Major Revision to Fin'l Statements from the FASB & IASB

[HenryTo]

A must-read, courtesy of the WSJ. This will provide a significant amount of work for CPAs, CFAs, attorneys, consultants, etc., for many years to come. However, this is just what the US needs after the scandals of recent years, as no-one that I talk to believe net income numbers can be trusted anymore.

A sample of the new proposal from the FASB can be found here: http://online.wsj.com/public/resources/documents/WSJ0507-fasac_march07.pdf
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Profit as We Know It Could Be Lost
With New Accounting Statements
By DAVID REILLY
May 12, 2007; Page A1

Pretty soon the bottom line may not be, well, the bottom line.

In coming months, accounting-rule makers are planning to unveil a draft plan to rework financial statements, the bedrock data that millions of investors use every day when deciding whether to buy or sell stocks, bonds and other financial instruments. One possible result: the elimination of what today is known as net income or net profit, the bottom-line figure showing what is left after expenses have been met and taxes paid.

It is the item many investors look to as a key gauge of corporate performance and one measure used to determine executive compensation. In its place, investors might find a number of profit figures that correspond to different corporate activities such as business operations, financing and investing.

Another possible radical change in the works: assets and liabilities may no longer be separate categories on the balance sheet, or fall to the left and right side in the classic format taught in introductory accounting classes.

ACCOUNTING OVERHAUL

Get a glimpse of what new financial statements could look like, according to an early draft recently provided by the Financial Accounting Standards Board to one of its advisory groups.The overhaul could mark one of the most drastic changes to accounting and financial reporting since the start of the Industrial Revolution in the 19th century, when companies began publishing financial information as they sought outside capital. The move is being undertaken by accounting-rule makers in the U.S. and internationally, and ultimately could affect companies and investors around the world.

The project is aimed at providing investors with more telling information and has come about as rule makers work to one day come up with a common, global set of accounting standards. If adopted, the changes will likely force every accounting textbook to be rewritten and anyone who uses accounting -- from clerks to chief executives -- to relearn how to compile and analyze information that shows what is happening in a business.

This is likely to come as a shock, even if many investors and executives acknowledge that net income has flaws. "If there was no bottom line, I'd want to have a sense of what other indicators I ought to be looking at to get a sense of the comprehensive health of the company," says Katrina Presti, a part-time independent health-care contractor and stay-at-home mom who is part of a 12-woman investment club in Pueblo, Colo. "Net income might be a false indicator, but what would I look at if it goes away?"

The effort to redo financial statements reflects changes in who uses them and for what purposes. Financial statements were originally crafted with bankers and lenders in mind. Their biggest question: Is the business solvent and what's left if it fails? Stock investors care more about a business's current and future profits, so the net-income line takes on added significance for them.

Indeed, that single profit number, particularly when it is divided by the number of shares outstanding, provides the most popular measure of a company's valuation: the price-to-earnings ratio. A company that trades at $10 a share, and which has net profit of $1 a share, has a P/E of 10.

But giving that much power to one number has long been a recipe for fraud and stock-market excesses. Many major accounting scandals earlier this decade centered on manipulation of net income. The stock-market bubble of the 1990s was largely based on investors' assumption that net profit for stocks would grow rapidly for years to come. And the game of beating a quarterly earnings number became a distraction or worse for companies' managers and investors. Obviously it isn't known whether the new format would cut down on attempts to game the numbers, but companies would have to give a more detailed breakdown of what is going on.

The goal of the accounting-rule makers is to better reflect how businesses are actually run and divert attention from the one number. "I know the world likes single bottom-line numbers and all of that, but complicated businesses are hard to translate into just one number," says Robert Herz, chairman of the Financial Accounting Standards Board, the U.S. rule-making body that is one of several groups working on the changes.

At the same time, public companies today are more global than local, and as likely to be involved in services or lines of business that involve intellectual property such as software rather than the plants and equipment that defined the manufacturing age. "The income statement today looks a lot like it did when I started out in this profession," says William Parrett, the retiring CEO of accounting firm Deloitte Touche Tohmatsu, who started as a junior accountant in 1967. "But the kind of information that goes into it is completely different."

Along the way, figures such as net income have become muddied. That is in part because more and more of the items used to calculate net profit are based on management estimates, such as the value of items that don't trade in active markets and the direction of interest rates. Also, over the years rule makers agreed to corporate demands to account for some things, such as day-to-day changes in the value of pension plans or financial instruments used to protect against changes in interest rates, in ways that keep them from causing swings in net income.

Rule makers hope reformatting financial statements will address some of these issues, while giving investors more information about what is happening in different parts of a business to better assess its value. The project is being managed jointly by the FASB in the U.S. and the London-based International Accounting Standards Board, and involves accounting bodies in Japan, other parts of Asia and individual European nations.

The entire process of adopting the revised approach could take a few years to play out, so much could yet change. Plus, once rule makers adopt the changes, they would have to be ratified by regulatory authorities, such as the Securities and Exchange Commission in the U.S. and the European Commission in Europe, before public companies would be required to follow them.

As a first step, rule makers expect later this year to publish a document outlining their preliminary views on what new form financial statements might take. But already they have given hints of what's in store. In March, the FASB provided draft, new financial statements at the end of a 32-page handout for members of an advisory group. (See an example.)

Although likely to change, this preview showed an income statement that has separate segments for the company's operating business, its financing activities, investing activities and tax payments. Each area has an income subtotal for that particular segment.

