In an attempt to continue the improvement in disclosure practices, the IASB has begun a new initiative, explains Graham Holt
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This article was first published in the November/December 2016 international edition of Accounting and Business magazine.
As the complexity of financial reporting increases, it has become increasingly challenging for entities to meet the International Financial Reporting Standards (IFRS) requirements for more disclosure while still providing shareholders with clear, concise and relevant information about their business.
In May 2011, the International Accounting Standards Board (IASB) issued IFRS 12, Disclosure of Interests in Other Entities, as part of a suite of new standards that address inter-entity investments. IFRS 12 requires information about the significant judgments and assumptions that an entity has made in determining control over another entity as well as details concerning an entity’s interests in subsidiaries, associates and joint ventures. However, from an investor’s perspective the key disclosure enhancement was that information about unconsolidated structured entities is now required. This information was largely unavailable in financial statements prepared prior to the standard.
In an attempt to continue the improvement in disclosure practices, the IASB has launched the Disclosure Initiative. This started in 2013 when the IASB hosted a public discussion forum on financial reporting with the objective of clarifying the problem with disclosure and its causes. Further, the IASB wished to identify ways of making disclosure more effective and to try to solve the problem within the existing framework. The opinion of the forum seemed to be that disclosures fail to be entity-specific and do not communicate an entity’s business model and strategies, which are key elements of financial reporting.
Better quality information
The forum also felt that many of the disclosures potentially obstruct more useful information and concluded that better quality information was needed. Another view was that the concept of materiality and the lack of its appropriate application contributed to excessive disclosures. There is an accounting risk attached to disclosure as regulators now make public any issues with entities, with the result that investors may mistrust management’s integrity. The forum highlighted a sense of shared responsibility but felt that the best way forward would be if the IASB took a lead.
Forum comments have been used to inform the initiative, which comprises a number of short- and longer term projects. The objective is to develop a drafting guide for the IASB to use when setting disclosure requirements in new and amended standards. As a result, the IASB has issued amendments to IAS 1, Presentation of Financial Statements, and IAS 7, Statement of Cash Flows. The amendments to IAS 1, Presentation of Financial Statements, address some of the concerns expressed about existing presentation and disclosure requirements, and ensure that entities are able to use judgment when applying IAS 1. The amendments to IAS 7, Statement of Cash Flows, require a disclosure of changes in liabilities arising from financing activities, including changes arising from cashflows and non-cash changes. The IASB’s initiative is made up of a number of implementation and research projects.
The issue with disclosure overload is also prevalent in the US. In 2014, the US Financial Accounting Standards Board (FASB) issued the Conceptual Framework for Financial Reporting, Chapter 8: Notes to Financial Statements. Here, the FASB states that the primary purpose of notes to financial statements is to supplement or further explain the information on the face of financial statements by providing financial information relevant to existing and potential investors, lenders and other creditors for making decisions about providing resources to the entity. The document further says that decisions about whether to provide resources depend, at least in part, on resource providers’ assessments of cashflows that they ultimately would receive.
A number of other standard-setters and regulators have undertaken projects on disclosure overload. In 2013, the European Financial Reporting Advisory Group issued Towards a Disclosure Framework for the Notes. The document supported communication principles and called for the development of a more consistent and rational approach to disclosures. There was general agreement that there should be a shift away from just compliance with regulation.
In July 2016, the IASB set out in a staff paper its proposal for a project on primary financial statements. Feedback indicated that the research should focus initially on the reporting of financial performance. However, some respondents suggested that the focus should be on the structure and content of the statements of financial performance, while others thought that a single measure should be determined and that the distinction between profit or loss and OCI (other comprehensive income) be more precisely defined.
In the conceptual framework project, the IASB has tried to develop detailed guidance on the use of OCI and recycling but has only managed to develop high-level guidance. It was suggested that the IASB explore how the statements of financial performance could be improved to provide more useful information to users. In addition, there was a growing concern about the increasing use of alternative performance measures and non-IFRS information in the communication of performance.
Research highlighted that investors had many more questions about ‘adjusted’ or ‘non-GAAP’ earnings than before. This had been partly prompted by media articles discussing the gap between adjusted and IFRS earnings. Further, the research paper indicated that 95% of FTSE 100 entities had adjusted their IFRS figures to show a more favourable profit. In addition, the descriptions of reconciling items were often too general and the adjustments were not comparable between entities. Restructuring costs were often disclosed as exceptional year after year, with many entities excluding these charges from their measure of underlying earnings.
Some respondents stated that investors would like to understand the return that management has generated from its operations and resources, and the interaction between an entity’s business model and the entity’s performance. It was felt that this project should be prioritised because investors spend a significant amount of time adjusting the profit and loss figures to arrive at a more representative earnings figure, and that there should be more flexibility in the presentation of information by considering the interaction of financial and digital reporting.
Some investors wish to have a better understanding of an entity’s underlying financial performance and, generally, they focus on operating profit, net income and earnings before interest, tax, depreciation and amortisation for their analysis. However, there was no suggestion as to how this was to be achieved.
- As a result of the feedback and research undertaken, the IASB has suggested five areas for inclusion in its project: standardising the structure of the statement of financial performance
- standardising some subtotals in the statement of financial performance (for example, operating profit)
- considering disaggregation of line items
- considering whether to remove options that allow some items to be included in either operating expense or financing expense
- analysing the use of alternative performance measures and non-IFRS information.
The objective of this research project is to identify and develop a set of principles for disclosure that could form the basis of a standards-level project. The IASB’s focus is the review and revision of the general requirements in IAS 1, Presentation of Financial Statements. The IASB is looking to potentially amend IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, to clarify the definitions of a change in accounting policy and accounting estimate.
Entities sometimes struggle to distinguish between accounting policies and accounting estimates, and enforcers have identified divergent practices. The Interpretations Committee felt that it would be helpful if more clarity were given and brought the issue to the IASB’s attention. In addition, the IASB is considering how materiality is applied in practice and has provided some guidance in the form of a practice statement.
The project came about as a result of uncertainty about how the concept of materiality should be applied, with the result that it was felt that preparers were adopting a cautious approach to disclosure, leading to disclosure of information that is not relevant. Further, some standards seem to suggest that their requirements override the statement in IAS 1 that an entity need not provide information that is not material.
The inclusion of immaterial information is not explicitly prohibited under IFRS and the IASB does not propose to prohibit entities from disclosing immaterial information for operational reasons. Reducing disclosure overload can only be achieved by reference to the primary purpose of the financial statements and by communicating in a transparent manner the financial position and performance of the entity. The improvement in the effectiveness of communication through the financial statements will reduce the users’ uncertainty about its financial position and performance and, potentially, the cost of capital.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan Business School