Putting Financial Reporting Standards Into Practical Perspective

Posted by Robert Eccles (Oxford University) and Kazbi Soonawalla (Oxford University), on Tuesday, August 2, 2022

In our previous post, The Complex, Contentious, and Changing Nature of Financial Reporting Standards, we show that financial reporting standards, despite what some might think, are hardly set in stone. An ever-changing world can lead to changes in standards, and the process for making these changes is a contentious one. It is thus fair to ask how useful having standards really is in the first place. The answer is that they are very useful because they provide the social construct for the measurement of financial performance. They are a necessary foundation for doing financial analysis, but the statements are not analyses themselves. The types of analysis done are a function of the user of the financial statements. It is also important to note that the preparation and audits of financial statements are done in a broader institutional context intended to ensure the quality of both.

Financial statements are the starting point for companies to provide information on their financial performance. Companies may have incentives to opportunistically use the discretion permitted in GAAP and elsewhere to present their financial performance in ways that favor them. They do this in three ways. First, they report so-called “non-GAAP” profit measures. As explained by the CFA Institute, “Non-GAAP earnings are an alternative method used to measure the earnings of a company. Many companies report non-GAAP earnings in addition to their earnings as calculated through generally accepted accounting principles.” The Institute notes that “The discrepancies between GAAP and non-GAAP earnings can thus be enormous,” but also acknowledges that “some asset managers believe that these alternate figures provide a more accurate measurement of the company’s financial performance” due to the fact that “Standard financial reporting requirements are fairly prescriptive.”

Govindarajan, Shrivastava, and Zhao note that 95% of S&P 500 companies report non-GAAP earnings. They identify three common reasons for this practice intended to provide a “truer” view of a company’s underlying financial performance: Stock option expenses, write-off of acquired intangibles, and restructuring charges. In order to deal with the obvious possibility that non-GAAP measures are an intentional way to report earnings performance as more favorable than it really is (noting that there is no fundamental reality in any of this), the SEC has issued Regulation G which prohibits the dissemination of false or misleading GAAP or non-GAAP financial measures.

Whatever method for reporting earnings is used, the question then becomes “Is this good news or bad news?” There are many factors which shape this answer. A key one is what the market expects the earnings to be. This is the second way in which companies seek to get a positive view of their financial performance. They engage in “earnings guidance” to properly set the expectations of sell-side analysts who publish “earnings forecasts.” The game here—and everyone involved knows it’s a game—is to have a consensus forecast the company knows it can meet or beat.

Third, companies work to provide information beyond what is reported in financial statements. This can include quantitative information (e.g., revenues, earnings, and cash flow) by business segment, how their performance compares to competitors, and substantial narrative information about a company’s strategy and prospects that goes well beyond which is published in a U.S. 10-K (with the obligatory disclaimers about forward looking information). For example, consider the presentation from ExxonMobil’s March 2, 2022 virtual webcast Investor Day. This 100-slide deck (two-thirds as long as the company’s 144 page 2021 10-K) contains an enormous amount of quantitative and narrative information, some at a very granular level of detail such as:

• Earnings and cash flow by business segment (upstream, downstream, and chemical)

• Production compared to a set of competitors

• Carbon capture capacity

• Earnings growth potential through 2027 and the reasons why (e.g., structural cost reductions, volume, and mix)

• Operating cash flow potential through 2050 based on the IEA NZE Scenario

• Different industries supporting the energy transition and ExxonMobil’s competitive strengths in the high growth ones

• >$15 billion in investments through 2027 to lower carbon emissions

• Capital expenditures, production capacity, and free cash flow out of the Permian basin through 2027

• 10 pages of quantitative and narrative data on product solutions

• A nine page “Low Carbon Solutions Spotlight”

• A nine page “Financial Plan” through 2027

Investors do their own work to ascertain the meaning of the numbers reported in the financial statements. They have their own views of GAAP vs. non-GAAP earnings, they put these in the context of their own earnings’ expectations, they analyze the other information companies provide, they speak to fiduciaries and other important corporate stakeholders, they do extensive comparative analysis between the company and its competitors (such as adjusting for differences in depreciation schedules), they purchase data from various sources (such as ESG ratings), they do their own proprietary research (such as talking to industry experts, doing customer surveys, and accessing data from sites such as Glassdoor), they look at industry and market trends, they consider the impact of exogenous factors like growth and interest rates, and they put accounting data in the context of market data, like calculating the price/earnings ratio.

And while both companies and investors build and elaborate on financial statements in many ways and put them in a much larger information context, the financial statements based on standards create a common language for dialogue and engagement. For the most part the words in the language are understood and accepted by both parties which spares them time discussing exactly how each number in the income statement and balance sheet was produced. This enables them to focus on those words where there may be questions of derivation and interpretation, such as non-GAAP earnings. Imagine if every company had its own accounting standards and investors needed to learn these multiple languages and keep clear which language they need to speak in when talking to a company. And the company wondering if the investor really understands the language it’s speaking. While it wouldn’t be a Tower of Babel it would certainly detract from the time available to discuss the meaning of the numbers rather than the definition of the numbers.

Right now we are in the throes of the birth of the ISSB. “The International Sustainability Standards Boars [sic] As An Ideological Rorschach Test” notes that some think it is trying to do too little, some too much. Such was the case with financial supporting standards. Some think it won’t accomplish anything important. Some hope too much from it. Standards aren’t a silver bullet. They don’t set targets, like for carbon emissions. They simply give guidance how such targets should be developed, measured, reported, and then provide a standard for reporting on the extent to which a target has been achieved. Whether targets are set, and the progress on them, will depend on many other factors, such as pressure from investors and NGOs, government regulations, and executive compensation.

Staying with carbon and the Greenhouse Gas (GHG) Protocol, there is a clear analogy to earnings. After much debate a standard will be established. With the appropriate support, this standard will be mandated. It won’t be too long before companies start reporting non-GHG Protocol emissions for the same reason they report non-GAAP earnings. This will be more problematic since the regulatory infrastructure does not exist to provide guidance on the legitimate reporting of non-GHG Protocol emissions. Companies will set and manage GHG emissions targets. Analysts will create expectations about them. There will be a new game called “GHG Emissions Management.” Companies will then provide substantial contextual information, both quantitative and qualitive, to influence how their GHG emissions numbers are interpreted.

Investors will do all the things we describe above.

And a common language will have been created to facilitate and improve dialogue between companies and investors on climate performance, and eventually other sustainability issues.

Again, the analogy to financial reporting standards follows pretty easily and directly. The big difference here, and an even bigger challenge, is how to interpret the relationship between financial and sustainability reporting standards. This is often called “integrated reporting,” although there is substantial variation in practice in terms of its meaning and how an integrated report is done. The International Integrated Reporting Council (IIRC) published “The International <IR> Framework” in 2013. While the concept of “integrated thinking” is implicit in “[Draft] IFRS S-1 General Requirements for Disclosure of Sustainability-related Financial Information” it is the framework of the Task Force on Climate-related Financial Disclosures which has been adopted. Obvious questions to raise include “How to determine if a standard developed by the ISSB should be integrated into IFRS?” and “Can a common conceptual framework be developed that covers both IFRS and the work of the ISSB?”

Time will tell on this bigger question. For now, the focus must be on developing as much as possible a global set of sustainability reporting standards. This will involve all of the challenges and more experienced in setting standards for financial reporting. And recognizing that once these standards are developed, and it is a regulatory requirement to use them for reporting, they will simply be the starting point for dialogue between the companies who prepare them, the stakeholders who use them, and the regulators who enforce them.