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The Design of Financial Statements

Penman, Stephen H.

This paper proposes a redesign of financial statements. It is written in response to proposals by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) to revise the presentation of financial statements. The paper is not an evaluation of the Boards’ proposals, but rather a stand-alone design developed from first principles to contrast with those proposals. After a hiatus, the IASB and FASB recently returned to the issue, so this document is offered as a contribution to that effort. The aim of the design is to reformulate financial statements in a way that reflects the operations of the business. Accordingly, the design readies the financial statements for an analysis of the performance of a business, the valuation of the business, and an evaluation of the stewardship of management. In practical terms, financial statements can then be loaded into an analysis spreadsheet without the cumbersome adjustments that often have to be made with the current financial statements. The paper largely endorses the approach proposed by the Boards while varying significantly in the implementation. Like the Boards’ proposals, it is built around three key ideas: (1) the cohesion between financial statements is an important aspect of accounting that conveys information that needs to be brought to the fore, (2) activities to do with a firm’s business operations should be clearly distinguished from activities that involve the financing of the business, and (3) disaggregation in the financial statements should be made with the objective of enhancing information about future cash flows. The architecture in the paper in built in three steps. First, the bottom-line numbers in each financial statement―the totals to which all other line items aggregate―are specified under the principle that the financial reports are to report faithfully to shareholders. Second, subtotals that sum to those bottom-line numbers are identified under the principle of distinguishing operating activities from financing activities. Third, further disaggregation is carried out under the principle of providing further information about the future cash flows. With this breakout of financial statement information, the paper shows how the component parts of financial statements connect to each other to provide information that adds to that in each financial statement—thus bringing the cohesion principle into life. A key feature of the design is the recognition that the accounting system is organized by a set of accounting relations—an accounting structure—that can be exploited to convey information. That is, financial statements convey information, not only through the accounting for individual line items, but also in the way those line items are organized in the financial statements and aggregated into totals according to this structure. Employing the structure to organize financial statements in a form that aligns with the way firms operate significantly enhances their information content.

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More About This Work

Academic Units
Business
Center for Excellence in Accounting and Security Analysis
Publisher
Columbia Business School, Center for Excellence in Accounting and Security Analysis
Series
Center for Excellence in Accounting and Security Analysis Occasional Paper Series
Published Here
August 3, 2017
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