1.1 The EBR Consortium and the Role of the Galileo Project

Since the joint collapse of Enron and Arthur Andersen in 2000, there has been a series of accounting related scandals which, at the very least, raise serious concerns about the appropriateness of the current financial reporting system. In response, the AICPA has taken the initiative of re-thinking financial reporting by establishing the Special Committee for the Enhanced Business Reporting Model (EBRM), also called the Starr Committee after its chairman Michael Star from Grant Thornton. This committee examined the proposals presented in the early nineties by another special Committee, the Jenkins Committee. Despite the fact that its chairman, Ed Jenkins, subsequently headed the FASB, the Jenkins Committee recommendations were mainly not put into practice, one reason being that the late 1990s bull market made its concerns about the adequacy of GAAP seem redundant. By contrast, one of the underlying questions confronting the Starr committee was an unanswerable one - whether the malfeasance crisis could have been avoided if the improvements to financial accounting and reporting suggested in that earlier report had been implemented. While these questions are mostly speculative, the committee decided that the accounting profession by itself did not have the authority or the ability to create a new reporting model with its enormous societal consequences, and so in order to bring about substantive change it transformed itself in July 2004 into a broader consortium of stakeholders in the financial reporting process. The Enhanced Business Reporting Consortium (EBRC) describes itself as: "A Consortium of stakeholders collaborating to improve the quality, integrity, and transparency of information used for decision-making in a cost effective, time efficient manner." The Star Committee, under its Public Company Task Force, had a set of work products that will serve as inputs to the EBRC. These work products of the consortium were a set of sample reports that illustrate the kinds of enhanced disclosures that it advocates as necessary and useful for complex organizations in today’s information economy, and which serve as a starting point for further discussion. By design, the content of the first two sample reports are not especially “radical”. As Paul Herring, the chair of the Public Company Task Force wrote during the process that created these reports: “Formats that follow outlines that are already in general use in the business information supply chain are likely to gain faster acceptance than those that are new… We will explore potential enhancements to the existing financial reporting format but will not consider wholesale re-structuring of the financial statements.” By contrast, the third sample report project, labeled the “Galileo project” was the one that was meant to be far-reaching in nature. The Starr Committee examined extended financial reporting—additions to the standard set of GAAP based accounting reports, with the explicit understanding that while these reports are no longer appropriate for stakeholders, the committee itself was not in a position to change GAAP. This incremental approach may make perhaps sense in terms of change management, but it can also constrain the possible changes to the reporting model that are made available to the consortium to discuss. Thus the Galileo project serves as a remedy to the cautious approach, by being the medium to consider “extreme accounting” including both supplements to standard reports as well as possible changes or modifications to GAAP itself. Further, while all the sample reports use somewhat technology to transform the way in which financial information is presented, Galileo goes further in examining how the IT infrastructure of today’s digital can also fundamentally transform the process of obtaining and preparing, as well as communicating, financial information.

