Posted: May 25th, 2022

The nature of the Forward-Looking Statement

Accounting Profession

Towards a More User Friendly Financial Statement

Anyone that has ever read a financial statement is familiar with the disclaimer that begins, “This statement contains forward-looking statements” However, when one begins to read the contents of the financial statement, one soon finds that there is very little that could be considered forward-looking at all. The financial statement provides a historical look at company performance, suggesting that the future of the company will be similar to the past. However, every investor knows that this is not necessarily true. What has happened in the past may have nothing to do with the future of the company. Shocks in the market happen and companies cannot always be prepared for what is to come. This research will explore the backward-looking and forward-looking aspects of the financial statement and will support the need for better forward-looking models.

The nature of the Forward-Looking Statement

Shareholders and investors often turn to the financial statement to learn how companies have performed in the past. However, the most popular section of the financial statement is often the forward-looking statement. In this section, the managers and executives present their expectations and predictions for the future of the company. There is no standard formula for making these predictions. Every manager has their own method and set of factors that they consider in making their predictions.

Some estimates are conservative, while others are optimistic. The forward-looking statement reflects that personality and experiences of the managerial staff. One of the key tenets of the forward-looking statement is that it is only a guess. However, many investors place much more faith in the statement than it would merit.

Sometimes, investors base their entire decision on the forward-looking statement. When something happens and they do not get the return expected, or lose their investment, it often led to lawsuits in the past. In Harris v. Ivax Corporation (1999), the U.S. Court of Appeals for the Eleventh Circuit held that a company’s statements in press releases were protected from liability, as long as they included the proper cautionary statements. The company does not need to accurately predict every circumstance that could occur, but they do need to address any major risks that are identified.

The “Safe Harbor” rule of the Securities Act of 1933 protects companies from losses incurred due to forward-looking statements, as long as the company had a reasonable basis for making them (Cadwalader, Wickersham, & Tact LLP 1999). Companies may not engage in deception, but they are not required to foresee every situation that could occur in the future. This makes it a caveat emptor situation on the part of the shareholder. They must trust that the information contained in the financial statement is sufficient and accurate enough to be predictive, or at least reasonably so.

Ulterior Motives

Safe Harbor offers the company some protection against litigation due to shareholder losses as a result of statements contained in the forward-looking statement. Accounting statements must comply with all elements of the Generally Accepted Accounting Practices (GAAP). This assures at least some degree of uniformity and standardization of the information contained within. The purpose of the GAAP is to make certain that everyone can read and understand the statements made in the accounting statement. This offers shareholders at least some degree of certainty about what they are reading in the statement.

However, one must realize that the GAAP is more of a set of guidelines than a set of hard, fast rules. Within the GAAP, there is some room to adjust the accounting practices to suit the specific needs of the company. For instance, there is some room for deciding what to include for direct and indirect expenditures. Differences such as these can change one’s perceptions about the information contained in the statement.

Shareholders are often not sophisticated enough in their accounting knowledge to understand what all of these changes mean for the value and predictive nature of the statement. Therefore, they rely on the interpretations of others for the information that they need to make their investment decisions. Shareholders expect brutal honesty from the accountant and from the managers responsible for making those familiar forward-looking statements.

Everyone expects honest answers, but the question is, “Do they get it?” The Enron and WorldCom scandals changed the way investors, shareholders, and employees view the financial statement and accountants, in general. After unsuspecting employees lost their pensions and everything that they had managed to save, the government enacted rules that require corporations to set aside a portion of their earnings to be used for future needs, such as retirement plans and pensions. However, doing this reduces profits and can make the company look less attractive to the investor in the present (Thompson 2007).

The manager has a motive to make their company appear to be a good investment for the future. However, so many times, shareholders only look at profits now, rather than what the company is stashing away for the future. Saving for the future means having less in the present. Managers must attract investors, therefore, there is a motive to make their company appear to be more profitable than it is in reality. They are not telling untruths, they are just rearranging the numbers so that they will appear to be more attractive to the present investor.

The GAAP gives them room to do this legally in many circumstances. This is where the experienced investor has an advantage over the inexperienced investor. There is a fine line between an illegally misleading statement and one that is simply attuned to the more experienced investor. Shareholders often rely too much on the forward-looking statement to make their financial decisions.

Historical Information

Past performance of a company is no guarantee of its performance in the future. GM and Chrysler investors twenty years ago, would never have imagined that this same company would be talking bankruptcy today (Stoll and Terlep 2009). These companies were once considered the most promising and stable of investments for a secure future. Now that future is not so secure. As stock prices fall, investors are realizing that forward-looking statements are not the best crystal ball for the future.

