For the Investor:
Market Volatility—Implications for Financial Reporting
The headline atop a recent Barron’s cover story (The Volatility Lovers) proclaimed that market swings are back with a vengeance, shaking investors’ resolve to buy on the dips.
Recent stock market declines, signs of economic slowdown in China, and continuing uncertainty around the timing and implications of interest rate increases in the U.S. have all contributed to this volatility.
In a market cycle such as this, how can financial statements be used and improved to help investors see through the murkiness to make sound investment decisions?In a market cycle such as this, how can financial statements be used and improved to help investors see through the murkiness to make sound investment decisions?
Investors and lenders tell us that they use financial statements and related footnotes to get a solid understanding of the financial performance of an organization in recent periods (and in similar periods in past business cycles) as well as the organization’s financial position. This base of understanding gives capital providers the ability to make predictions about future cash flows that the organization will produce, and thus the return on their investment.
In times of market volatility, this assessment is all the more critical.
Financial statements need to provide information about past performance that investors can use to make future predictions.Good performance information should help investors understand whether changes in the current period are due to alterations in the operations of the business, or volatility in the markets. The financial statements therefore need to provide information about past performance that investors can use to make future predictions.
To address this issue, the FASB staff is undertaking preliminary research on how we can improve the relevance and display of performance information in the financial statements, concentrating on the income statement.
The staff is first working on identifying different approaches that could help investors understand components of performance in ways that might better facilitate analysis and financial modeling. In identifying approaches, the staff has a goal in mind: to increase the clarity of the performance statement by presenting certain items that may affect the amount, timing, and uncertainty of an organization’s cash flows.
The following approaches are not mutually exclusive, and some are trickier to implement than others.
|Define an “operating income” subtotal.||Various ways can be used to develop a required subtotal for “operating income” if one is desired. GAAP today does not require such a subtotal.|
|Require breakout of “recurring” versus “non-recurring” items.||Improve the display of infrequently occurring items on the face of income statement or in the notes.|
|Add transparency about remeasured items in the income statement.||As some balance sheet assets and liabilities are remeasured each quarter, impacting the income statement, separating out some remeasurements could help investors with earnings predictions.|
|Improve the display of natural and functional classifications.||Some line items, such as cost of goods sold and selling, and general & administrative expenses could be required to be broken out into further detail.|
|Better describing what can be grouped within a line item.||Provide more guidance on what items can be aggregated together into a single line on the income statement.|
As I mentioned, during periods of market swings, investors have told us that it is essential to dig into the financial statements and related footnotes. Their analysis requires putting the pieces of the puzzle together in a way that communicates the elements of reported earnings that deserve a greater multiple, as compared to other market-dependent earnings components.
While investors already use the information provided in the financial statements in order to accomplish this, the FASB’s research project on Financial Performance Reporting is looking into ways to improve the display of performance information in the future. Visit our website to track our progress.