No Closure on Disclosures

(First of two parts)

Hans Hoogervorst, Chairman of the International Accounting Standards Board (IASB), delivered a very interesting speech during the International Financial Reporting Standards (IFRS) Conference held in Amsterdam last 27 June 2013. While his speech touched on three areas, the part relating to financial reporting disclosures was the one which particularly caught my interest.  No, I was not in Amsterdam to hear him deliver the speech.  But upon reading his speech, I felt compelled to write and share certain points that he made to those who have not heard nor read his speech. 

The Disclosure Paradox

“For many companies, the size of their annual report (referring to financial reports) is ballooning. The amount of useful information contained within those disclosures has not necessarily been increasing at the same rate. The risk is that annual reports become simply compliance documents, rather than instruments of communication.” – Hans Hoogervorst

I have been waiting for quite some time for a standard-setter or a regulator to say those statements in public simply because I have similar sentiments but am too afraid to air them lest I be misunderstood by standard-setters and/or regulators.  Since we have adopted the IFRS (as Philippine Financial Reporting Standards or PFRS), the volume of disclosures in the financial statements have increased significantly, resulting seemingly from the desire or the obligation to comply with the disclosure requirements of PFRS.  However, even with the increase in the volume of disclosures, investors and other users of financial information continue to complain that they don’t get the information they need from the financial statements.   There just doesn’t seem to be a similar notable increase in the usefulness of information despite the significant increase in disclosures.  Or worse, the increased volume of disclosures may have even decreased the usefulness of the information in the financial statements especially if you do not know where and what to look for.  Hoogervorst made a similar point in his speech by saying, “excessive disclosures can even be very handy for burying unpleasant, yet very relevant information.”  It should be noted however, that at certain times, relevant information is not even buried under a bunch of non-relevant or less relevant information but rather, the more relevant information is not even there.  And when you ask why such information is not presented, one of the common answers of preparers is that “it is not required by the standards,” conveniently forgetting that while individual standards specifically indicate certain “minimum” disclosures, there is also general requirement to provide information relevant to understanding any of the information presented elsewhere in the financial statements.  I can still recall our accounting professor (called by most people as Dean Irog) when she was teaching us the qualitative objectives of financial reporting, telling us that there should be a balance between the qualitative objectives of financial reporting; that, for example, while additional disclosures might enhance the objective of “Completeness,” it should not be at the cost of other objectives such as “Understandability” and that we should never forget the primary qualitative objective – “Relevance.”  Dean Irog, I’m sure, has explained such in a more emphatic manner than how I have put it.  But the point is that, despite the numerous changes in the conceptual framework and the accounting standards, what she was teaching us decades ago still rings true today – that in preparing financial statements, we should always keep in mind that the objective is to provide information that is useful in making decisions.  At times, such may require us to provide more disclosures or go beyond the “minimum” requirement of the standards.  But at other times, we need to cut back on some irrelevant information to make the financial statements more understandable and therefore more helpful – Less is More.  The big question is “In the light of current accounting standards and regulations, how free are we to exercise such judgment?”

Risk-aversion as one of the main culprits

“Many preparers will err on the side of caution and throw everything into the disclosures.  They do not want to risk being asked by the regulator to restate their financials….”-Hans Hoogervorst

They say the first step to solving a problem is to understand the problem.  In an effort to further understand the “disclosure problem,” IASB organized a Discussion Forum on Financial Reporting Disclosures which was participated by regulators, standard-setters, auditors, preparers and users of financial statements.  While there were different perspectives from the participants, a common conclusion, according to Hoogervorst, was that many aspects of the disclosure problem have to do with behavioural factors, referring specifically to risk-aversion. 

The following texts taken from The Feedback Statement on the Discussion Forum on Financial Reporting Disclosures released by IASB in May 2013 paint an even more detailed picture of how risk aversion contributes to the problem.

• Some preparers treat financial statements as compliance rather than communication documents. The result is an excessive use of boilerplate text. In their own defense, some preparers said that the cost of failing to disclose what later proved to be relevant information was high.

• Auditors and securities regulators had focused on compliance at the expense of communication, leading to a ‘tick the box’ approach to disclosure.

• Regulatory enforcement using a ‘comply or explain approach,’ whereby preparers are called to explain why a particular disclosure is not material, leads to a ‘better safe than sorry’ attitude. Preparers, and auditors, claim that this leads them to err on the side of caution so preparers include disclosures even if they do not consider the information to be material.

I do not know if there were participants to the Discussion Forum coming from the Philippines but I wouldn’t be surprised if the same views will be heard if a similar forum is held locally.

What can be done?

When the standard-setters prescribed what disclosures should appear in the financial statements at a minimum, surely they didn’t imagine it will result in “excessive disclosures.”  Preparers complain about the increasing disclosure requirements in the standards. Users complain that they are not getting the information that they need. The Discussion Forum demonstrated that there was no clear agreement on the problem definition among the participants.  But they all accept that they contributed in a way to the problem and that there are no quick fixes for the problem. 

They also agreed on another thing – that IASB should take the lead in addressing the issue.

In response, Hoogervorst set out in his speech a 10-point plan for the IASB to deliver tangible improvements to disclosures in financial reporting which includes among others:

• Clarifying that the materiality principles does not only mean that material items should be included, but also that it can be better to exclude non-material disclosures.

• Clarifying that if a Standard is relevant to the financial statements of an entity, it does not automatically follow that every disclosure requirement in that Standard will provide material information.

• Making sure that the Standards, particularly IAS 1 - Presentation of Financial Statements, give companies flexibility on the order of the notes and where  they disclose accounting policies, allowing companies to communicate their information in a more logical and holistic fashion and  to give greater prominence to important accounting policies.

• Seeking to use less prescriptive wordings for disclosure requirements when developing new Standards, creating more explicit room for judgment on materiality.

• Reviewing the Standards, starting with IAS 1, IAS 7 – Statement of Cash Flows and IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors, with the goal of creating a new disclosure framework, to be followed by a general review of disclosure requirements in the other existing Standards.

It might take more than a change in the standards to change the current culture of boilerplate disclosures and checklist mentality but Hoogervorst and the IASB hopes that the above measures will “help to ignite the much-needed change in mindset of preparers, auditors and regulators that is so sorely needed.”  Well, I too hope so.

Oliver C. Bucao is a Risk Management Partner of Manabat Sanagutin & Co. (MS&Co.), the Philippine member firm of KPMG International.

This article is for general information purposes only and should not be considered as professional advice to a specific issue or entity.

The view and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG International or MS&Co. For comments or inquiries, please e-mail manila@kpmg.com or rgmanabat@kpmg.com