We have discussed the caveat of relying too much on the forward-looking statement and the problems associated with using historical trends to predict the future performance of a stock as well. Most financial statements are already outdated at the time they are published. Year-end statements may not be published until the new accounting year is well underway. They many contain information that has changed considerably since they were began. The world of finance is fast-paced and what was true yesterday, may not necessarily be true tomorrow.

As a result of these two factors, shareholders are basing their decisions on information that may no longer be relevant, or on statements that may or may not come true. Shareholders and other investors have a need for information that is up-to-date and that reflects and accurate representation of the company’s current financial state or potential future state. The current accounting system does neither adequately enough for the average shareholder to interpret.

The Need for Relevancy

The average investor is not an accountant in many cases. They need relevant information that is presented in a “user friendly” format. In the past, the investor often relied on a stockbroker to interpret the accounting statement and make wise investments for them. Now, many investors are making their own investments and managing their own accounts. They are reading the financial statements for themselves and making their own decisions. Yet, a number of shareholders and investors are not aware of the nuances of reading these statements. This issue has raised the question of whether a more user-friendly accounting system is needed.

The accountant can be compared to a photographer, providing a snapshot of the company and their finances. This snapshot has many nuances that can provide clues as to the financial position of the company, both in the past, and in the future. The financial statement should tell give the reader an idea of what the business does and how it operates. It should reflect business cycles and expected shocks in the business. The financial statement should tell the reader what they can expect in the future, with a certain amount of reliability, Although, no one can predict the future, it is possible to predict the most common business cycles.

The relevancy of a financial statement can change over time. When the business is experiencing the normal business cycle, with its array of expected ups and downs, the financial statement holds a considerable amount of relevancy. For example, the retail industry has a highly predictable business cycle throughout the year. Normal ups and downs are expected. Investors can use these regular cycles to their advantage. In this case, the financial statement is highly relevant and timely information. It is a useful tool in the ability to predict business cycles.

As long as the business is in a state of regular growth or a cyclical pattern, the relevancy usefulness of the information in the accounting statement is high. However, when a shock happens that changes that pattern, the information is no longer relevant. In periods of turmoil, only the most up-to-date information is relevant. The usefulness of the information wanes quickly as the behavior of the company becomes more erratic. After a period of erratic behavior and change, the company may be forced to make internal changes that affect the way they do business. They may make changes that affect their inventory management, sales cycle, stock levels, supply chain, distribution network or other fundamental business functions. New patterns may emerge and the old information no longer applies.

The term “relevancy” can have many different meanings depending on what is happening with the company. A new accounting regime may need to be instituted when a change takes place. Looking at the most recent historical information is one way to determine the relevancy of the accounting information. The analyst needs to look for patterns and cycles, as long as the cycles appear to be consistent, the information could still e considered relevant. Another source of information to help determine the relevancy of the accounting statement is company news. One could monitor the company news to determine if there have been any stories about events that could affect the relevancy of the information in the financial statements.

Like the task of accounting itself, determining the relevancy of the accounting statement itself is an art. Many beginning investors skip the question of relevancy and timeliness. This leads to dangerous assumptions. It is easy to focus on historical patterns and the statements contained in the forward-looking statement, but in order to make the best decisions, investors need to ask themselves, not only what the information says, but how relevant it is to the current financial situation of the company. Information that was relevant to stocks in GM and Chrysler ten years ago, are no longer relevant considering the most recent news regarding those companies.

Accounting for Intellectual Property

One of the more recent topics that could affect the relevancy of the accounting statement is the problem of how to account for intellectual property. The introduction of the concept of intellectual property is relatively new to the accounting profession. Accounting systems typically address the problems and activities associated with the production and distribution of tangible products and services. Modern accounting systems were first developed at the beginning of the industrial era, in response to the needs of mass manufacturing facilities (Giroud n.d.). However, the information age has heralded a new need in the accounting profession.

Intellectual property represents and intangible asset. It can include things such as a brand name, ideal, concept, or software. These items are real business assets. Without them, the business would not be the same. However, placing a monetary value on them can be difficult. The modern accountant must devise a way to place a value on such intangible assets as these (Schweihs 2002). Setting guidelines for the valuation of intellectual property is the focus of a new set of accounting guidelines. Financial Accounting Standards Board Statement of Financial Accounting Standards No. 141 and 142 (SFAS 141 and SFAS 142) requires business to disclose the value of intangible assets and goodwill (Schweihs 2002).

The methods chosen for the valuation of intangible assets are quickly become necessary in order for the accounting information to be considered relevant and accurate. This new addition to already rigid guidelines places an additional strain on accountants. They must not only place a value on the assets, but they must decide how to present the material so that it makes sense to the average person reading the report.

Do We Need New Guidelines?

