Bin the clutter
The phenomenon of financial statement clutter is increasingly under discussion, with initiatives launched to combat it.
Clutter in financial reports is a problem. Not only are financial statement disclosure notes growing longer and longer, but the primary financial statements are also preceded by numerous, lengthy reports – such as the Chairperson’s statement, financial reviews, strategic reports, corporate governance reports, and more. IAS 1 Presentation of Financial Statements says that information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions of the primary users of the financial statements. The sheer volume of information presented in annual reports can hinder these users from finding relevant information about the reporting entity.
Organisation of disclosures
The length of the annual report is not necessarily a problem if it is well organised. Unfortunately:
- relevant information is often scattered throughout the financial statements, making it difficult to find, or to fully appreciate, and
- material information is often hidden by immaterial information, making it difficult for a financial statement user to determine what is important.
In a well organised annual report, users can bypass much of the information they consider unimportant. In recent years, there have been several amendments made to IAS 1 with the aim of reducing financial statement clutter. For example, reporting entities are now required to systematically order or group their disclosure notes. This might mean:
- giving prominence to the most relevant activities
- grouping items that are measured in the same way, such as at fair value, or
- following the order of line items in the statement of profit or loss, and statement of financial position.
Entities are producing disclosures because a disclosure checklist suggests it may need to be made, rather than assessing whether the disclosure is actually necessary. Materiality should therefore be the driving force of disclosure. However, the assessment of what is material can be highly judgmental and vary from user to user.
The IASB have issued IFRS Practice Statement 2, Making Materiality Judgements. This outlines the role materiality plays in the preparation of financial statements, with a focus on the factors the entity should consider when making materiality judgements. This Practice Statement confirms that reporting entities do not need to provide a disclosure specified by an IFRS Accounting Standard if the information is not material, even if that IFRS Accounting Standard contains a list of specific disclosure requirements or describes them as ‘minimum requirements’.
The Practice Statement identifies a four-step materiality process which entities are recommended to apply when producing their financial reports:
1) Identify information that might be material
2) Assess whether the information from step 1 is material
3) Organise the information so that it is clear and concise
4) Review the draft financial statements
Materiality considerations should be quantitative and qualitative. Moreover, when making materiality judgements, an entity needs to consider the impact information could reasonably be expected to have on the primary users of its financial statements. As per the Conceptual Framework, the primary users comprise current and potential investors, lenders and other creditors.
The pressures of time and cost can understandably lead to defensive reporting and to choosing easy options, such as repeating material from a previous year, cutting and pasting from the reports of other companies, and including disclosures of marginal importance. However, it is hoped that application of the principles in the Practice Statement will increase the usefulness of financial information through a renewed focus on materiality when producing annual financial reports.
Barriers to improvement
A significant cause of clutter in annual reports are the requirements imposed by different laws, regulations and financial reporting standards that operate in a jurisdiction. For example, an entity that has incurred a small amount of research expenditure during the reporting period might be required to disclose this under local company law, even though disclosure would not be required under IFRS Accounting Standards on the grounds of materiality. Similarly, a listed company may have to comply with listing rules, company law, IFRS Accounting Standards, the corporate governance codes, and if it has an overseas listing, any local requirements, such as those of the Securities and Exchange Commission in the US. Thus, a major source of clutter is the fact that different parties require differing disclosures for the same matter. Regulators and standard setters have a key role to play in reducing clutter by both cutting the requirements that they themselves already impose and by guarding against the imposition of unnecessary new disclosures.
There are also behavioural barriers to reducing clutter. For example, the threat of criticism or litigation could be a considerable limitation on the ability to cut clutter. Preparers of annual reports are likely to err on the side of caution and include more detailed disclosures than are strictly necessary to avoid challenge from auditors and regulators. Disclosure is perceived as the safest option and is often the default position.
The issue of over-disclosure has been seen with accounting policy disclosure notes. For many years, entities were required to disclose ‘significant’ accounting policy information. Most entities simply outlined every key principle from every IFRS Accounting Standard used in the preparation of their financial statements. However, in 2021, IAS 1 was amended to require disclosure of ‘material’ accounting policies, as well as to provide guidance on what constitutes a material accounting policy. IAS 1 now specifies that accounting policies are likely to be material if:
- changed during the reporting period
- selected from one or more options permitted by an IFRS Accounting Standard
- developed in the absence of a specific IFRS Accounting Standard covering the transaction
- it relates to an area requiring significant judgements or assumptions, or
- the accounting treatment is complex.
These amendments should deter entities from disclosing every accounting policy, enabling financial statement users to concentrate on the most relevant information.
Although financial statement users complain about the length of financial reports, this does not mean there is a drive for less information. For example, users have called for better quality information to help them assess how climate-related matters, risks and opportunities affect an entity’s financial performance and position, and the timing of net future cash flows.
In response, the International Sustainability Standards Board is finalising requirements for an entity to disclose sustainability-related financial information as well as its climate-related risks and opportunities.
IFRS Sustainability Disclosure Standards will require management to apply judgement to identify the information about climate-related risks and opportunities that is material. Once again, proper application of the concept of materiality should ensure that the annual financial reports do not become overly cluttered.
It is important for the efficient operation of the capital markets that annual reports do not contain unnecessary information. However, 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 entity’s financial performance and position, its business model, and the opportunities, risks and constraints that it faces. A balance is needed. Thankfully, recent amendments to IFRS Accounting Standards and Practice Statements have provided much needed guidance on how to bin the clutter.
Written by a member of the Strategic Business Reporting examining team