1.2 Back to Basics

Financial reporting would not be needed if all stakeholders in the firm shared the same information about how the firm has performed in the past and had similar expectations as to how it will perform in the future. Furthermore this shared information should be correct and well representative of the actual business conditions of the firm. In reality, those within the firm are inevitably in a better position to know its state than those stakeholders outside of it. Moreover, the former are not just informationally advantaged, but as managers they can actually shape the firm’s future performance. This is the fundamental informational asymmetry that bedevils financial reporting, a reflection of the conflict of interest between shareholders who only care about the financial performance of the firm as reflected in its market price, and managers who can directly benefit from exploiting the firm’s assets. [m1] These informational asymmetry and moral hazard issues add the possibility of deliberately distorted reporting to the already formidable problem of measuring firm performance even in a non-strategic setting. Moreover, measuring past firm performance is largely a means towards the end of forecasting future performance for it is only the future and not the past that affects firm valuation. [m2] Clearly managers can affect the degree to which past performance predicts future performance, thus affecting the value of financial reporting. Adding to these measurement problems are changes in the way in which firms transform capital into returns. Once the main function of the firm was to apply unskilled labor to physical assets, so that the reporting which concentrated on the disposition of those physical assets adequately captured firm performance. Xxxx Indeed, even accuracy in measuring assets could be sacrificed for other goals such as verifiability through the doctrine of conservatism without greatly reducing the usefulness of the reports. But today firms create value by the use of such intangible assets as knowledge and the skills of its workers with the result that the relationship between its physical assets and its performance is greatly diminished. This creates two problems: a pure measurement issue of how to account for the presence and role of intangibles and a strategic measurement problem in that this broken relationship opens up a wider scope for managers to manipulate earnings. An example of these problems comes from a sizable accounting transaction[m3] : the decision by Cisco Systems, in May 2001, to write-down its inventory by $2.25 billion, an amount larger than the inventory value in its books.xxx[m4] One explanation is that the write-down related to the value of inventories that could be not sold by its suppliers in the value chain where Cisco had a contractual or moral obligation. In particular, during the e-commerce boom Cisco had offered vendor financing to many dot com firms in exchange for sales contracts, while signing contracts itself with downstream suppliers in anticipation of tight demand. These obligations were not reflected anywhere in the financial reports. Of course, even granting these problems, there was also the suspicion that the sheer magnitude of the write-off resulted from the use of the well known tactic of the “big bath”, in which all the bad news are anticipated in advance, all at once, thereby creating reserves to boost income in the future. [m5] [m6] This example and the difficulty in disentangling its purpose are indicative of the difficulty that users face today with financial reports. In fact, the underlying accounting fails to account for the way in which the modern firm operates and for the intangible factors which underlie value creation or destruction. Moreover, managers are able to take advantage of the resulting ambiguity to act in their own best interest and not necessarily that of the firm or other stakeholders. Most importantly, this is not an example of outright fraud or audit failure, but rather an example of what is arguably a far more compelling problem: the systematic inability of the current financial reporting system to meet the needs of users, to understand the ways in which complex organizations perform and to hold managers accountable. This example also undermines one of the arguments in support of the current financial reporting system and against changes to that system: the need to maintain comparability and consistency across firms in the ways in which they account. But even strict rules, such as those that apply to inventory valuation or special purpose entities, is no guarantee that firms will apply those rules in the same way given the underlying ambiguity about what is being measured. This is really an argument for more information disclosure to enable stakeholders to better discern the purpose and meaning of specific business activities. Other examples of the difficulties posed by the existing financial reporting system are reflected in many of the recent scandals, as the prosecution of the perpetrators did not deal directly with the core malfeasance issues but attacked more peripheral facts. Thus, * Arthur Andersen was not convicted for performing bad audits but of destroying evidence. * Martha Stewart was not convicted for trading on insider information, but for lying to federal investigators. * Dennis Kozlowski of Tyco will likely be convicted for not paying sales taxes in the state of New York not for plundering the treasury of his company in lavish self-given benefits that were “approved” by a deceased director. The press attributes these aberrations to the hesitation in the part of prosecutors to discuss a set of “arcane accounting laws” in a court of law where jurors, lawyers and judges will have great difficulty comprehending the issues presented by armies of highly paid attorneys who, in collaborations with expert witnesses, point out the ambiguities of the law and explore the “beyond reasonable doubt” concept. It is also striking that the parties that have been involved in many of these cases are stalwart institutions which help define the nation’s economic environment. [m7] Take for example the case of Enron, which had over 600 CPAs on its payroll and hired McKinsey for strategic advice, Arthur Andersen for audit and consulting services, and worked with Citibank, Merrill Lynch, and JP Morgan for structuring and supporting its financial operations. These firms, the best and the brightest in the business, helped Enron stretch the boundaries of accounting in order to manage its earnings. These financial institutions had entire groups devoted to “structured [m8] transactions”[1] whose main purpose was to disguise the nature of the financial transactions of Enron within the “arcane set of rules” of accounting that they expected never to be revealed to the world, and in case of litigation expected the prosecutors to avoid. Enron also had an intricate web of additional financial relationships with its directors who advised it on many issues while handsomely profiting from their relationship. These directors were also stalwarts of society and most likely were aware of the aggressive nature of Enron’s accounting even if there were not cognizant of the criminal profiteering of some of its top managers. Ex-regulators, leading academics and well known international figures were compensated by being on Enron’s board as well as by providing other services as external consultants. The fundamental problem is that the highly complex nature of Enron’s transactions would have been very difficult to detect by even the most committed and best trained external director. The need for drastic change in financial reporting has been recognized by many. Arthur Levitt[2], the former chair, commenting on Senator Carl Levin makes a very damning statement: … well before the Enron disaster, he saw the fiction that corporate financial statements had become: companies technically were in compliance with accounting rules, yet their financial statements were hiding huge debts and other liabilities. (p 243, emphasis added) What is needed to update the financial reporting system to deal with this kind of complexity? The rest of this paper discusses the options in detail. Here we present the main issues and principles of a new financial reporting process.