In the face of the Enron and WorldCom scandals, the public began demanding increasing transparency in the accounting industry. The world of accounting becomes increasingly complex as time goes on. The accountant now must meet increasing governmental regulation, increasing demands for public transparency, and increasing demands to make the information easily understood by investors that may not have a strong accounting background. In addition, recent trends consider accounting and auditing activities separate from one another (the American Assembly 2003).

At the current time, the GAAP remains the gold standard in the accounting industry. However, recent concerns indicate that these standards may need to be updated to reflect changes in business practices and new business models. Many accountants find it difficult to make their business fit into the GAAP standards (Wallison 2004). Because the new business models do not fit neatly into the GAAP, there are concerns that they may not represent the accounting information accurately, or in a way that represents a good snapshot. Information may be easily misinterpreted by those that are not familiar with these new business models. This may create a misunderstanding of future projections as well.

Concerns over the ability of the GAAP standards to accurately represent the climate of a changing business world have not only raised the question of if new standards are needed, and also which direction these new standards should take. Originally, accounting reports were intended for accountants and mangers with extensive training as to how to interpret them. Now we are seeing a new audience, one that has varying degrees of accounting knowledge. In addition to this new audience, the trend towards globalization also raises the question of the need to meet international standards so that everyone can read the financial statement of businesses abroad. The GAAP was developed in a closed environment with a select audience in mind, Now, the financial statement is accessible to a wider range of people.

One solution to the problem may be to require two different versions of the accounting statement, one for managers and technical people and the other for the layperson and the international investor. One of the key problems with this is that it places an even greater burden on an already bogged down accounting profession. It appears that the accounting profession is in need of simplification, not greater complication. Currently, the debate is still out on this topic.

Conclusion

The accounting industry has changed dramatically over the past several years. New standards from the government, coupled with new standards from the public are changing the accounting industry. There is pressure for the industry to become more “user friendly” for the non-accounting professional. In the future, the accounting profession is likely to experience even greater levels of demands for transparency. The accounting profession is under scrutiny by those that do not have the proper background to understand what they are reading. The accountant must answer to nonprofessionals, as well as professionals. They must attempt to meet the needs of all of these groups, while continuing to develop new techniques to meet new business challenges.

New standards are in order. However, these new standards must also meet the needs of a changing audience. The average investor relies on narratives and forward-looking statements as their key tools for making financial decisions. They often do not realize that they must consider the relevancy of historical patterns to the company’s current position.

The need for relevancy, transparency, and user friendliness are the drivers of new accounting standards. Perhaps all that is needed are extra sections added to the current reporting standard. Sections need to explain in everyday language, what the numbers mean and how they were derived. Statements regarding the relevancy of the information, similar to the forward-looking statements would make the lay investor aware of these issues. If the accountant made modifications to standard practices, they need to explain these methodology changes so that everyone can easily follow what they did and what they mean.

The GAAP was meant as a set of guidelines, not hard and fast rules. They were designed to unify reports so that everyone understood them. Instead of writing a new set of standards, some simple additions to the GAAP would help to fulfill the changing needs of a changing audience. The accounting audience has changed forever and no longer is limited to the accounting professional. A new report format is suggested that meets the needs of the new audience.

The future of the accounting profession depends on its ability to continually meet increasingly harsh demands from a larger number of people. Accountants need to accommodate many different audiences. Just as the fields of accounting and auditing have evolved into two separate profession, the accountant may one day hire writers that are versed in accounting to deliver a financial statement that is relevant, accurate, and easy to understand by all.

References

Cadwalader, Wickersham, & Tact LLP. 1999. Application of the Safe Harbor for Forward-

Looking Statements. Findlaw. Accessed April 23, 2009

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Giroux, G. (n.d.). American Big Business and Cost Accounting. In a Short History of Accounting and Business. Accessed April 23, 2009

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Harris v. Ivax Corporation 182 F.3d 799, 807-08 (11th Cir. 1999). Findlaw. Accessed April 23,

2009
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Schweihs, R. 2002. Valuation of Intellectual Property is the focus of the new accounting guidelines. Intellectual Property and Technology Law Journal. May 1, 2002. Accessed

April 23, 2009
25432670_ITM.>.

Stoll, J. And Terlep, S. 2009. GM to Offer Two Choice: Bankruptcy or More Aid. February 16,

2009. Wall Street Journal. Accessed April 23, 2009

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The American Assembly. (2003). The Future of the Accounting Profession. 103rd American

Assembly. November 13-15, 2003. Leesburg, Virginia. P. 1. Accessed April 23, 2009

file_future%20of%20the%20accounting%20profession%20report%20final.pdf>.

Thompson, V. 2007. Is Government Accounting Misleading the Nation? Center for a Just

Society. October 17, 2007. Accessed April 23, 2009

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Wallison, P. (2004). The Future of the Accounting Industry. American Enterprise Institute for Public Policy Research. June 17, 2004. Accessed April 23, 2009

.

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