This paper examines the limitations of current financial reporting practices and argues for a more user-friendly approach to financial statements. It explores the nature and legal protections of forward-looking statements, the flexibility and potential misuse of Generally Accepted Accounting Principles (GAAP), and the relevancy of historical financial data in a rapidly changing business environment. The paper also addresses the emerging challenge of valuing intellectual property under new accounting standards and evaluates whether existing guidelines need to be reformed. Ultimately, it proposes that supplemental plain-language sections be added to standard financial reports to serve a broader, less technically sophisticated investor audience.
Anyone who has ever read a financial statement is familiar with the disclaimer that begins, "This statement contains forward-looking statements…" However, when one begins to read the contents of the financial statement, one soon finds that there is very little that could actually be considered forward-looking. The financial statement provides a historical look at company performance, suggesting that the future of the company will resemble its past. Every investor knows, however, that this is not necessarily true. What has happened in the past may have nothing to do with the company's future. Shocks in the market occur, and companies cannot always be prepared for what is to come. This paper explores the backward-looking and forward-looking aspects of the financial statement and supports the need for better forward-looking models.
Shareholders and investors often turn to the financial statement to learn how companies have performed in the past. However, the most popular section of the financial statement is often the forward-looking statement. In this section, managers and executives present their expectations and predictions for the company's future. There is no standard formula for making these predictions — every manager has their own method and set of factors that they consider.
Some estimates are conservative, while others are optimistic. The forward-looking statement reflects the personality and experiences of the managerial staff. One of the key tenets of the forward-looking statement is that it is only a projection, yet many investors place far more faith in it than it warrants.
Sometimes investors base their entire decision on the forward-looking statement. When outcomes fall short of expectations, or when investments are lost entirely, it has often led to litigation. In Harris v. Ivax Corporation (1999), the U.S. Court of Appeals for the Eleventh Circuit held that a company's statements in press releases were protected from liability, provided they included proper cautionary language. The company does not need to accurately predict every possible circumstance, but it must address any major risks that have been identified.
The "Safe Harbor" rule of the Securities Act of 1933 protects companies from losses incurred as a result of forward-looking statements, as long as the company had a reasonable basis for making them (Cadwalader, Wickersham, & Taft LLP 1999). Companies may not engage in deception, but they are not required to foresee every situation that could arise. This creates a caveat emptor situation for the shareholder, who must trust that the information in the financial statement is sufficiently accurate to be at least reasonably predictive.
Safe Harbor offers companies some protection against litigation arising from shareholder losses related to forward-looking statements. Accounting statements must also comply with all elements of Generally Accepted Accounting Principles (GAAP). This ensures at least some degree of uniformity and standardization in the information presented. The purpose of GAAP is to make certain that statements can be read and understood by a broad audience, offering shareholders some degree of certainty about what they are reading.
However, GAAP functions more as a set of guidelines than as a collection of hard and fast rules. Within GAAP, there is room to adjust accounting practices to suit the specific needs of a company. For instance, there is some discretion in deciding what to include as direct versus indirect expenditures. Differences such as these can meaningfully change a reader's perception of the information in a statement.
Shareholders are often not sophisticated enough in accounting to understand what these variations mean for the value and predictive reliability of the statement. They therefore rely on the interpretations of others when making investment decisions, and they expect honest answers from both accountants and managers.
The Enron and WorldCom scandals changed the way investors, shareholders, and employees view financial statements and accountants in general. After unsuspecting employees lost their pensions and personal savings, the government enacted rules requiring corporations to set aside a portion of earnings for future obligations such as retirement plans. However, doing so reduces reported profits and can make a company appear less attractive to present-day investors (Thompson 2007).
Managers have a clear motive to make their company appear to be a sound investment. Yet shareholders too often focus only on current profits rather than on what a company is setting aside for the future. Saving for the future means reporting less in the present. Because managers must attract investors, there is an incentive to make a company appear more profitable than it actually is — not by telling outright falsehoods, but by arranging the numbers in the most favorable light permissible under GAAP. This is where the experienced investor holds an advantage over the inexperienced one. There is a fine line between a legally misleading statement and one that is simply tailored to a more sophisticated reader.
Past performance of a company is no guarantee of its future performance. Investors in GM and Chrysler twenty years ago would never have imagined that those same companies would one day face bankruptcy (Stoll and Terlep 2009). These companies were once considered among the most promising and stable investments available. As stock prices fell, investors learned that forward-looking statements are not reliable predictors of the future.
Most financial statements are already outdated by the time they are published. Year-end statements may not be released until the new accounting year is well underway, and they may contain information that has changed considerably since it was first compiled. The world of finance moves quickly, and what was true yesterday may not be true tomorrow.
As a result of these factors, shareholders often base their decisions on information that is no longer relevant, or on statements that may or may not prove accurate. Shareholders and other investors need information that is current and that accurately represents the company's present financial condition and realistic future prospects. The current accounting system does neither adequately enough for the average shareholder to interpret with confidence.
"Timely, accessible information for non-expert investors"
"Valuing intangible assets under new accounting standards"
"Debate over reforming or replacing GAAP standards"
The accounting industry has changed dramatically over the past several years. New standards from the government, coupled with new standards from the public, are reshaping the profession. There is pressure for financial reporting to become more user-friendly for non-accounting professionals, and that pressure is likely to intensify in the future. Accountants are now scrutinized by people who may lack the background to fully understand what they are reading, and they must answer to nonprofessionals and professionals alike while continuing to develop new techniques for new business challenges.
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