The Future of Financial Reporting Part 1

by FEI Daily Staff

How companies get information from their balance sheet to investors will include a combination of new technology and old simplicity.

Financial executives often decry the amount of information they are being asked to provide regulators each year, with many contending the regulations and methods used for reporting that information have become too burdensome and costly.

The flip side to that argument is that firms that fail to provide transparent and easy-to-understand annual reports may risk losing high-level investors who have become weary of complex company reports that are sometimes too good to be true.

Regulators, too, are continuing to insist companies’ financial reports serve to illuminate rather than cloud a corporation’s true financial health. While much is being done by government entities and advocacy groups looking to improve the way public companies file their 10-Ks and annual reports, the jury is still out on whether any of these changes will eventually take place. One thing that regulators, corporations and investors can all agree on is that the current state of corporate filing needs to be updated. Following the collapse of the tech bubble in the early 2000s and the accounting scandals that ensued at companies such as Enron and WorldCom, the Sarbanes-Oxley Act of 2002 was passed in response to a directive from Congress.

“At the time, there was the idea that things needed to be cleaned up, independent of company boards and auditors,” says Craig Lewis, professor at the Owen Graduate School of Management at Vanderbilt University, and a former chief economist of the U.S. Securities and Exchange Commission (SEC) (serving from 2011 to 2014). One of the requirements the SEC had under Sarbanes-Oxley was it would review every public filing at least once every three years.

Unfortunately, the markets unraveled again only a short time later. In 2008, the Bernie Madoff Ponzi scheme served to shine a glaring light on the unprecedented amount of fraud that had taken place, unnoticed by regulators, for years. The mortgage crisis that unfolded that same year also illuminated the fact that many investors had purchased financial products tied to subprime mortgages that they, and apparently the rating agencies, didn’t understand.

To respond to the crisis and the lack of transparency in the markets, the SEC initiated new requirements that firms must abide by when filing their statements each year. The XBRL Compliance Initiative was enacted in 2009 as part of an effort to make the filing of company data more accessible and usable to the average investor. It mandated that a standardized format be used by all public companies when reporting their financial results, and that a system of tagging company data be implemented.

Since that time, regulatory bodies and industry advocates are continuing to push for the development of new and better methods of reporting and for better tools to be used by agencies reviewing company financials. The hope is that these changes will not only help regulators identify fraudulent behavior or inconsistencies in reporting, but will also help move the industry to a more transparent model that will better serve corporations and the investors they are competing for.

A Push for Electronic Filing One specific area that industry experts would like to see improved is the SEC’s Electronic Data Gathering Analysis and Retrieval (EDGAR) system. EDGAR is currently a form-based disclosure database that companies must fill out to complete their filings each year. The problem is that it still relies on paper or PDFs, as opposed to being run electronically. The system is outdated, according to William Lutz, emeritus professor of English at Rutgers University. “If you walk down the hallway and go through the SEC’s Corporate Finance Division, you will see all these cubicles of staffers reviewing piles of printed 10-Ks,” says Lutz. “The use of paper to review filings now seems prehistoric,” he says.

Lutz, director of the SEC’s 21st Century Disclosure Initiative from 2008 to 2009, says he has talked to many executives in the corporate world who agree with his anti-paper stance. “I will never forget talking to the CFO of one of three largest corporations in world, and he told me that the only time their numbers are on actual paper is when they send their reports to the SEC. That’s because in the corporate world, everything is electronic and digital,” notes Lutz.

There are software systems being used today that allow executives to send data to and from various business units within the corporation to be reviewed or amended electronically. It all can be done through the use of a dashboard, says Lutz. These systems allow data to be summarized and manipulated in any number of ways. Comparisons can be made to previous year’s filings or to the financials of similar companies, he notes.

Lutz believes companies should be sending their financial reports to the SEC in the same manner. “The SEC would then have a live feed of data that could be used by investors and regulators to compare the information provided by, for instance, several different major clothing retailers,” he says. “You would have it on a dashboard and be able to compare the sales per square foot of the stores of one company to another,” Lutz explains.

