Disclosure Regime - Achieving Its Purpose?

Financial Reporting Brief: May 2021

Not enough relevant information, too much irrelevant information, ineffective communication of the information provided.

The International Accounting Standards Board (IASB), and other standard-setters, refer to these collectively as the ‘Disclosure Problem’. They highlight inadequacies in the standards set and ineffective application of the standards by preparers of financial reports. In turn, this places excessive strain on audit and regulatory processes. The inevitable consequence is that information disclosed to investors and other stakeholders is in many cases insufficient to support their process for key decision making, including the allocation of capital. More and more, corporates find themselves having to publish additional information, at least some of it to address shortcomings in disclosures in the financial statements.

The International Organisation of Securities Commissions (IOSCO) is a leading participant in the regulation and supervision of more than 95% of the World’s capital and financial markets. In April 2020, IOSCO published globally ‘IOSCO Statement on Application of Accounting Standards during the COVID-19 Outbreak’. IOSCO places great emphasis on the importance of consistent application and enforcement of high-quality accounting standards. They are of critical importance to the functioning of the capital markets. While particularly relevant during these times of great uncertainty, accounting standards are the bedrock of financial reporting at all times. Any limitations on their effectiveness to provide these foundations must be addressed.

With the call for improved non-financial reporting, including sustainability reporting, to the fore, sight should not be lost of the need for robust financial reporting. The primary objective of developing a comprehensive corporate reporting framework demands focus on both financial and non-financial reporting. Each must work compatibly to drive forward the quality and transparency of information made available to the various stakeholders.

Our Financial Reporting Brief series has included many articles on non-financial reporting – sustainability, climate change and other relevant matters. Recent developments place some additional focus on financial reporting. The challenges of the pandemic, and ESG matters including climate change, reinforce the need to make the disclosure regime more robust. Recently, the IASB published a pilot study on developing and drafting disclosure requirements going forward. Earlier this year, the IASB amended two standards to achieve more clarity and provide improved guidance in relation to both accounting policies and accounting estimates.

What needs to be done?

There is a widely held view that a ‘checklist’ approach is being adopted in the reporting process by preparers and that auditors and regulators have also subscribed to that approach. No one doubts the importance of complying with specific disclosure requirements but questions must be asked of whether adequate attention is being given to applying the overarching concepts of judgement and materiality to disclosures. These very challenging times highlight a potential need in many circumstances to go beyond the requirements of the standards and provide additional disclosure to ensure that investors and others are provided with key information.

Respondents to the IASB’s Discussion Paper ‘Disclosure Initiative – Principles of Disclosure’ have commented strongly on the limitations of a ‘checklist’ approach. Many possible reasons for this are expressed including the use of prescriptive language in disclosure requirements and their volume, lack of specific disclosure objectives and inconsistent drafting.

The stakeholders highlight three main concerns about disclosures in general purpose financial statements:

1. Not enough relevant information - Information is relevant if it is capable of making a difference in the decisions made by the primary users of financial statements. If financial statements provide insufficient relevant information, their users might make inappropriate investing or lending decisions;

2. Too much irrelevant information - Irrelevant information is undesirable because it:

Clutters the financial statements so that relevant information might be overlooked or hard to find, making financial statements difficult to understand; and
Can add unnecessary ongoing cost to the preparation of financial statements; and

3. Ineffective communication of the information provided - Information communicated ineffectively makes the financial statements hard to understand and time consuming to analyse. Users of the financial statements may overlook relevant information or fail to identify relationships between pieces of information in different parts of the financial statements.

In 2017 the Board launched its Disclosure Initiative, a portfolio of projects aimed at improving the effectiveness of disclosures in financial statements, and to date six individual projects have been completed with a primary focus on such key areas as judgement and materiality.

The Pilot Approach

Continuing with its overall objective of enhancing its current disclosure framework, the IASB has recently published an Exposure Draft ‘Disclosure Requirements in IFRS Standards — A Pilot Approach (Proposed amendments to IFRS 13 and IAS 19)’. The Amendments to the standards illustrate what the IASB is intending to achieve and future articles may return to them. For now, our focus is on the Pilot Approach.

The overarching objective of the Pilot Approach is to:

Improve the ways the IASB develops disclosure requirements; and
Test whether these improvements could help stakeholders in addressing the disclosure challenge.

Any improvements made will only achieve their full benefit if preparers use appropriate judgement when applying the disclosure requirements. Improved judgement could result in some entities disclosing additional information and other entities removing information that is immaterial or summarising information more concisely. For many entities, a combination of all three may be needed to result in better quality information being provided.

The Pilot Approach proposes to use:

Overall disclosure objectives that describe the needs of users of financial statements and;
Specific disclosure objectives that address in detail the information needs of users in each particular area.

