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Complexity in financial reporting
There has been a sustained effort in recent years for major standard-setters around the world to tackle the issue of complexity in financial reporting. “Reducing the complexity and improving the transparency and usefulness of the reported financial information”[1] has been a hallmark theme of the Financial Accounting Standards Board (FASB) in the US, while the IASB have recently issued a discussion paper, Reducing complexity in reporting financial instruments.
It is clear however, that considerable complexity can originate from the intricacy of commercial transactions and events themselves. The accounting for such transactions, by their very nature is complicated and this is beyond the confines of standard setting. It is therefore imperative to acknowledge and distinguish two types of complexity in financial reporting from the outset: that which is inescapable, due to the inherent complexity of certain transactions, and that which could be avoidable, having been brought about by accounting standards themselves.
Inherently complex transactions
One of the most complex areas of financial reporting is the accounting for financial instruments with one of the reasons certainly being that many of these are in themselves complex. Issues such as the multifaceted forms that these instruments can take as well as the highly specific features they can include make them difficult to analyse and account for. The apparent inconsistency in accounting treatments for what are in substance, very similar instruments is the basis for another current discussion paper by the IASB[2].
The issue of products including embedded multifaceted elements, which have to be split out from a ‘host’ contract and accounted for accordingly, is not confined to derivative financial instruments, as the host contract might be a lease or a sale or purchase contract. Certainly multiple-element product and service agreements, increasingly used in business transactions can also be challenging to interpret from an accounting perspective.
Unnecessary accounting complexity
With these inherent complexities in mind, it is vital that standard-setters take every opportunity to reduce any complexity that is solely a result of the financial reporting regime that is in place. Such avoidable complexity has an adverse affect on all participants in the financial reporting process – be they preparers, auditors, users, regulators themselves and other stakeholders. There are time and resource costs related to maintaining knowledge of detailed requirements, record-keeping, performing difficult calculations and estimations as well as the analysing and interpreting of the resulting financial reports by decision-makers.
While additional guidance and disclosure is often beneficial to preparing and understanding elements within company financial statements, complexity in standards simply adds to the volume of both. In terms of guidance this can lead to greater risks of error and compliance failure. Where this additional guidance is in the form of detailed rules at the expense of soundly based principles professional judgement can be frustrated, if not eroded. Similarly, voluminous disclosure requirements, which increasingly occupy greater proportions of the financial statements, can be counter-productive. Overly complex disclosures can efface the transparency of the financial statements such that they do not reflect the financial performance and condition of the entity, thereby potentially increasing the cost of capital.
What is causing avoidable accounting complexity?
One of the main factors contributing to the problem with financial reporting standards is surely the volume of formal and informal literature. While this is an issue for the IASB it is far more pronounced in US GAAP, which encapsulates literature from a host of authorities. Not only does this make it difficult to make improvements to the current standards in force, but it acts as a veritable minefield for those searching and applying guidance.
The other key concern with accounting standards is that are often overly prescriptive. Not only can this lead to more complex and lengthy standards but core principles can be obscured by detailed ‘bright line’ rules, which in turn are vulnerable to financial engineering.
Some areas of accounting which are prone to criticism for these reasons include:
- Hedge accounting
- Lease accounting
- Revenue recognition
- Pensions accounting[3]
- Varying methods of measuring transactions
- Accounting for share-based payments
Clearly the causes of complexity are numerous and impact a vast range of elements in financial reporting. That these causes are both inherent in the transactions
References
[1] From the opening address to the SEC and Financial Reporting Institute, by the FASB Chairman Bob Herz, in July 2007.
[2] The IASB discussion paper Financial instruments with characteristics of equity, seeks to gauge opinion on the FASB’s preliminary views document of the same name, which aims to resolve some of these issues, as part of the longer term project of simplifying the accounting for financial instruments
[3] As part of the joint project between the IASB and FASB, in March 2008, the IASB issued a discussion paper, Preliminary views on amendments to IAS19 Employee benefits as part of the short term phase of this project.
What's your opinion?
Which areas of financial reporting do you find overly complex as a result of complexity in financial reporting standards?
To what extent do you believe that business transactions are conducted with regard to their accounting consequences?
Could some of the complexity and volume of current financial literature be reduced by less rules and more principles?