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This article was first published in the May 2012 International edition of Accounting and Business magazine.
The effects of clutter have typically come in for little consideration by the preparers of annual reports, but the phenomenon is increasingly under discussion, with initiatives recently launched to combat it.
The Financial Reporting Council (FRC) in the UK is one organisation that has called for a reduction in clutter in annual reports. And the International Accounting Standards Board (IASB) commissioned the Institute of Chartered Accountants in Scotland (ICAS) and the New Zealand Institute of Chartered Accountants (NZICA) to make cuts to the disclosures required by a group of International Financial Reporting Standards (IFRSs), and to produce a report.
Clutter in annual reports can be a problem for users. It obscures relevant information and makes it more difficult for users to find the key points about the performance of the business and its prospects for long-term success. The main observations of a discussion paper, called Cutting Clutter, that was published by the FRC were:
- There is substantial scope for segregating standing data in a separate section of the annual report (an appendix) or putting it on the company’s website.
- Immaterial disclosures are unhelpful and should not be provided.
- The barriers to reducing clutter are mainly behavioural.
- There should be continued debate about what materiality means from a disclosure perspective.
It is important for the efficient operation of the capital markets that annual reports do not contain unnecessary information. It is equally important that useful information is presented in a coherent way so that users can find what they are looking for and gain an understanding of the company’s business and the opportunities, risks and constraints that it faces.
However, a company must treat all its shareholders equally in its provision of information. It is for each shareholder to decide whether to make use of that information. It is not for a company to pre-empt a shareholder’s rights by withholding information.
Too many rules?
A significant cause of clutter in annual reports is the vast array of requirements imposed by laws, regulations and financial reporting standards. Regulators and standard setters have a key role to play in cutting clutter both by cutting the requirements they themselves already impose and by not imposing unnecessary new disclosures. A listed company may have to comply with listing rules, company law, IFRS, the corporate governance codes and (if it has an overseas listing) any local requirements, such as those of the Securities and Exchange Commission (SEC) in the US. A major source of clutter is that different parties require differing disclosures for the same matter.
For example, an international bank in the UK may have to disclose credit risk under IFRS 7, Financial Instruments: Disclosures, the Companies Acts, the Financial Services Authority’s disclosure and transparency rules, the SEC rules and Industry Guide 3 as well as the requirements of Basel II’s pillar 3. One problem is that different regulators have different audiences in mind for the requirements they impose. Their attempts to reach more actual or potential users can lead to a loss of focus and structure in reports.
There may be a need for a proportionate approach to the disclosure requirements for small and mid-cap quoted companies that take account of the needs of their investors, as distinct from those of larger companies. This may be achieved by different means. For example, a principles-based approach to disclosures in IFRS, specific derogations from requirements in individual IFRSs or the creation of an adapted local version of IFRS for SMEs. Time and cost pressures can lead to defensive reporting by smaller entities and to a preference for easy options, such as repeating material from a previous year, cutting and pasting from the annual reports of other companies and including disclosures that are of marginal importance only.
There are behavioural barriers to reducing clutter. The threat of criticism or litigation is one. The risk of future litigation may outweigh any benefits from eliminating catch-all disclosures. As a result, preparers of annual reports are likely to err on the side of caution and include more detailed disclosures than strictly necessary to avoid challenge from auditors and regulators. Removing disclosures is seen as creating a risk of adverse comment and regulatory challenge. Disclosure is the safest option and therefore often the default position. Preparers and auditors may be reluctant to change this unless the risk of regulatory challenge is reduced. There is also a tendency for companies to repeat disclosures simply because they were in the annual report last year.
However, while explanatory information may not change from year to year its inclusion remains necessary to an understanding of aspects of the report. There is merit in a reader of an annual report being able to find all of this information in one place. If the reader of a hard copy report has to go to a website to gain a full understanding of a particular point, it heightens the risk of making the report less accessible. And even if the standing information is kept in the same document but relegated to an appendix, that may not be the best place to facilitate a quick understanding of a point. A new reader may be disadvantaged by having to hunt in the small print for what remains key to a full understanding of the report.
Preparers wish to present balanced and sufficiently informative disclosures and may be unwilling to separate out relevant information in an arbitrary manner. The suggestion of relegating all information to a website assumes that all users of annual reports have access to the internet, which may not be the case. A single report may best serve the investor, by putting all the information in one reference document rather than scattering it across a number of delivery points.
Yet shareholders are increasingly unhappy with the substantial lengthening of reports in recent years. This has not resulted in more or better information but more confusion as to the reason for the disclosure. A review of companies’ published accounts will show that large sections such as the statement of directors’ responsibilities and the audit committee report are almost identical.
Materiality should be seen as the driving force of disclosure, as its very definition is based on whether an omission or misstatement could influence the decisions made by users of the financial statements. The assessment of what is material can be highly judgmental and can vary from user to user. One problem may be that disclosures are being made because a disclosure checklist suggests they may need to be made, without assessing whether disclosure is necessary in a company’s particular circumstances. However, the whole point of such checklists is to include all possible disclosures that could be material. Most users of these tools will be aware that the disclosure requirements apply only to material items, but often this is not stated explicitly for users.
One of the biggest challenges is the changing audience for the annual report. Its original purpose was to report to shareholders, but preparers now have to consider many other stakeholders including employees, unions, environmentalists, suppliers, customers, etc. The disclosures required to meet the needs of this wider audience have contributed to the increased volume of disclosure. The growth of previous initiatives on going concern, sustainability, risk, the business model and others identified by regulators as key has also expanded the size of the annual report.
Big but perfectly formed
It is not necessarily the length of the report that is the problem but the way in which it is organised. The inclusion of immaterial disclosures will usually make this problem worse but, in a well-organised report, users will be able to bypass much of the information they consider unimportant especially if the report is online. It is not the length of the disclosure of accounting policies that is itself problematic, but the fact that new or amended policies can be obscured in a long note running over several pages. A further problem is that accounting policy disclosure is often boilerplate, and provides little detail of how companies apply their general policies to particular transactions.
IFRS requires disclosure of ‘significant accounting policies’. In other words, it does not require disclosure of insignificant or immaterial accounting policies. Omissions in financial statements are material only if they could, individually or collectively, influence the economic decisions that users make. In many cases, they would not. Of far greater importance is the disclosure of the judgments made in selecting the accounting policies, especially where a choice is available.
A reassessment of the whole model will take time and may entail changes to law and other requirements. For example, clutter could be removed by not requiring the disclosure of IFRS in issue but not yet effective. Currently, disclosure seems to involve listing each new standard in existence and each amendment to a standard, including separately all those included in the annual improvements project, regardless of whether there is any impact on the entity. The note is then a list without any apparent relevance.
The IASB has asked for comment on its forward agenda in which it acknowledges that stakeholders have said that disclosure requirements are too voluminous and not always focused in the right areas. However, the drive by the IASB has been to increase disclosure to address comparability between companies. Therefore, in the short to medium term, a reduction in the volume of accounting disclosures does not look feasible, although the IASB will be considering this area for its post-2012 agenda.
Graham Holt is an examiner for ACCA, and associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School