Complexity in corporate financial reporting

Corporate financial report communicates economic impact of transactions and other events on the economic resources and the capital stru-cture of the company. The aim is to provide information that is relevant for economic decision-making by inves-tors and creditors. The information is also used to evaluate management in its stewardship function. It is expected that the infor-mation in financial report should be presented in such a manner that it is easy to comprehend and analyse.

Accounting principles and methods stipulated in accounting standards (IFRS) should be easy to understand and implement.

Many complain that financial reports issued by companies are too complex to comprehend the infor-mation and accounting standards have become too complex to understand and implement.

It is true that financial reporting by companies that are engaged in complex transactions and operate in different geographies cannot be simple. Similarly, accounting standards that deal with complex issues cannot be simple.

However, when prepa-rers and analysts complain of complexity, regulators have to pay attention to their concerns.

At the beginning of this month, the Financial Reporting Council (FRC) (www.frc.org.uk), which is the UK’s independent regulator responsible for promoting confidence in corporate reporting and governance has issued a report entitled ‘Louder Than Words — Principles and actions for making corporate reports less complex and more relevant’. The research by FRC focussed on mandatory corporate reporting for publicly traded companies in the UK.

The report observes that the preparers, who were interviewed, almost unanimously believe that the process of compiling a corporate report is too complex, and so are the reports themselves. In contrast, users discuss a number of shortcomings in annual rep-orts but do not consider them too complex overall.

They have greater concerns about ‘relevance’ than ‘complexity’. Perhaps, such a research in India or elsew-here will reveal the same concern.

The FRC research report observes that there is a need to re-establish the principle that corporate reports should be designed for their prim-ary purpose — providing investors with information that is useful for making their resource allocation decisions and assessing management’s stewardship.

Effort to fulfil aspirations of all stakeholders (e.g. regulators and social activists) and to make the report useful to all of them results in a report that is OK for all but ideal for none. This observation deserves attention of regulators and accounting standard setters.

Preparers face difficulties in implementing accounting standards due to a lack of clarity. Accounting stand-ards fail to clearly articu-late the objective of the standard.

Many experts observe that objectives, in most standards, are stated in a language that is vague and it is difficult to understand the same. This makes interpretation of principles and methods stipulated in standards difficult.

Another source of difficulty in implementing accounting standards is that International Financial Reporting Standards (IFRS) are moving towards ‘rule-based standard’ in the continuum which has ‘principle-based standard’ at one end and ‘rule-based standard’ at the other end.

There is a consensus that IFRS should be principle-based standards. But when International Accounting Standard Board (IASB) issues accounting standards it cannot resist the temptation to provide elaborate implementation guidance and illustrations. This appro-ach takes standards close to rule-based standards. Rule-based accounting standards fail to provide the flexibility in formulating accounting policies, which is required ensure that the information in financial statements reflects business reality.

Large audit firms (particularly Big Four) issue their own interpretations in an effort to provide solution to the problem. But issuance of interpretations by them does not solve the problem, rather it adds to the difficulty of preparers. They narrow down the scope for judgement at the enterprise-level. Preparers do not want to get into any kind of conflict with regulators and auditors.

Therefore, they strive to fit the transactions and other events in situations that are assumed in interpretations and illustrations provided in accounting standards and in interpretations issued by audit firms.

The result is presentation of financial reports that fail to capture business reality appropriately. It also adds complexity to the process of preparation and presentation of financial report.

The relevance of information in financial report is impaired if key information is lost in the clutter of information that is not relevant to investors. Two primary reasons for this are: ever-increasing disclosure requirements and reluctance on the part of preparers to argue with the auditor on the materiality of information.

Every accounting standard has disclosure requirements. Thus, disclosure requirements are scattered and not well compiled at one place. Fair value accounting has also increased the volume of disclosure significantly.

Disclosures required by an accounting standard are considered minimum. An enterprise has to disclose all the information required to be disclosed by accounting standards. It has no flexibility to disclose only that information that it considers relevant. As a result, key information is lost in the clutter of irrelevant and immaterial information.

Materiality is another issue that makes preparation of financial statement complex and impairs the relevance of information provided in the financial report. Materiality is assessed with reference to quantitative factors (e.g. cost of a component as a percentage of total cost of equipment) as well as qualitative factors such as relevance of the information to investors.

It is difficult to form a judgement about materiality of information that is neither obviously material nor obviously immaterial. Preparers prefer to include such information in financial statements to avoid adverse comments from auditors and regulators. This also clutters information presented in the financial report.

In some cases principles stipulated in accounting standards are theoretical.

A case in point is hedge accounting. Hedge accoun-ting is not permitted for economic hedge (also called natu-ral hedge). Similarly, the requirement for formalising hedging strategy and establishing hedge effectiveness is so complex and costly that CFOs often prefer volatility in reported profit rather than adopting hedge accounting. All these result in distorted information on the economic consequences of the risk management strategy of the company. There are many such situations where application of accounting standards fails to capture the business reality.

Although there is substantial scope to simplify and improve financial reports, it is not an easy task. It poses enormous challenge. Regulators, auditors and others, who have interest in corporate financial reports, have to work together. The first step is to understand and appreciate that there is a need to simplify financial report.