The severity of the recent losses in the financial markets took many investors by surprise, sending shock waves through the economy and fueling concerns about the transparency of financial reporting.
To help restore confidence in reporting and in the markets, the Financial Accounting Standards Board (FASB) is rushing out an unusually heavy dose of disclosure requirements. In a flurry of last-minute standard-setting activity, some new requirements were issued or have been proposed, with the expectation that the changes would be applied to calendar- year 2008 financial statements; a second round of disclosure requirements is likely to be issued and implemented this year.
For the most part, the areas targeted by the FASB for more robust disclosures are those where the related risks are neither visible nor well understood by investors, analysts, and regulators. Many of these areas—off-balance sheet entities, derivatives, and retirement plan assets—figured prominently in the news headlines as the aftershock from the large losses reported by major financial institutions reverberated through the world’s economy.
Investors want credible financial reporting, and companies want to provide meaningful data in the notes to the financial statements. Many will find the new FASB disclosure requirements both timely and helpful. But even a cursory review of the extent of the changes made last year and contemplated for this year can’t help but raise a few questions.
The most critical questions are:
- Are the expanded disclosures sufficient to restore confidence in financial reporting and address the deficiencies revealed by the financial crisis of 2008?
- Are all of the additional disclosure costs justified?
- Is the guidance sufficiently specific and standardized so that companies can follow it and investors can locate it easily?
What can be done to ensure meaningful disclosures in the future?
While a complete set of answers is elusive, a few observations seem painfully clear. First, there is little doubt that investors were caught by surprise by unforeseen risks; some major corporations were taken by surprise, too, and didn’t fully understand the extent of the risks they were taking. Second, although these are unusual times and it is understandable that new standards are being rushed out, our instincts tell us a more systematic and comprehensive approach to disclosures would be preferred in the future.
Could the financial reporting community work together to accomplish that goal? Based on our analysis of the disadvantages of piecemeal disclosures, the short answer is “Yes. We can and we should.”
There are three key drawbacks to today’s piecemeal approach to disclosure requirements:
1. Disclosures are no substitute for sound accounting. No matter how extensive, voluminous, and well-intentioned, disclosures are no substitute for good accounting principles. Increasingly, to provide flexibility in scheduling projects, the FASB appears to be using added disclosure requirements as bridges to better accounting that have not yet been agreed upon with the International Accounting Standards Board (IASB). In effect, the establishment of disclosure requirements on an ad hoc, project- by-project basis becomes a temporary measure when time is too tight to promulgate significant accounting changes and allow companies sufficient time to transition to sounder practices. This approach is sub-optimal because the disclosures become a compromise solution and the series of short-term fixes adds up to more changes than necessary.
2. No sunset process. If disclosure requirements must be established on a piecemeal basis, this process would best be accompanied by a sunset process for reevaluating disclosure requirements periodically, and removing the ones that may have been rendered unnecessary by subsequent changes in accounting requirements of related standards. Currently, the FASB does not have a process of this nature. While a full review of all disclosures could be a daunting task, there is a common theme underlying many of the disclosure requirements added in 2008 (i.e., the need for improved transparency of risks and uncertainties). Perhaps this aspect of disclosures could be singled out for special review, similar to the way the board reviewed all references to fair-value measures in connection with the issuance of FASB Statement No. 157. The goal would be to simplify the literature and combine individual requirements into general requirements wherever possible.
3. No 21st Century Disclosure Initiative. Without a periodic review of the FASB’s disclosure requirements, the United States may fall behind other countries in the move toward interactive data as described in the Securities and Exchange Commission staff report, “Toward Greater Transparency.” Prepared as part of the SEC’s 21st Century Disclosure Initiative, the report describes survey results that show many readers already find U.S. disclosure documents too long and wordy; they prefer to get their information another way, such as through a broker or financial analyst.
A more systematic and comprehensive approach to disclosures should, at a minimum, encompass the following steps:
- Establish objectives and the purpose of disclosure. Who is the target user of the disclosures? Existing disclosure requirements seem inconsistent. Some appear to be providing context for understanding financial statements. Others appear to be patches for underlying bad accounting that the FASB hasn’t been able to fix yet. Still others appear to have become the primary source of information about a particular set of transactions.
Similar inconsistency exists with respect to the target audience. Some disclosures appear to be oriented to a reasonably educated reader, while others are more detailed and appear to be oriented to a professional securities analyst. The right audience is the reasonably educated reader of general- purpose financial statements; the additional detail that securities analysts want should be provided in statistical supplements.
- Integrate related disclosures rather than having them appear in separate notes to the financial statements. Because disclosure requirements are established on a piecemeal basis, standard-by-standard, companies often provide each set of disclosures in a separate note to the financial statements. The FASB should seek to identify relationships among disclosures and encourage companies to integrate disclosures for related transactions, even if the requirements arose in different standards.
- Streamline existing disclosure requirements, eliminating redundancies and excessive detail. Disclosure requirements are established on a piecemeal basis, so redundancies arise. A comprehensive approach would identify and eliminate redundancies. The level of detail among disclosure requirements also varies significantly. A comprehensive approach would identify areas of excessive (or missing) detail and conform all to a more consistent approach.
- Consider disclosure requirements for both GAAP (generally accepted accounting practices) and IFRS (international financial reporting standards), with an objective of conforming them. The FASB and IASB have established disclosures on a standard- by-standard basis. A comprehensive review could identify strengths and weaknesses of each set of disclosure requirements and choose the better of the two.
- Consider current GAAP and SEC requirements with an objective of conforming them and eliminating redundancies. The SEC’s disclosure requirements for Management’s Discussion and Analysis (MD&A) go beyond GAAP in some respects and duplicate GAAP in others. Some registrants duplicate large blocks of text in both MD&A and the notes to financial statements. Redundancies exist between the notes and the Business and Contingencies sections of registration statements.
Given the integration of U.S. GAAP into the SEC’s interactive data rules and the lessons learned from the current financial and economic crisis, the FASB should add a comprehensive disclosure initiative to its agenda and make it a priority.
Ben Neuhausen is national director of accounting at BDO Seidman LLP. Contact him at: bneuhausen@bdo.com.
Ben Neuhausen was a great thought leader, with courage in expressing his views about financial reporting and standard-setting issues, and moreso called upon for courage in his personal life; sadly he passed away from pancreatic cancer on July 31, 2009. My sympathies to his family and his many friends and colleagues.
On July 8, 2009, three weeks before Ben lost his courageous battle with cancer, the FASB agreed to undertake a project on disclosures with an eye toward making financial statement disclosures more effective, coordinated, and less redundant. Though Ben’s distinguished career ended far too soon, his accomplishments were many, and he leaves a rich legacy of lessons in both literacy and life. The Center for Financial and Accounting Literacy has published a tribute to Ben’s life and legacy at http://www.fincenter.org/Ben_Neuhausen.htm