1.3 Rethinking the Role of the Standard Financial Statements

The current financial reporting system is centered on the annual income statement and balance sheet as prepared and distributed by the firm. They serve as summary measures of the state of the firm and its performance. Such summarization and condensation inevitably results in a loss of information which cannot be in the best interest of users unless the measure perfectly captures future firm value, or the costs of more detailed information exceed its benefits to users. Given that the former is an unlikely prospect, the rationale for the current systems of disclosure is predicated on the basis that: a) users are assumed to be unsophisticated (the “widows and orphans” mentioned at the time the ’33 acts were passed) and incapable of processing more disaggregate information for themselves, and b) it is costly to prepare and report information on a more timely basis. These conditions speak more of the 19th century beginnings of financial reporting than they do of the circumstances in which financial markets operate today. Firstly, technology enables the firm to manipulate data at low cost, meaning that there is no longer a compelling reason to restrict information disclosures to an annual basis. Second, the purpose of financial reporting has shifted from its original stewardship function toward valuation and comparative evaluation, which necessitates a broader, future oriented set of information. As these statements have proven to be insufficient for the needs of more sophisticated users, they have been expanded periodically in response to demand or the latest scandal, in a largely haphazard fashion. In some cases, the statements themselves have been reconfigured (for example, to allow mark to market accounting to reduce the dependence on historical cost) or else additional information has been provided outside the statements, as through the use of footnotes. But the centrality of the two primary statements has been retained, along with their underlying assumption that it is important to restrict the scope of information provided to users in order to avoid overwhelming them (akin to the recent proposals for a condensed and simplified version of mutual fund prospectuses). The end result is a highly aggregate, episodic flow of information from the firm in which a small set of standardized information attempts to satisfy the widely varying needs of users. This approach implies that auditing is also centered on the mandated financial statements. Thus auditing is also episodic and focused largely on whether the firm has correctly condensed and aggregated its information into those statements (which is what “prepared in accordance with GAAP” literally means). Validating information on a more concurrent basis is held to be outside the scope of the external auditor and assigned to the internal auditors instead. But it has also become steadily apparent that the mandated statements cannot be considered independently of the underlying data of the firm and the firm’s accounting and control infrastructure that gives rise to that data and records, manipulates and aggregates it. Thus, as with financial reporting, auditing has been periodically expanded, albeit also in a largely haphazard fashion, first to encompass general examination of controls, and with the passage of Section 404 of the Sarbanes/Oxley Act, to a detailed attestation of financial reporting controls. With the financial reporting environment almost exclusively focused on the income statement and the balance sheet[m9] it is not surprising that the financial markets also have tended to view a firm largely through the prism of those documents. In an extreme, this can lead to forms of functional fixation, where form can seem more important than content, as when information in the statements themselves dominate the market’s reaction even when information in footnotes modifies or contradicts it. In turn, firms expend vast resources in fighting accounting changes that impact the income statement even if that same information is presented elsewhere and could be readily used to recalculate the reported numbers, as in the current debate over stock option expensing. [m10] The continuing fascination with reported net income is not, however, due to the lack of sophistication of market participants. Financial markets today have today some professionals who are not only capable of handling highly disaggregate financial data and forming their own conclusions about it, but actively do so. Thus some analysts simply discard the financial statements issued by firms in favor of extracting specific information from them and inserting it, along with other external information, into their own models of firm performance[m11] . However, there are a some constrains including a) the focus of the financial reporting system on the mandated statements leaves them with few other options on which to base their analysis, and, flowing from that, b) the lack of other instruments of communication lead firm managers to use those statements to signal information, requiring a continuing focus on the form of those statements, independent of their content.; and of course, c) the assurance that is attached to those statements alone, requiring that they receive disproportionate weight, again regardless