposed that all warranties would be accounted for as performance obligations but comment letters objected • Concept: Warranty that covers defects that existed at time of sale versus warranty that covers defects that arise later • Practical distinction in the standard: Account as a performance obligation if the warranty is sold or negotiated separately or it provides a service other than assurance that the “entity’s past performance was as specified in the contract” (para BC 372) • Apply these factors: legally required, length of warranty period, nature of tasks the entity promises to perform • Complexity issue: Is this guidance implementable?

18. Proposed complexity in lessee expense recognition • Example 6: two types of leases for lessee expense recognition • Type 1: Expense recognition following practices currently applied to capital leases, including separate amounts for interest and amortization • Type 2: Expense recognition similar to the pattern of expense recognition currently applied to operating leases, including a single lease expense amount • Amortization expense is a “balancing amount” so that total lease expense recognition is straight-line • Distinction: “whether the lessee acquires and consumes more than an insignificant portion of the underlying asset…” [from the FASB’s website] • Property => straight-line expense recognition unless the lease term is for the “major part of the economic life” or the present value of the lease payments accounts for “substantially all” the fair value of the leased asset • Other => expense recognition following practices currently applied to capital leases unless the lease term is an “insignificant portion of the economic life” or the present value of the lease payments is “insignificant” relative to the fair value of the leased asset • Complexity issues: violates comparability; requires guidance to distinguish two types of leases; loss of information about amortization and interest for Type 1 leases

19. Comments about income statement complexity • The complexity appears to derive from two main sources • Type 1: Creating two categories within comprehensive income, with movement between them • The categories are not conceptually defined, and there is no stated and consistently applied criterion for assignment to categories • There is no conceptual foundation for reclassifications between categories • Reported amounts may appear ad hoc and confusing, particularly to a student encountering them for the first time • Could be resolved by a single statement of comprehensive income, with no movement (no reclassification) between categories • Type 2: Creating over-time patterns within income that are (by design) smoothed • Additional complexity if the smoothed pattern is optional or requires qualifying conditions • Additional complexity if the smoothing is associated with movement between categories of comprehensive income

20. Questions to consider about complexity • Is there a conceptual basis for income statement complexity? • Some refer to the importance of “non-distorted” income or undesirable (or unacceptable) volatility • What is the definition or benchmark that captures “non-distorted” income or an “acceptable” level of volatility? • What is the relation between smoothed (less volatile) income and “non-distortion”? • Does a smoothed/nondistorted pattern/presentation of income confer benefits and if so what are they? • What is the incremental cost of income statement complexity? • Costs to create the guidance • Cost to understand and apply the guidance • Cost to audit the resulting amounts and disclosures • Cost to understand and use the resulting financial information • Accounting educators • Students • Financial statement users (financial statement analysis; valuation)