“A check-the-box attitude can result in notes that are not terribly useful,” says John Pappas, spokesman for US accounting standard setter the Financial Accounting Standards Board (FASB). “And we [FASB] don’t want notes described as not terribly useful.”
Unfortunately however disclosures made in the footnotes of firms’ financial statements are becoming an exercise in compliance rather than a means of transparency and communication, according to an International Accounting Standards Board (IASB) survey.
A strong majority (80 percent) of the roughly 225 survey respondents, comprised of both preparers and users of financial statements from all parts of the globe, agreed that improvements could be made to the way financial information is disclosed. Preparers, such as private equity firms and their portfolio companies, say the problem stems from disclosure requirements becoming too extensive, adding that not enough is being done to exclude immaterial information.
David Larsen, a managing director at valuation specialist Duff & Phelps, says many private equity chief financial officers have questioned the relevance and sheer volume of information that must be contained in disclosure notes. For instance, “having to disclose specific inputs used in the fair value estimates of portfolio companies could be an information overload for investors.”
To cut the clutter many in the industry are advocating for accounting standards with more built-in flexibility
To cut the clutter many in the industry are advocating for accounting standards with more built-in flexibility.
Earlier this year at an IASB forum discussing disclosure notes, Hermes Equity Ownership Services director Paul Lee said that accounting standards should move towards principle-based guidance, which he feels would help shift the focus of financial reporting away from compliance and onto communication.
Backing his position is Russell Picot, who is responsible for external reporting at HSBC group, and chaired an IASB advisory committee on disclosures. Picot, also speaking at the IASB forum, said inserting disclosures for fear of non-compliance results in too many useless footnotes.
He adds poor organization and structure of financial reports, boilerplate disclosures and disclosures not focused on a firm’s key issues are also contributing factors to extraneous disclosure.
Tessa Park, technical partner at accounting firm Kingston Smith, says structural issues can sometimes be down to firms following standards too literally, for example IAS1, which covers financial statements.
“IAS1 states what order you would normally put the notes in, but it doesn’t go as far as saying you have to; it means that sometimes the most important notes are not given the prominence users would like.”
A FRAMEWORK FOR DISCUSSION
The problems around disclosure notes does not rest solely with standard setters, sources add.
Criticism had often been aimed at FASB and IASB for increasing disclosure requirements every time it was brought onto their agendas. But in the codification of FASB’s accounting standards, US Generally Accepted Accounting Principles (US GAAP), preparers can rely on “materiality” to help minimize their disclosure burden. “People don’t seem comfortable using materiality when thinking about disclosures, and I’m not sure why that is” says FASB’s Pappas.
The same can be said for the concept of materiality under IASB’s accounting standards, the International Financial Reporting Standards (IFRS), according to HSBC’s Picot. Although preparers and auditors understand the concept of materiality, they are less certain about how it should be applied, resulting in being too cautious and bloating their notes, he said at the IASB forum.
Park agrees: “If you look at IAS1 paragraph 31 it actually says information need not be disclosed if it is not material. A lot of the other accounting standards could be read as suggesting you have to disclose whether material or not. People tend to think let’s be on the safe side.”
To the delight of preparers, IASB acknowledges that its materiality concept is not being used enough. In a response to its disclosure survey, IASB said preparers are reluctant to filter out information that is not relevant to the readers of their financial statements, and auditors and regulators are reluctant to accept such omissions at face value, even though they are not necessarily required by IFRS.
To combat the growling list of disclosure notes included in financial statements, the IASB plans to start a project on materiality, with a view to creating either general application guidance or educational material, as part of its Conceptual Framework, which sets out the research agenda for the IASB and outlines possible courses of action. “That means addressing the root causes of why preparers may err on the side of caution and ‘kitchen-sink’ their disclosures,” Hans Hoogervorst, chairman of the IASB, said in a statement.
FASB too has been working towards changes in the way disclosure notes are reported. In July 2012, FASB released a consultation paper asking stakeholders how best to improve disclosures.
As part of the project, the FASB is reviewing the 84 comment letters it received on the consultation paper and working toward an exposure draft. The FASB is also conducting a field study to better understand the areas where preparers of financial reports feel they can exercise judgment over which disclosures they provide.
“We want to improve the effectiveness of the notes so that the disclosures focus on the most relevant areas,” says Pappas, who adds that FASB “is considering giving flexibility to preparers but needs to test the best ways to do so.”
But the wait for clarity is far from over. The FASB’s field test is in its infancy and the board is still soliciting participants. The IASB’s work too is far from completion and the Conceptual Framework is not scheduled to finish until the second half of 2015.
The IASB also stated that any changes to disclosure notes at the standards level wouldn’t be until 2016 at the earliest. So for the time being at least, working out exactly which disclosures notes to include in the financial statement is a challenge many firms may continue to struggle with.