Addressing disclosure overload: The interim measures

SUITS THE C-SUITE By Wanessa G. Salvador

Business World (08/25/2014 – p.S1/4)

(Second of two parts)

In last week’s column, we discussed the issue of disclosure overload in statutory financial statements, and the ‘disclosure initiative project’ of the International Accounting Standards Board (IASB) to address the concern that disclosure overload can undermine the usefulness and readability of financial statements. We also discussed the first of three common themes which were, based on discussions among preparers, readers, and users of financial statements, identified in the July 2014 Ernst & Young (EY) publication titled Applying IFRS: Improving Disclosure Effectiveness as underpinning the issue of disclosure overload. In this column, we will continue with the last two themes identified, namely: tailoring and materiality.

TAILORING DISCLOSURES

Boilerplate disclosures — those that follow a certain template or wording — do not add incremental value to financial statements. They actually tend to increase disclosure overload. These generic boilerplates and irrelevant disclosures may draw attention away from more relevant entity-specific information. In practice, boilerplate disclosures are predominantly used in relation to significant accounting policies and significant judgment and estimates.

• Significant accounting policies. This disclosure provides information to help users understand the accounting policies and measurement bases that the company applied in preparing the financial statements. Tailoring this disclosure may help reduce the clutter as policies which are not applicable in the reporting periods or to the entity are excluded in the notes (e.g., accounting policies on financial instruments which the entity does not hold). Tailoring the disclosure also entails inclusion of entity-specific policies that are useful and that go beyond mere repetition of the requirements in the standards.

• Judgment and estimates. Other than being required by the standards, this disclosure is important as it provides information on the assumptions used by the entity, as well as the other sources of estimation uncertainties that may have a significant impact on financial statement balances. Similar to other disclosures, significant judgment and estimates should only be limited to those that are relevant to the users of the financial statements. However, concerns have been raised that companies are disclosing all possible accounting areas in the notes where judgment and estimates are required and made, even for those areas in which the amounts and impact are not material or significant to the financial statements. Another concern raised was that the preparers are just reiterating the accounting policies, without actually describing the specific judgments made (i.e., the basis on which they are made) and the assumptions used in deriving the estimates.

As materiality concepts also apply to judgments and estimates, the preparers should be conscious of what they should include or exclude in the notes. As with significant accounting policies, this disclosure should be as entity-specific as possible. Doing so will enhance the usefulness and comparability of the financial statements.

APPLYING MATERIALITY TO DISCLOSURES

Materiality, as a concept, plays a significant role in the preparation of financial statements. However, due to the limited guidance on materiality, this concept is not effectively applied in practice, resulting in the inclusion of irrelevant information. Thus, it is important that the concept of materiality is applied properly to help preparers assess which information should be presented in the financial statements.

Under the IASB’s proposed amendments to IAS 1 (paragraph 31), the international body aims to shift the focus of the preparers from a mere “compliance mode” to a more “decision usefulness mode.” It emphasizes that minimum disclosures required by IFRS need not be complied with if this is immaterial or irrelevant to the entity. It also states that items relevant to the users of the financial statements, even if not required by a particular standard, need to be disclosed in the financial statements. The IASB, however, does not propose to prohibit disclosure of immaterial information, leaving it to the preparers to use their best judgment in assessing materiality.

When conducting materiality assessment, both quantitative and qualitative factors should be considered. It should not be determined by a simple quantitative comparison with primary statement totals (e.g., net income, balance sheet totals). Each entity must make its own assessment as materiality is an entity-specific aspect of relevance and this may vary depending on the nature of the entity’s circumstances or financial statements.

In improving the application of the concept of materiality, the following measures may be considered:

• Immaterial disclosure. A common mistake among preparers is that as soon as the material line items in the financial statements are identified, all related disclosures are immediately deemed material. In assessing materiality, a disclosure that relates to a line item in the financial statements that is material by itself does not necessarily make the related disclosure material. Materiality consideration should be applied to specific disclosure requirements and to individual elements of such a disclosure, if any, instead of covering all the disclosures required by the standards.

• Irrelevant accounting policies. In deciding which accounting policies to be disclosed, the preparers need to consider whether the policies will assist users in understanding the transactions or events reported in the financial statements. Policies for potential or future transactions need not be disclosed. Likewise, entities need not disclose policies for past transactions that happened outside the reporting period. Instead, entities will have to maintain internal processes to keep track of all previously applied accounting policies (even those that are no longer disclosed) to ensure consistent application in future periods.

• Use of illustrative or other entity’s financial statements. Illustrative financial statements are usually designed to capture all possible scenarios. Preparers need to critically assess the disclosures found in the illustrative financial statements. They need to be aware that the disclosures in the illustrative financial statements are often boilerplates, which need to be tailored to the entity’s specific circumstances. Even if they are applicable to the entity, these disclosures should also be assessed if they are significant or material to the entity’s financial statements. Failure to properly assess their applicability and significance may mean copying immaterial or irrelevant information and thus, adding to the clutter.

Likewise, another entity’s financial statements are tailored to that specific entity’s needs and circumstances and preparers should only refer to these financial statements to identify possible best practice. These should be used merely as guides in deciding which information should be disclosed in the financial statements.

• Auditors and regulators. Auditors and regulators are not spared from this problem. They have received their share of the blame by encouraging a disclosure checklist approach. Such an approach is said to have aggravated the disclosure overload problem. The key is that preparers must be ready and able to explain and justify the judgment behind its disclosures and the process used in concluding that the information is immaterial and irrelevant to both their auditors and regulators. However, preparers should note any additional local or industry requirements on top of what the standards require.

• Continuing assessment of materiality. A common practice among preparers is to simply carry forward disclosures from prior years without scrutinizing whether these are still relevant or material to the current reporting period. Preparers prefer to retain prior year disclosures rather than to explain why it was discontinued and this practice adds to the clutter. Materiality assessment should be done regularly to ensure that items or disclosures which were once considered material are properly eliminated once concluded to be immaterial in the current reporting period and vice-versa.

The suggestions presented in this article are interim measures to address the growing concern over disclosure overload and the overall effectiveness of financial statement disclosures. The IASB may come up with the final or revised standard. Nevertheless, both preparers and reviewers of financial statements will have to assess what really matters to the users of the financial statements.

Because the main objective of financial reporting is to provide information that is useful for decision-making purposes, and because improving disclosure effectiveness may ultimately result in a decrease in the cost of capital, addressing the challenges of disclosure overload may prove to be a worthwhile exercise for those who prepare financial statements.

Wanessa G. Salvador is a Director of SGV & Co.