Judgement would be needed to identify items for each specific disclosure objective by considering whether the information is relevant or irrelevant and whether it helps to communicate effectively. Preparers will have to use judgement to assess compliance with the overall disclosure objectives in each entity’s case, and to move away from a ‘checklist’ approach. It is proposed to minimise requirements to disclose particular items of information, thus removing a perceived compliance burden and making it clearer that only material information should be disclosed. There will continue to be items of information a company will be required to disclose under legislation and regulation. Auditors and regulators will be challenged to assess the reasonableness of the judgements made and the adequacy of the disclosures.

The Board is proposing to include examples of items of information that could help companies meet the specific disclosure objectives in a Standard. These examples should help achieve comparability between companies for which similar information is material. While two companies might disclose information that looks different, the information would be comparable in all material respects if both companies have met the investor needs described in the objectives.

Addressing the disclosure problem will require all those involved in financial reporting to play their part. Incremental costs may be incurred by companies, particularly when first applying disclosure requirements developed using the proposed approach. Those costs would primarily relate to behavioural changes needed to more thoroughly reflect on the application of judgement in key areas.

Comments on the draft guidance and the proposed changes are requested by 21 October 2021.

Accounting Policies

Earlier this year, the IASB published amendments to IAS 1 ‘Presentation of Financial Statements’ to require entities to disclose their ‘material’ accounting policies rather than their ‘significant’ accounting policies. This is also part of the response to the IASB’s Disclosure Initiative to assist entities in determining which accounting policies to disclose, and many of the matters addressed are relevant to considerations on disclosures in the notes to the financial statements.

To support the Amendments, the IASB has developed guidance and examples to explain and demonstrate the application of the four-step materiality process described in IFRS Practice Statement 2 ‘Making Materiality Judgements’. The four-step process at the core of PS2 is:

Step 1: The entity identifies information that has the potential to be material;

Step 2: The entity assesses whether the information identified in Step 1 is material – from the perspective of both size and nature, or either factor;

Step 3: The entity organises the information within the draft financial statements in a manner that supports clear and concise communication; and

Step 4: The entity steps back and assesses the information provided in the draft financial statements as a whole. The final assessment may lead to adding information, aggregating or disaggregating information, reorganising information, or ultimately removing information that is considered immaterial.

An entity is likely to consider accounting policy information material to its financial statements if that information relates to material transactions, other events or conditions and the accounting policy:

Has changed during the period;
Was chosen from alternatives permitted by IFRS Standards;
Was developed in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors in the absence of an IFRS Standard that specifically applies;
Relates to an area for which the entity is required to make significant judgements and assumptions; and/or
Relates to complex accounting, and users of the entity’s financial statements would otherwise not understand the relating transactions, other events or conditions.

What is ‘material’ may be answered by reference to how it is defined in the Conceptual Framework – ‘Materiality is an entity-specific aspect of relevance based on the nature or magnitude (or both) of the items to which the information relates in the context of an individual entity’s financial statements’.

Accounting Estimates

The IASB has also published ‘Definition of Accounting Estimates (Amendments to IAS 8)’ to help entities to distinguish between accounting policies and accounting estimates. Accounting estimates are defined as ‘monetary amounts in financial statements that are subject to measurement uncertainty’. Examples of accounting estimates are:

A loss allowance for expected credit losses (IFRS 9 Financial Instruments)
The net realisable value of an item of inventory (IAS 2 Inventories)
The fair value of an asset or liability (IFRS 13 Fair Value Measurement)
The depreciation expense for an item of property, plant and equipment (IAS 16 Property, Plant and Equipment)
A provision for warranty obligations (IAS 37 Provisions, Contingent Liabilities and Contingent Assets)

In developing an accounting estimate, an entity uses estimation techniques (for example, to estimate the loss allowance for expected credit losses) and/or valuation techniques (for example, to measure the fair value of an asset or liability). The IASB clarifies that a change in accounting estimate that results from new information or new developments is not the correction of an error, including where it results in a new measurement technique. It therefore does not require a prior period restatement and is accounted for prospectively.

The Amendments to both IAS 1 and IAS 8 will be effective for annual reporting periods beginning on or after 1 January 2023, with earlier application permitted.

Conclusion

The importance of high-quality financial reporting is hugely significant in these challenging times. The transparency and reliability of key messages to investors and other stakeholders must be first and foremost. Entities often approach disclosure as a compliance exercise, rather than as a means of effective communication with users of financial statements. This mindset must change in the interests of all stakeholders.

Developments are taking place and all engaged have a responsibility to stay up to speed, and to plan ahead for changes in approach to disclosure.

Those that see clearly the benefits of good disclosure will do well in the battle for trust and loyalty.

Reflecting on his ten-year tenure in office in his final speech at a meeting of international standard setters, the Chairman of the IASB concluded with the comment: