In the accounting world, an important development took place earlier this year: the Financial Accounting Standards Board (FASB), which sets US accounting standards, conducted a field study to test how chief financial officers reacted to competing sets of guidelines instructing them when and how to write disclosure notes.
For years now private fund chief financial officers and others have questioned the relevance and sheer volume of information that must be contained in these disclosure notes. Any way to reduce the amount of notes written, or to in some way make them simpler and more meaningful to LPs would be a massively celebrated development for the firm’s finance team.
As pfm has been reporting, FASB and its more global counterpart the International Accounting Standards Board (IASB) are keenly aware of the problem. To begin offering solutions, FASB reached out to 25 companies for its field test – a mixture of private, public and not-for profit – to figure out how different wording in accounting guidance can result in preparers of financial statements exercising greater discretion when making disclosures. On the one hand, the FASB and IASB want to make sure enough disclosures and transparency is being provided to stakeholders; on the other hand, no one wants so much disclosure that it results in an information overload.
In the study, one set of companies was simply told if something is considered material, based off its own judgment, disclose it; if not, leave it out. At the other end of the spectrum participants were given much more descriptive rules-based guidance. A control group was given FASB’s current disclosure guidance, which FASB spokesperson John Pappas admitted to pfm was still resulting in CFOs making disclosure notes that weren’t always meaningful.
So what did the study find? Turns out that giving CFOs full discretion over the disclosure note writing process still results in bloated financial statements. That’s a somewhat surprising result, in that CFOs say the rules-based guidance makes them feel overly cautious about what disclosures to make, even if only marginally useful to investors. More trust in CFOs’ discretion is needed, critics of the current system say.
Pappas explains the results by pointing out that the definition of materiality contains some baggage, noting specifically that the US Supreme Court’s interpretation of the word seems to be ignored by preparers of financial statements. In a case ruling on the matter, the court said information is material if there’s a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available”.
In other words, information is material if it could influence an investor’s perception of the entity’s financials, and thus should be disclosed. Otherwise, leave it out. So why is this principle being ignored?
“Under Sarbanes-Oxley the concept of materiality has gone away because you have to have accounting systems that give you the right answer no matter what,” says David Larsen, a managing director at valuation specialist Duff & Phelps. He explains that auditors don’t tend to create much distinction between private and public companies when conducting audits, meaning Sarbanes-Oxley ended up having a strong presence in the private-sector too.
Market sources agree that pressure from auditors and regulators causes them to be wary in what disclosures they choose to omit. “If the Securities and Exchange Commission writes us a letter and says ‘why didn’t you put this disclosure in?’, we don’t write back and say ‘because it is immaterial’; we start putting the disclosure in,” says one US-based private fund CFO.
A CFO is free to write back explaining why a disclosure was omitted; but most end up slotting it in to save themselves from a potential argument, according to sources.
A global effort
Meanwhile an IASB working group is making its own efforts to improve disclosure notes. The group is asking national and regional standard-setters about how auditors and regulators use judgment when applying the concept of materiality. The group is expected to present its findings to the board sometime later this year. IASB declined to provide any further details.
However, a source close to the board said a problem being discovered by the working group is that even though auditors and preparers understand in principle what disclosure notes are material, they’re less certain about when discretion should actually be applied.
Turning attention back to the US, a handful of industry representatives have been speaking with FASB board members about how certain disclosure rules are forcing CFOs to write notes that are oftentimes meaningless to investors, for example a disclosure table showing the roll forward of portfolio companies by security type. Sources tell pfm the board was unaware of these types of outcomes and appeared receptive to industry concerns.
Another sentiment being expressed to the board – either through informal chats or consultation submissions – is that simply updating current guidance isn’t necessarily the best way forward to solve the problem. In today’s post-Sarbanes-Oxley world, with the harsh punishments for CFOs or auditors who flirt the line on accounting rules, everyone wants to play it safe.
As part of its work on disclosure notes, the FASB launched an exposure draft in 2012 asking stakeholders to provide their feedback on how the board could improve the effectiveness of disclosures. FASB is in the process of reviewing those comment letters, and its results from the field study, to recirculate an updated exposure draft sometime later this year.
Some say the problem can be solved by reforming Accounting Standards Topic 946, which contains specialized accounting and disclosure requirements for investment companies. Changing Topic 946 doesn’t impact the fair value disclosures of other preparers, such as banks or insurance companies, which also use fair value accounting, meaning targeted reform can happen for disclosure-related challenges unique to GPs, points out Larsen.
Take for instance the disclosure of “Significant Quantitative Input Assumptions Used for Level 3 Fair Value”. In the private funds context, the disclosure requires CFOs to list all the valuation inputs used for a fund’s portfolio companies. By this respect, the disclosure typically explains that portfolio companies are valued on a multiple of EBITDA basis with, say, EBITDA ranging from 2x forward EBITDA to 36x forward EBITDA. The industry calls this kind of information meaningless, because it presents the aggregated valuation range, which doesn’t give much clue as to how any one portfolio company is measured. But for banks or insurance companies who may have a more homogenous set of assets to value, the ranges may not be so wide – so the disclosure would be important to their investors.
Ultimately whatever changes FASB and IASB do make will take time to realize in practice. The FASB is still reading over comment letters to its March exposure draft and, as mentioned, plans on producing even more exposure drafts as part of its overall disclosure project. The IASB’s work too is far from completion: its disclosure notes project is not scheduled to finish until the second half of 2015 at the earliest.
The good news then is accounting standard setters are forming dedicated teams to extinguish meaningless disclosure notes. The bad news is that, at least in the short-term, CFOs will continue to wrestle with what notes to include as regulators demand fully compliant financial reporting.