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Complete disclosing and accurate accounting information, can effect individuals, investors, markets and in general all stakeholders. It is vital to inform the current investors and even prospect investors on the accounting strategies used in order to develop financial statements including the statement of financial position and the statement of cash flow.
Over the past few years there have been ongoing concerns over the effectiveness of financial disclosures, and doubts behind the level of truth and transparency of disclosed financial information. In response to these concerns and as a reaction to the global financial crisis the Financial Accounting Standard Board launched a public discussion forum on the Disclosure Framework Project to reach out to all interested parties in order to get a clearer picture of the problems and their causes.
According to the accounting standard IFRS 7 entities are required to provide disclosures in their financial statements, disclosures that enable users to evaluate the significance of financial instruments, the nature and extent of risks arising from them, how entities manage those risks and further explain unclear transactions thus apply the substance over form principle.
Financial Disclosures represent secondary information that consists of important data, comments and explanations that are listed in companies' financial reports to clarify certain aspects of companies' procedures and other significant items that should be revealed. Disclosures must provide investors with information that is useful for making their resource allocation decisions and assessing management's stewardship. Most disclosure requirements are similar for all publicly traded companies; however some industries are required to provide more specific disclosures based on the operations of a business. For example in the banking industry banks are required to provide details of all their loans, deposits, guarantees and other financial instruments in the form of schedules attached at the end of financial statements.
The importance of disclosures increased significantly after 2002 as some major accounting and corporate scandals of misleading financial statements such as Enron, Tyco International,Â Peregrine SystemsÂ andÂ WorldCom, this caused companies to collapse costing investors millions of dollars and the public lost their trust in the nation's securities markets. Not long after that theÂ Sarbanes-Oxley Act of 2002 was enacted, which stated the following " An act to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes."
Types of Financial Disclosures
There are two main categories for disclosures, the first is information about the significance of financial instruments and the second is information about the nature and extent of risks arising from financial instruments.
The first category is clearly regarding disclosures related to information about the nature and extent of risks arising from financial statements; statement of financial position and statement of comprehensive income and other disclosures. For example Assets measured at fair value, loans and receivables, financial liabilities measured at amortized cost, accounting policies applied.
As for the latter, these disclosures are related to information gained from financial instruments, which is divided to qualitative disclosures which describes risk exposures for each type of financial instrument and management's objectives, policies, and processes for measuring and managing those risks and changes. The other is quantitative disclosures which provide information about the extent to which the entity is exposed to risk based on information provided internally by using the concentrations of risk liquidity risk, credit risk, and market risk.
Disclosure Framework Project
As previously mentioned the Financial Accounting Standard Board launched the Disclosure Framework Project with the objective to ensure that all and only relevant information is disclosed and improve the effectiveness of disclosures and communicate the information clearly to users of each entity's financial statements. The board would also like to guide organizations to improve the format and style of disclosures.
The FASB chairman announced the agenda of this new project on July 8, 2009 and there have been continuous meetings since then. Even though there hasn't been any official announcement yet, this project is taken seriously especially since many users are involved. A resource group has been created including users, analysts, preparers, auditors and regulators in order to gain insight from all interested users as each have different views. For example users argue that disclosures are poorly communicated and that not enough relevant information is presented whilst preparers complain of disclosure overload/clutter. This encourages all parties to work together by which all issues will be identified and hopefully a framework will be issued to address these problems.
Disclosures and Materiality:
The concept of materiality has a long history in accounting standards and jurisprudence. Materiality applicability to all firms makes it difficult to distinguish material information. However the IASB stated that "Information is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful." (International Accounting Standards Board's - "Framework for the Preparation and Presentation of Financial Statements").
Material information and disclosures are interconnected terms; firms are required to disclose material information to investors, but not all disclosed information is material.
Managers first determine whether information would be considered material to investors, the investors would need expanded information in order for them to evaluate the performance of the company and understand the wealth-generating processes if it is immaterial and not required to be disclosed, managers then consider whether the incremental benefits of making the disclosure exceed the cost (cost benefit relationship), as illustrated in the below figure:
* (TI) measures the relevance an investor attaches to the magnitude of the disclosed information & (k) is the threshold that causes the information to be material to a reasonable investor
CMB: total capital market benefit of making the disclosure.
PC: is the proprietary cost of the disclosure.
LRB: is the expected benefit of the disclosure from lowering the firm's litigation risk.
I believe that materiality should be recognized as the driving force behind disclosures; this will start to form a structure for disclosures and will enhance standardizing the components of disclosures among various industries which will help present useful information in a coherent way so that users can find what they are looking for easily and gain an understanding of the company's business and the opportunities, risks and constraints that it faces without dealing with confusing elongated disclosures which require a lot of time and effort to understand. Materiality limits the unnecessary information presented and therefore minimizes disclosure clutter.
In the year 2012 a survey was made by the IFRS with regards to disclosure, according to the survey 80% of the users and prepares think there is a disclosure problem. Whereas the users think that in the financial statement there is poor communication of information from the prepares of the financial statements. Furthermore there isn't enough information in the financial statement for proper judgment by the users. As for the prepares view, they don't want to overload the financial statements with information that the users will not understand as these data are immaterial.
Disclosure Clutter causes and solutions
Disclosure clutter is one of the emerging issues that all users are facing. This clutter undermines the usefulness of annual reports and accounts by obscuring important information and inhibiting a clear understanding of the business and the issues that it faces. Many argue that an immaterial disclosure also known as voluntary disclosure is the reason behind the clutter. This problem has increased considerably in recent years due to the vast array of requirements imposed by regulations, financial reporting standards and law, another reason is the change of the audiences of disclosures as they used to be presented mainly to shareholders while now prepares have to take into consideration stakeholders including employees, suppliers, environmentalists, customers, etc.
By reducing disclosures to what information is important, focusing on existing standards, clearly organizing and presenting disclosures and using materiality as a base for disclosures we limit disclosure clutter enabling users to clearly understand the information disclosed.
After conducting this research, I have learnt the importance of disclosures but I have also found that all related parties are facing many problems that I do believe can be solved with a more formal disclosure framework that all related parties can use as a guide. I also understood what disclosure is all about, whereas an accountant should always report existing accounting policies and any changes that occur with regards to the policies. Furthermore disclosure can contain matter where it cannot yet be accurately quantified. For example, the presence of a dispute between the government and a company over a tax position and also results of a lawsuit. Financial disclosures are the supporting notes for financial statements that have an impact on all interested parties therefore there should be a framework put in place.