The quest for effective disclosure continues

Business World (05/23/2016 – p.S1/2)

SUITS THE C-SUITE By Lloyd Kenneth S. Chua

In 2014, we wrote an article in this column on the efforts and initiatives of the International Accounting Standards Board, the Financial Accounting Standards Board (FASB), and the United States Securities and Exchange Commission (US SEC) on how to improve disclosures in financial statements.

In September 2015, the US SEC released a formal request to various parties to obtain comments on how it can improve disclosure effectiveness. Meanwhile, the FASB proposed guidance in applying materiality to disclosures as part of its disclosure framework project which aims to improve notes in financial reporting.

Encouraged by the initiatives from standard-setting and regulatory bodies, companies have stepped up their own efforts to maximize disclosure effectiveness. These efforts have resulted in measurable benefits for both organizations and users of financial statements.

In a bid to find out more about the progress and benefits of the disclosure initiatives of companies, the Financial Executives Research Foundation, in collaboration with Ernst & Young, surveyed and interviewed more than 120 finance and accounting executives from various industries in the US. Of the companies surveyed, almost 75% have already taken action towards improving their financial reports, with a majority being focused on annual and quarterly financial reports.

The survey revealed that the primary motivation for companies to improve their financial reports came from senior-level executives who questioned the level of clarity and readability of disclosures that were prepared in a compliance-driven language. Meanwhile, benchmarking studies and comparisons of the financial reports with their peers also provided companies with the needed impetus to launch their own disclosure initiatives project. For others, embarking on the improvement stemmed from their need to continuously provide more effective financial information to their users.

Nowadays, investors do not just focus on the numbers; they also look at other information in the financial reports to help them better assess the companies’ performance and plan their investment strategy more effectively. Because of this, the survey respondents said that they are shifting their focus to streamlining and improving the comprehensibility of their financial reports, particularly in these three areas:

(1) Eliminating immaterial information and disclosing material information;
(2) Utilizing more cross-referencing and reducing redundancies in their disclosures; and,
(3) Eliminating outdated information.

Although the process of improving disclosures is far from over, proactive companies have already begun seeing benefits. Positive responses were elicited from stakeholders — such as board members, senior management, and investors — since they believe they were making more informed decisions through information that were easier to read and understand. The enhanced clarity of the information resulting from the removal of unnecessary or redundant disclosures was one of the most noticeable improvements. Significantly, 40% of the companies surveyed disclosed that they improved their process efficiencies in that they saved, or are expecting to save, one to three days’ worth of manpower costs in preparing their financial reports.

One major challenge in efforts to improve and streamline disclosures in the financial statements is the materiality concept — or the question of what information is considered material. Clearly, this has an impact on deciding what should be included in the financial reports. The consistency of materiality considerations, or the basis for calculating materiality, poses another challenge as the companies surveyed disclosed varying calculation practices. A majority responded that they used a percentage of net income as their basis for calculating materiality, while around 25% adopted an assortment of quantitative measures. Interestingly, some 40% revealed that they also considered qualitative measures.

Another challenge is the prescriptive nature of disclosure checklist, which was cited as limiting the flexibility of some companies when it came to emphasizing material information or scaling back on disclosures. Completing such a disclosure checklist may be a tedious process for many companies as they have to provide explanations for all the “no” answers on the checklist. To address this, some companies identify the reasons upfront to avoid any delays in the process later on.

Still another challenge comes from management, particularly those who sign the financial reports. These executives often have a view of how the information should be disclosed and often resist any revisions to traditional processes. This can, however, be mitigated by close communication with these executives, as well as coordination with the investors’ relations team.

Lastly, some companies hesitate to cut back on disclosures for fear of being questioned or commented on by the SEC.

The companies surveyed shared some lessons they learned in the process. One is that the process involves various functions (i.e., finance and accounting, investor relations, internal and even external counsels) and positions (from the Audit Committee to the senior management to the middle management). The involvement of various levels of management and stakeholders is needed right from the start to ensure that all opinions, comments, and thoughts are completely captured and considered. Starting early and planning ahead are also critical when engaging the people involved. Lastly, consistent communication between the management team and the companies’ key stakeholders is pertinent to ensure that all expectations are aligned and misunderstandings are avoided along the way.

For companies that are planning to embark on their own disclosure initiative project, the surveyed companies offer some advice:

Starting early is the first step, as this project requires time for design, review, approval and ultimately, implementation. Obtaining the support of top management will also help support efforts towards ensuring disclosure effectiveness.

Engaging key stakeholders is another vital step as they need to be brought up to speed with the plan and to allow them to provide timely feedback on the project. Active discussions with audit committee members should also be made to obtain their views on matters of importance and to share how other companies are faring in their disclosure initiatives. Similarly, companies should also look into discussing the changes with local regulators (i.e., the SEC) and their external auditors to provide them the rationale for the changes being made.

The next steps involve removing immaterial, redundant, or outdated information and looking at ways to improve not only the content, but also how this content is presented in the financial reports. A fresh look at opportunities to make information more understandable is also another step in this process. To this end, companies should assess what information is actually important to their investors and focus their disclosures on those areas.

In summary, while there is still a long way to go towards the completion of the disclosure initiative projects, many companies are already proactively looking into improving their own financial reports. These companies have already seen that such efforts are not easy with many challenges along the way, but the benefits are evidently worthwhile. They also recognize that improving the financial reports is not a one-time exercise but is a continuous process to ensure that the financial reports continuously adapt to the changes in the business and regulatory environment, as well as to the changes in accounting rules.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.

Lloyd Kenneth S. Chua is a Partner of SGV & Co.