There is also a "total comprehensive income" category that is wider ranging than net profit as it is known today, and so wouldn't be directly comparable. That is because this total would likely include gains and losses now kept in other parts of the financial statements. These include some currency fluctuations and changes in the value of financial instruments used to hedge against other items.

Comprehensive income could also eventually include short-term changes in the value of corporate pension plans, which currently are smoothed out over a number of years. As a result, comprehensive income could be a lot more difficult to predict and could be volatile from quarter to quarter or year to year.

As for the balance sheet, the new version would group assets and liabilities together according to similar categories of operating, investing and financing activities, although it does provide a section for shareholders equity. Currently, a balance sheet is broken down between assets and liabilities, rather than by operating categories.

Such drastic change isn't likely to happen without a fight. Efforts to bring now-excluded figures into the income statement could prompt battles with companies that fear their profit will be subject to big swings. Companies may also balk at the expense involved.

"The cost of this change could be monumental," says Gary John Previts, an accounting professor at Case Western Reserve University in Cleveland. "All the textbooks are going to have to change, every contract and every bank arrangement will have to change." Investors in Europe and Asia, meanwhile, have opposed the idea of dropping net profit as it appears today, David Tweedie, the IASB's chairman, said in an interview earlier this year.

Analysts in the London office of UBS AG recently published a report arguing this very point -- that even if net income is a "simplistic measure," that doesn't mean it isn't a valid "starting point in valuation" and that "its widespread use is justification enough for its retention."

Such opposition doesn't surprise many accounting experts. Net income is "the basis for bonuses and judgments about what a company's stock is worth," says Stephen A. Zeff, an accounting professor at Rice University. "I just don't know what the markets would do if companies stopped reporting a bottom line somewhere." In the U.S., professional investors and analysts have taken a more nuanced view, perhaps because the manipulation of numbers was more pronounced in U.S. markets.

That said, net profit has been around for some time. The income statement in use today, along with the balance sheet, generally dates to the 1940s when the SEC laid out regulations on financial disclosure. But many companies have included net profit in one form or another since the 1800s.

In its fourth annual report, General Electric Co. provided investors with a consolidated balance sheet and consolidated profit-and-loss account for the year ended Jan. 31, 1896. The company, whose board at the time included Thomas Edison, generated "profit of the year" -- what today would be called net income or net profit -- of $1,388,967.46.

For the moment, net profit will probably exist in some form, although its days are likely numbered. "We've decided in the interim to keep a net-income subtotal, but that's all up for discussion," the FASB's Mr. Herz says.

Write to David Reilly at david.reilly@wsj.com

[rffrydr]

William Isaac FDIC head during RTC offers some thoughts (focused on FASB 157, 159):

http://online.wsj.com/article/SB122178603685354943.html


During the 1980s, our underlying economic problems were far more serious than the economic problems we're facing this time around. The prime rate exceeded 21%. The savings bank industry was more than $100 billion insolvent (if we had valued it on a market basis), the S&L industry was in even worse shape, the economy plunged into a deep recession, and the agricultural sector was in a depression.

These economic problems led to massive credit problems in the banking and thrift industries. Some 3,000 banks and thrifts ultimately failed, and many others were merged out of existence. Continental Illinois failed, many of the regional banks tanked, hundreds of farm banks went down, and thousands of thrifts failed or were taken over.

It could have been much worse. The country's 10-largest banks were loaded up with Third World debt that was valued in the markets at cents on the dollar. If we had marked those loans to market prices, virtually every one of them would have been insolvent. Indeed, we developed contingency plans to nationalize them.
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Today is the Tomorrow you worried about Yesterday!

[rffrydr]

Hold-to-maturity prices: This is key:


http://www.marketwatch.com/news/story/avoiding-fire-sale-price-key-paulson/story.aspx?guid=%7BBE116D8A-C118-48FE-938C-2D43070424BC%7D&dist=msr_4
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Today is the Tomorrow you worried about Yesterday!

[rffrydr]

Yes, the only downside is buying back own debt is a cap gain and taxable...no prob if you have the loss. Private Equity has been doing this to take down some of the big big takeover deals.--and had to fight every step, amazingly. Contracts again. Would have liked to buyback my own mortgage--that should be in the plan!

It's hard to buy this stuff from a retail perspective. Few holders willing to stay holders. There's a few stuck bond funds but who knows where the hot potato goes?
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Today is the Tomorrow you worried about Yesterday!

[Odysseus]

Really really good point. Reality is 90% perception.

My dumbass solution to this quagmire is to suspend FASB 157 for 12 months and give time to establish a transparent market for the toxic and NOT so toxic waste and derivitives. Problema solvedad.

Let those with good books allow them to run off for a time. We may be talking 5% at the end of a 7 year average mark and that may well be the equity of a firm but in the end, we could be talking a 100 billion capital raise over time instead of a convoluted distress purchase with unintended consequences. But perhaps there are those WITH intended consequences?

But what do I know. I want to buy back my performing loan at 35 cents on the buck. Just follow the money to X marks the spot. Pirate treasure may only be found by the pirate that knows where it is buried.

As an individual, who do I call? As an institution, I WANT a call.

Wow!!! To buy 90% good paper at 35% with leverage could mean my kids can have new shoes this Christmas. What a woild, what a woild.
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Psychic with Alzheimers. I can predict what I will forget.

[rffrydr]

"Fair Value" turns out to be the biggest revision of all:

[rffrydr]

Look for more of these "results" trickling up the money chain on our way to a "write-up" recovery in the financials:


http://www.forbes.com/markets/2008/08/26/thornburg-mortgage-earnings-markets-earnings_md_0825markets18.html
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Today is the Tomorrow you worried about Yesterday!