of their information value. The lack of other audited information has also resulted in auditors becoming insurers of last resort[m12] , as users who are forced to view the firm through those statements come to see the auditors as gatekeepers for the firm, and so hold them responsible not only for the preparation of those statements, but also for their content. If the financial reporting system was being built from scratch today, it would likely be aimed also to the needs of these very sophisticated users than the “mother and orphans” type of investors predominant at the time of the ’30’s acts. In particular, there exists today a large group of financial intermediaries that work on behalf of these unsophisticated users, or who interpret information for them, (for example, mutual fund managers, financial analysts) so that there is no real need for these investors to personally assimilate financial information, obviating the need to pitch financial information at the lowest common dominator. A reengineered financial reporting system would be predicated on two underlying assumptions: First, that technology has reduced the cost of preparing and reporting financial information with much finer detail on a more timely basis; and Second, that some very important users are much more sophisticated and capable of forming their own metrics for firm performance, rather than having to depend on the condensed and aggregate annual statements issued by the firm. These two assumptions have to be applied against the financial process value chain of financial information which extends from the raw data of the firm at one end to sophisticated users at the other. Part of this chain takes place within the firm and part of it is external to the firm, with a handover of financial statements taking place at the boundary between the firm and its constituents. As the forces affecting the supply and demand of financial information have changed, it is surely time to ask whether the location of that boundary point is still appropriate. So the question becomes whether the firm should aggregate and condense information to such an extent before releasing it, or whether users can be assumed to be sophisticated enough to perform these functions on their own. That is not to say that firms will not prepare income statements and balance sheets. After all, they already do so for their own internal management purposes. But there is no reason why users should be restricted to that one perhaps self serving and highly restrictive method of aggregation when users can be allowed to see how that report was created and either accept it as it is, or else use the underlying data as they see fit. Reducing the single minded emphasis on just the income statement and balance sheet will not only increase the information content in the marketplace about a firm, but would reduce the likelihood of functional fixation, since it would be clear that valuation is meant to be based on a broad set of information. Questions that have to be examined are a) the degree of aggregation that will take place given the needs of users and the concerns of the firm about revealing competitive data, b) how much pre-processing of information will be undertaken before information is released and who is in the best position to do that processing, and c) how much validation will be provided with the information and who will provide that assurance. These three are not independent issues, since aggregation is a form of information processing in which a great deal of information is lost. It also allows for those who have access to the raw information (i.e. the managers) to shape the degree and form of condensation that suits their interests best. At present, managers constrained only by their ability to get their interpretation of GAAP through the auditor, direct their energies towards making one metric of firm performance, earnings per share, as favorable for them as possible. Reducing the degree of pre-processing and aggregation of information by the firm would presumably also reduce the ability of firm managers to manipulate that information. Technology can be an effective tool in providing a richer flow of information to users, with tagging, as in XBRL, being a particularly promising technology. Tagging is particularly important because it makes information content independent of its presentation, thus reducing the tendency for functional fixation. Ultimately the latency between economic activity and reporting can be reduced, in order to bring the reporting frequency more closely in line with the dynamics of the business and the needs of users. A reengineered financial reporting system will also, of course, impact the role of auditing. With more information being issued more frequently, auditing will have to move away from an annual focus towards a more continuous auditing model. Moreover, with more disaggregate information being reported, auditing will also shift its emphasis away from verifying the way in which the firm aggregates and condenses its data, towards more data-level assurance. The degree of verification which users will demand from the broader set of data they receive will determine the extent to which data is actively audited, as opposed to being assured passively, for example, by threat of criminal liability or civil litigation.