Several investor advocacy groups have tried in the past to convince the SEC to consider the use an electronic filing system, but the commission has not yet heeded the call to date, and there are currently no plans to do so.

XBRL: A Step in the Right Direction While the move to a non-paper-based EDGAR model may be a ways away, the SEC is already doing much to chart the data collects from companies that file through XBRL system. Lewis, who also served as director of the SEC’s Division of Economic and Risk Analysis (DERA), has been behind much of that effort.

“The idea was to make the financial statement information more usable to investors,” he says. Once the firms provide the required data in their 10-K, through the EDGAR system, XBRL is then able to present it in a structured data form that allows investors and analysts to not only look at the actual paper copies of reports, but to extract data from these financial statements and use it for analysis or to generate their own reports.

The way the XBRL program works is that it attaches a unique identifier to each piece of data a company provides in its 10-K filing, such as net profit or net sales. To date, over 11,000 XBRL data tags have been created to catalog every element found in the U.S. Generally Accepted Accounting Principles (GAAP) standards. “XBRL ultimately provides a way for organizing and defining data, which improves the way in which all financial data is communicated, reported and shared,” Lewis says.

While XBRL has, indeed, added a level of information gathering that wasn’t available before, there has been some controversy over which companies should have to abide by the standards of reporting that it mandates. “The problem with XBRL now is that the SEC allows too many exceptions for specific companies in how they use it,” says Lutz. “The more exceptions there are, the less data there is, and the less there is to compare,” he asserts.

For example, some corporations have petitioned the SEC saying that they should not have to use the same XBRL tags as other companies because their firm is composed of unique components, and therefore not comparable to other companies in the same industry. “The SEC’s Corporate Finance Division has been generous in granting these exceptions,” says Lutz. The result is that “if an investor wants to compare gross sales of corporations across an industry, certain corporations’ number won’t pop up, because they have a unique tab,” he explains. Lutz claims the XBRL system has been undermined because too many inconsistencies in reporting are already occurring.

Smaller Firms Want Out An even larger debate surrounding XBRL is taking place in Congress. Some corporations have protested to lawmakers that using the XBRL tagging system is too costly and that it puts undue burdens on smaller firms.

The legislation that addressed the issue, the Small Company Disclosure Simplification Act, was first introduced by representatives Robert Hurt (R-VA) and Terri Sewell (D-AL), and passed the House Financial Services Committee on March 14 by a vote of 51 to 5. The proposal is now part of a bill called H.R. 5405, which passed the House on September 16, requiring that the SEC exempt public companies with annual revenues under $250 million from filing their financial statements in the XBRL format for up to five years. The bill awaits a vote in the Senate.

In the meantime, several industry groups, including the National Consortium for XBRL Business Information Reporting, is fighting the bill, noting that too many companies would be exempt under it. “To give you some idea of which companies would be affected, some Fortune 500 firms actually have revenues of less than $250 million,” notes Lewis. “So these are not small companies they are talking about; it is a very significant portion of all filers,” Lewis notes. He estimates about 60 percent of filers would potentially no longer be required to submit XBRL statements to the SEC if the bill becomes law.

Supporters of the bill are holding their ground, claiming the XBRL-formatted financial statements cost tens of thousands of dollars a year to create. However, a survey done by Financial Executive International found that the median annual cost for small companies to file these reports is just $2,000, and that there are third-party providers offering XBRL preparation services at even lower prices. “This is one of these issues that just doesn’t go away, even in spite of the evidence that it is not that expensive to generate these XBRL reports,” Lewis notes.

Lutz concurs, adding that U.S. corporations are still far behind Japan and Europe in terms of providing transparent information to investors and regulators. “European countries are now moving much more aggressively in demanding this kind of reporting and data collecting than regulators in the U.S. are,” Lutz says.

This article first appeared in the Fall 2014 issue of Financial Executive magazine. Part 2 of the article will run tomorrow.

Leslie Kramer has worked as a journalist for over 10 years covering a wide range of corporate, investment and personal finance topics.