BUS103: Introduction to Financial Accounting

A useful place to start the discussion is by asking the question, "Why do we care about financial reporting?" Put simply, we care because capital is the engine of our economy, and information is the oil that keeps the engine running smoothly. It is on this premise that the entire disclosure framework of our securities laws rests. The assumption - and I think it is a good one - is that providing information on which sound investment decisions can be made is the best way to allocate the scarce resource known as investment capital. In an efficient market, capital will seek its highest use. It is, therefore, not an overstatement to say that without good information our markets could not function effectively. 

As the economy has evolved, so have our needs for different kinds of information, and different ways to use that information to measure a company's value. If you are talking about a small sole-proprietorship with primarily hard assets, you have a fairly straightforward valuation exercise. On the other hand, a drug company whose main asset is in-process research and development presents a real challenge. Going back to my food analogy, one is made of milk and flour, the other with fructooligosaccharide. 

The foundation of financial reporting is the historical performance and financial position of a company as recorded using GAAP. GAAP, however, only provides a starting point for a conversation in the marketplace about the value of a company. As the Commission noted last year in its proposal regarding critical accounting estimates, GAAP represents an imperfect compromise in conveying information about a business. One thing many investors don't realize is that GAAP reports don't express a company's performance with pinpoint precision. Some GAAP measures employ assumptions that involve a fair amount of subjectivity. Other items that are not quantifiable with a fair degree of certainty may not be reflected in GAAP earnings at all, even though they can have important present and future economic consequences for shareholders. Earnings per share is frequently cited as a key performance indicator - or the key performance indicator - but for most companies it represents at best only one point within a range of results that reasonable people could arrive at using the agreed-upon rules. 

Another issue is that past performance is not necessarily indicative of future results. Because valuation looks to the future as well as the past and present, the Commission has attempted to get companies to provide more forward-looking information. As the Commission noted when it adopted the Management's Discussion and Analysis ("MD&A") disclosure requirement: "The Commission has long recognized the need for a narrative explanation of the financial statements, because a numerical presentation and brief accompanying footnotes alone may be insufficient for an investor to judge the quality of earnings and the likelihood that past performance is indicative of future performance". Accordingly, the MD&A must provide forward looking information "where there are known trends, uncertainties or other factors enumerated in the rules that will result in, or that are reasonably likely to result in, a material impact on the company's liquidity, capital resources revenues and results of operations, including income from continuing operations".

The goal of all of these disclosure requirements is to reduce uncertainty and narrow as much as possible the reasonable range of values for the company that might be inferred from its reported results. Despite these efforts, as businesses have become more complex, they have also become more difficult to categorize for reporting purposes. The fact that both managers and investors have increasingly based their decisions on nonGAAP measures of performance is a good indication that GAAP measures alone do not adequately serve the market's needs.