1.4 The Role of Technology

In the new accounting environment, the firm’s databases and ERP systems will play the same role the general ledger did in the old manual reporting world, with the difference being that the reporting system will require a monitoring and control layer, probably including a continuous assurance component, which will evolve from the systems being implemented for Sarbanes/Oxley 404 certification. It is likely that firms will progressively implement such monitoring layers for their own internal management purposes, the output of which could then be adapted for external reporting. Indeed, this would have the advantage of letting the market assess the adequacy of the firm’s control systems. On the other hand, it can be argued that the reporting system will depend on the IT decisions of individual firms and so it is not clear what would compel a firm to implement the particular monitoring layer that is desired by users. In other words, the more sophisticated the infrastructure underlying the reporting system, the more difficult it will be to obtain cross sectional consistency, at least in the absence of regulation, which is unlikely in this context. This fact may constrain how extreme the new reporting systems can be, given their reliance on technology.

1.5 Paper Outline

Having defined the problem facing the financial reporting system and outlined the drivers of the proposed solution we now turn to an in-depth examination of the issues raised in this introduction. This examination involves details of the specific problem areas in accounting today and then a look at the changes impacting the business environment, and especially the technological infrastructure of the firm that both undermines existing reporting systems and provides the foundation for the creation of a new and more effective system. [1] The New York Times in October 8, 2004 article by Eric Dash entitled “ Parmalat Files Another Suit Naming Bank of America” relates a law suit of Parmalat against Bank of America stating that “It charges that between December 1997 and December 2001 Bank of America helped certain Parmalat senior managers structure and execute "a series of complex, mostly off-balance-sheet transactions that were deliberately designed to conceal Parmalat's insolvency." … Meanwhile, the bank and its executives collected tens of millions of dollars in interest, improper payments and transaction structuring fees, ….. seven examples of what it claims were fraudulent and highly lucrative transactions that Bank of America managers arranged for Parmalat subsidiaries in Venezuela, Brazil, Chile and South Africa. "In some cases, what appeared to be conventional loans from Bank of America were in reality intracompany transfers or loans from other Parmalat entities," the complaint said. "In other cases, what appeared to be conventional debt offerings to third-party investors, supposedly underwritten by Bank of America, were in reality loans to other undisclosed Parmalat entities," the complaint said. The complaint said investors were intentionally misled into believing that Bank of America was standing behind Parmalat's creditworthiness when the bank's activities really suggested that it was doing all it could to reduce its risk. In some cases, the complaint said, it established secret loan guarantees and side-letter agreements so it had no risk at all

Comments

[2] Levitt, Arthur, Take on the Street, Pantheon Books, NY 2002. Back to Homepage [m1]Mike just the sharing of info is not sufficient… it is necessary that the information is a good measurement to support the many forms of decision making necessary for the different stakeholders of business. [m2]Is this a warranted comment… and valuation is not the only purpose of business measurement. For example taxation, pension liability estimate, production capability, etc. [m3]Mike please lets not bebombastic… we create enemies and sound like the new york post. [m4]Mike this does nto make sense can u explain better? [m5]We need a source – ref here) [m6]Silvia can u go to the statement and see if there is an explanatory foot note? [m7]Mike I would like to simplify the tone a bit ..we do not need its contentiousness, we’ll have enough of it just with our content [m8]I think this is too big for a footnote .. body of the paper??? [m9]Are u forgetting the funds flow? [m10]I do not think that the option disclosures allow investors or user to replicate adequately what the compensation is [m11]First, the markets are not dominated..most financial professionals are kind of clueless.. second do you have any evidence that this is eally the case that they go to other WHAT???- information.. I think we need to support this if this is true… I do believe that this is true at say goldman and morgan Stanley that they ar eusing other information but DOMINATED is an awfully strong work [m12]Again I think this is too strong…