Cutting the fat on annual financial statements

If you have been working with financial statements for longer than a year or two you would have noticed how these have become thicker with every passing year. Some of us can remember a simpler time when a full set of annual financial statements could fit into less than ten pages. Nowadays you would be hard pressed to find a set shorter than fifteen pages, and then it would certainly not be using International Financial Reporting Standards as a framework – in that case it would be much longer!

The reason is not necessarily that they do not make printers as efficient as they used to, or that the business has become that much more complex (although that is certainly a reason in many cases). Nor can we claim that the quality or usefulness of the information provided has improved enough to justify the added bulk.

The biggest reason for the apparent weight gain on the side of annual financial statements is probably the need to comply with an ever-increasing body of standards, regulations, laws, best practices, etc.

Don’t get me wrong, this is not an article against disclosure of relevant information. The pronouncements referred to in the previous paragraph contain disclosure requirements for very good reasons. In many cases it can be demonstrated that this information is absolutely necessary for decision making in a complex business environment.

Some preparers believe that, when they are not sure if something needs to be disclosed, it should be disclosed “just in case”. No harm can come from additional disclosure, whereas many accountants and auditors have gotten themselves into trouble for not disclosing required information (or disclosing unnecessary information). Time pressure also often means that it’s simply more efficient to use a disclosure checklist and ensure that everything is disclosed than to ponder on the relevance of the disclosures.

However, even the most conscientious standard setter will admit that the objective of disclosure standards is to present information that is relevant and useful and that everything is not always relevant in all cases. Where information exists but is not relevant, material and useful for decision making there is no reason to disclose it. In fact, unnecessary disclosure may serve to obscure the more important facts and render the annual financial statements even less useful. Even the International Accounting Standards Board (IASB) is concerned that “financial statements are increasingly perceived as burdensome”.

The difficulty is in applying judgement to the different requirements and then distinguishing between relevant and irrelevant information.

Standard setters, regulators and users have recently started realising that bigger is not necessarily better when it comes to annual reports. There is a desperate need among users of annual financial statements for improved communication in financial reporting, but this doesn’t necessarily mean more disclosure.

The IASB has therefore embarked on a “Disclosure Initiative” that is aimed at improving communication in financial reporting. 

The following are some examples of ineffective communication that we often see when auditing annual financial statements:

• Use of generic or “boilerplate” descriptions. Example: Copying a financial instrument definition directly from the standard without tailoring it or even considering if it is applicable.
• Including information because it may be required. Example: The Companies Act of 1973 required extensive narrative disclosure in the directors’ report, auditor’s remuneration, etc. None of this is required anymore.
• Including information because it was there last year so there must have been a good reason. Example: The detailed income statement or manufacturing statement.
• Use of unclear descriptions, technical jargon, etc. Example: In the risk management disclosure where simple language could much better convey the company’s approach to managing its risks.
• Unnecessary duplication of information. Example: Referring to risk management, we sometimes see a detailed note on risk management in the notes to the financial statements, summarised in the accounting policies and repeated, albeit in different words, in the directors’ report.
• Using narrative disclosure when a table would be more effective. Example: The note to describe terms, conditions and security of different loans. 

In a March 2017 discussion paper, “Disclosure Initiative – Principles of Disclosure”, the IASB undertook to address these and other concerns. The discussion paper defines a set of preliminary principles of effective communication by stating that information should be:

• Entity-specific, since information tailored to an entity’s own circumstances is more useful than generic, ‘boilerplate’ language or information that is readily available outside the financial statements.
• Described as simply and directly as possible without a loss of material information and without unnecessarily increasing the length of the financial statements.
• Organised in a way that highlights important matters. This includes providing disclosures in an appropriate order and emphasising the important matters within them.
• Linked when relevant to other information in the financial statements or to other parts of the annual report to highlight relationships between pieces of information and improve navigation through the financial statements.
• Not duplicated unnecessarily in different parts of the financial statements or the annual report.
• Provided in a way that optimises comparability among entities and across reporting periods without compromising the usefulness of the information.
• Provided in a format that is appropriate for that type of information. For example, lists can be used to break up long narrative text, and tables may be preferable for data-intensive information, such as reconciliations, maturity analysis, etc.

In practice, there will probably often be a need for a compromise between two or more of the above principles but they do appear to make sense as a reference to providing more useful financial information. A good place to start might just be to cut some unnecessary “fat”.

Henk Heymans

Director, Johannesburg

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