Financial Reporting – More Quality, Less Quantity!

A thirty percent reduction in the average length of financial statements - achievable? Trends and developments in financial reporting over recent years suggest not.

Burgeoning increases in the length of financial statements and annual reports over recent years have become the norm. With more new and substantially amended standards being published on a regular basis, substantial layers of additional disclosures are continuously being added. The average length of annual reports has increased by 38% since IFRS reporting first became mandatory in 2005, according to a Deloitte survey in the UK.

Has all of this additional information added value? Do primary user groups have a greater understanding of the financial statements they are being presented with? Is it only specialists in the field that can begin to understand the intricate web of disclosure? The adage 'can't see the wood from the trees' comes to mind.

Financial Reporting - What is the Purpose?
A key objective of the IASB's Conceptual Framework reads as follows - 'The objective of general purpose financial statements is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Relevant financial information is capable of making a difference in the decisions made by users'.

The Conceptual Framework does not use the term 'stewardship' but it describes what the term captures. How management makes efficient and effective use of resources, in addition to stewardship responsibilities, are key objectives of financial reporting. Are these objectives served by the financial reports that are currently being produced?

Comments by Supervisors
Ireland and the UK both have financial reporting supervisory authorities - Irish Auditing and Accounting Supervisory Authority (IAASA) and, in the UK, the Financial Reporting Review Panel (FRRP). In recent months, both have published annual reports. While both have been generally positive regarding an overall improvement in the quality of financial reporting they both draw attention to specific sectors within their scope which have considerable room for improvement, and specific issues where there is a lot more work to be done.

Comments from both supervisors underline the potential danger that for many companies faced by the challenge of disclosure requirements, financial reporting is becoming even more of a compliance exercise. Those areas of annual reports which require clear explanation and qualitative comment may not be receiving the attention needed to ensure that the primary users of financial statements are provided with appropriate information.

Areas particularly highlighted include the following:-

• Principal risks and uncertainties - long lists and generic description are frequent failings by reporters, together with inadequate disclosure of the action being taken by management. A major question to be addressed by directors is whether the risks and uncertainties identified are the principal ones facing the business and are they described in a manner consistent with the way in which they are discussed within the company
• Judgements, assumptions and other sources of uncertainty - improved clarity is required to explain the judgements exercised, the sensitivity of those judgements to changes in assumptions or a different approach being taken, where it could have a material impact on the financial statements
• Revenue recognition - generic descriptions, often borrowing words directly from accounting standards, are a common failing, and lead to descriptions which do not explain the accounting policy for revenue recognition in terms of the company's particular business model and transactions
• Capital management - failure to convey in any meaningful way how capital is assessed or managed, with boiler-plate disclosure, is a common weakness. Such disclosures fall well short of the requirement to provide qualitative information about a company's objectives, policies and processes for managing capital together with a description of what it manages as capital and quantitative analysis

The above are some of the more significant areas highlighted in the supervisors' reports. There are numerous others, many of which are regularly commented on in their annual reports. Does this indicate an almost systemic absence of attention to some disclosure requirements, a selective basis, or could it be construed as an adverse perception by those preparing financial reports towards the reporting and disclosure framework.

A Meaningful Response?
Perhaps it is in some way encouraging that the Deloitte survey indicates that the average length of annual reports surveyed reduced for the first time from 101 pages to 98 pages in 2011. Somewhat less so when the main factor in the reduction was a decrease in the number of pages devoted to narrative reporting by a small number of challenged financial institutions, with perhaps less to say!

It scarcely encourages one to return to the question of whether a 30% reduction in the overall length of the financial statements can be achieved. Yet, that is a conclusion drawn by two leading accountancy bodies in a recent jointly-published report commissioned by the IASB. What are the grounds for such a conclusion at a time when the IASB has published four major standards during 2011, with at least as many more on their way. Factors contributing to such a reduction could be:

• Disclosure requirements have in many instances been introduced in new or revised standards over the last ten years without any review of their overall impact on the length or usefulness of the resulting financial statements. A 'top-down lens' approach should be applied to consider the balance across the disclosures and their relative importance to users, with regard to both stewardship and decision-making
• Refinement is needed to how materiality is considered by distinguishing material items in financial statements and material information in disclosure notes, with materiality being emphasised by adding explicit references to it in each standard. Consideration should be given to items which may be material, and therefore require separate disclosure on the face of the financial statements or in the notes, but where additional information in the disclosure notes does not add to the relevance and understandability of the financial statements
• Specific deletions and amendments to disclosure requirements in existing standards are also recommended

These are some of the major areas commented on in the report which is currently with the IASB for consideration and it will be of interest to see whether it leads to action being taken.

It should be borne in mind that under current standards, entities need not provide specific disclosures required by a standard if the information is not material. A cautious approach has been the norm amongst preparers to omitting disclosures on grounds of materiality.

The Financial Reporting Lab
Building on the report earlier this year, 'Cutting Clutter: Combatting Clutter in Annual Reports', the Financial Reporting Lab launched by the UK Financial Reporting Council in recent weeks may help solve corporate reporting problems. The Lab brings together companies and investors to identify practical solutions to today's reporting problems, such as the length and complexity of financial reports. Some of the many areas under review are the potential to leverage technology to offer a more time and cost effective mechanism to assimilate the data reported, and the need for better linkage between the financial and non-financial data presented. The Lab encourages management and investors to experiment with new reporting formats that offer a tangible step forward in effective communication.

This comes at a time when a new discussion paper has been published with proposals intended to lead to a framework for integrated reporting with an initial pilot programme being launched with over forty global companies participating.

At a time of major population growth, scarcity of resources and other economic concerns, the call for sustainability reporting gets louder. A small contributor to protecting the environment and saving the rain forests may be possible if one could find a way to reduce the number of pages!

First published in Finance Dublin Online.