Footnotes of the future: reflections from the Disclosure Initiative

Investors tell us all the time: Financial statement disclosures are too complicated; a voluminous amount of insignificant detail obscures the useful information; footnote organization is rarely user-friendly and the frequent boilerplate text often reads straight from a checklist. You are correct and we have heard you! This article will discuss some of the actions we at the International Accounting Standards Board are taking to improve disclosure effectiveness. For those who follow accounting standard setting, you undoubtedly know that our colleagues at the Financial Accounting Standards Board have a similar project, covering many of the same issues. While not a joint project, we closely follow each other’s progress and our staffs regularly talk.

The IASB project to address “the problem” began in early 2013 and I am pleased to report we have made extensive progress. So far, we have amended two disclosure-related IFRS® Standards, several other proposals have been or will shortly be exposed for comment, and the remaining project initiatives are making good progress. In standard-setting terms, this is almost warp speed. We always keep in mind our mission is primarily to serve investor needs. From the outset the board has been clear: our Disclosure Initiative is not about reducing disclosures per se—it is about making disclosures more meaningful by improving their communication value while simplifying the preparation process.

Let’s review some of what we have accomplished and where this is going:

In the beginning, unshackling the preparers

Our first accomplishment occurred in late 2014 when we amended IAS 1 Presentation of Financial Statements, and in doing so opened up a world of possibilities for preparers to improve their financial reporting. First, we made it clear that preparers have flexibility in determining the order of the footnotes. Previously, Note 1 was usually a summary of the entity’s accounting policies followed by footnotes generally in the order of the balance sheet accounts. We clarified that preparers should order the footnotes in any rational manner they deem appropriate. For example, a company’s disclosures for debt, related hedging instruments and applicable accounting policies can now be co-located making the story easier to tell and eliminating the redundancy that occurs when related disclosures are dispersed. We further stated that merely because a particular subject (say income taxes) may be sufficiently material to be a financial statement line item, it doesn’t automatically follow that every specified tax disclosure is also material. Consequently, we concluded that the materiality, and therefore the need, for any individual disclosure is assessed in the context of the financial statements as a whole and not just in relation to the footnote’s subject. We observed many IFRS® Standards introduce disclosure requirements with phraseology such as “… at a minimum an entity shall disclose …” The IAS 1 amendments make it clear the materiality concept always overrules any “… at a minimum …” language. Lastly, although the board cannot prohibit immaterial disclosures, we discouraged them by stating they must not obscure or detract from material disclosures. As a former chief accounting officer of a Fortune 500 company I found these changes as exciting as accounting gets and in my earlier life I could have done a lot with them!

The key question a reporting decision needs to answer: Could this disclosure reasonably influence the decision of a primary user to make or change buy, hold, sell or lending decisions. If it does, it is material. If it does not, it is not.

Know your audience: A key consideration in promulgating accounting and disclosure requirements is identifying the intended audience (the ‘primary users’), a subject that has been debated for years. For example, some equity investors argue that, as the ultimate owners with the most at risk, all disclosure decisions should be focused on their interests; satisfying their needs should be sufficient for everyone else. At the other extreme, some retail investors have argued for a much simpler approach because their needs and resources are typically different from those of professional investors. These views certainly have merit. In general, though, I think most people are comfortable with the board’s traditional definition of primary users which, with some paraphrasing, is: “… existing and potential investors, lenders, and other creditors who do not have the ability to obtain this information directly and who have a reasonable knowledge of business and economics …” We have exposed for comment some guidance that when evaluating the materiality of disclosures, management should focus on the information needs of typical and rational primary users, rather than on single atypical users or a user who is behaving unreasonably or irrationally. Although subtle, this is an important clarification because, in my experience, many disclosures are made for very limited audiences and thus have the effect of obscuring more important information needed by larger audiences.

Assessing disclosure materiality: Unlike primary financial statements where numerical or trend analyses are helpful, how does a preparer decide if one or more omitted disclosures, out of maybe 500 individual nuggets, in a major corporate report is material? I suspect a contrarian could argue, when considered in isolation, that maybe 90% of individual disclosure requirements could be considered immaterial for a given company. For example, if share-based compensation is 2% of an entity’s operating costs, are the statements really misleading if the risk-free rate of interest for valuing these shares isn’t disclosed? But extreme use of this logic triggers the reductio ad absurdum principle—or, in plain language, don’t be ridiculous! Companies have to meaningfully tell their financial story and footnotes are critical. In the absence of objective or quantitative tools, in the end it comes down to judgement; there is no escaping this. Preparers and their auditors need to step back from the checklist and critically ask themselves what primary users really need to know about a subject in the course of making or changing buy, hold, sell or lending decisions about the entity. Those are the critical decisions primary users make which we facilitate with our standards. We have proposed in our current Conceptual Framework project that all new IFRS Standards will have an Objectives paragraph, introducing the disclosures section, to help preparers decide what is relevant in their circumstances to disclose. Soon, the board will seek input via a major Discussion Paper—Principles of Disclosure—which will comprehensively address this entire process, including principles of aggregation and disaggregation; use of cross referencing to other sections of reports; the purpose of accounting policy disclosures (hint: it is not to recite the standard); communication principles and formatting; the role of non-IFRS information, including performance measures, etc. Constituent input on this Discussion Paper is critical, because, when finished, it will be the basis of our future overall approach towards disclosures. We are also working closely with our New Zealand colleagues in creating a Drafting Guide which will assist us in developing Standards-level disclosure objectives and requirements. Lastly, we have started thinking about how we might approach a standards-level review of existing disclosure requirements. This is still at a very early stage and scope needs to be determined. Stay tuned!

Not all errors are equal: There are material, and there are immaterial, errors and both are comprehensively discussed in an Exposure Draft of a “Practice Statement” (non-mandatory guidance), Application of Materiality to Financial Statements, we published in late 2015. No one questions that material errors must be corrected in a timely fashion. The Exposure Draft also reminded everyone that one particular type of error—an intentional misstatement designed to achieve a particular presentation or result to influence the decisions of primary users—should always be considered to be material.

In the Exposure Draft we discuss at length what to do about “normal” immaterial errors, including those caused by practical expedients such as bookkeeping conventions, disclosures or auditor adjustments not made due to immateriality, minor accounting simplifications due to cost-to-comply considerations, etc. While our standards do not need to be applied to immaterial items, they are somewhat open-ended and do not go the next step and say that such non-application is not an error. In the financial reporting trenches, if something is technically an error, even if immaterial, a lot of busy work ensues which serves little useful purpose. I believe we need to close the loop on this point. In my former life as a preparer I know what position I would take, but as a standard-setter I’ll be circumspect and see where the feedback takes us.

Summary: Few disagree that annual reports typically contain large amounts of extraneous information which may obscure more critical disclosures. Current disclosure practices and habits have developed over decades and will not change quickly. Our Disclosure Initiative suite of projects can enable reporting improvements but they cannot alone change behavior or supplant the critical need for reasoned judgement.

The key question a reporting decision needs to answer: Could this disclosure reasonably influence the decision of a primary user to make or change buy, hold, sell or lending decisions. If it does, it is material. If it does not, it is not.

Mr. Kabureck is a Member of the International Accounting Standards Board. The views expressed in this article are his alone and do not necessarily represent the views of the Board.