High-Quality Financial Reporting Is a Growing Challenge
IMGCAP(1)]Financial reporting is increasingly complex, and many companies find it challenging to comply with the disclosure requirements of the standards while providing readers with information that is meaningful and understandable.
As a result, boards are looking for innovative ways to communicate the most important messages to their shareholders. There continues to be significant focus internationally on the content and presentation of financial statements by the standard setters and regulators.
In the U.S., the Financial Accounting Standard Board has been engaging with financial statement preparers, users, auditors and other stakeholders to support the reduction of the cost and complexity of financial reporting while improving or maintaining the usefulness of information, including more effective disclosures. When Russell Golden became FASB’s new chairman in 2013, he conveyed a hopeful new approach toward change. The groundwork had been laid in the prior year with the Private Company Council, newly formed to challenge questionable complexity in standards. Mr. Golden, while committed to “putting the interests of investors first” and “working to make financial reporting as clear, transparent and useful as possible,” also stressed the importance of “never losing sight of the balance between costs and benefits.”
FASB followed through by launching an initiative to simplify accounting standards. Even so, the FASB Outlook newsletter cautioned, “You may think that reducing complexity and promoting simplification is, well, simple. While desirable in concept, in practice achieving both is often easier said than done.”
FASB has to date completed and simplified the accounting and disclosure projects for extraordinary items, presentation of debt issuance costs, and the measurement date of defined benefit pension plan assets. It is still working on simplifying the accounting and disclosure requirements for other projects, such as share-based payment, income taxes, measurement of inventory, equity method of accounting, business combinations, and balance sheet classification of debt.
In addition to those projects, the staff is researching other simplifications for income taxes, employee benefit plans, and employee stock compensation for private companies.
The Private Company Council has suggested a few ideas for stock compensation, and the FASB staff is working closely with the PCC to evaluate alternatives. To be successful in meeting financial reporting obligations, financial reporting preparers, managers, directors, and executives need to drive the process, obtain the support of management, engage with their auditors and ask the right questions.
Planning for Year-End
High quality financial reporting requires the appointment of skilled staff, the implementation of appropriate processes and controls, and careful planning by management. Management should establish a process to ensure the quality and integrity of financial statements including their relevance, faithful representation, verifiability, comparability and timeliness.
In order to do so, management should dedicate enough time early in the financial year to focus on the year-end reporting process, establish a timetable for the completion of year-end reporting, and allow adequate time for all issues to be properly addressed. This will require from management enough time to deal with unexpected events and material matters and for the board and the auditors to properly review the financial statements before concluding them.
Management should frequently evaluate and streamline this process to confirm the financial reporting obligations of the entity under existing rules and obligations, the appropriate old and new standards which the financial statements are prepared and presented under, the materiality of disclosed information in the financial statements, the assessment of the going concern assumption in the preparation of the financial statements, and the outdated financial information and disclosures that should be considered in advance.
How well all participants in the preparation and completion of financial reporting of the entity interact with auditors plays a key role in producing the desired high quality financial reporting. It is important for management to establish a process to engage itself with auditors throughout the reporting period to discuss materiality, significant transactions, and changes to accounting policies, including what impact these may have on the financial statements and to address any matters raised by the auditors in the current and prior reporting periods.
Moreover, the board will need to consider the audit plan presented by the auditors and how current risks have been addressed in their plan. It should set enough time aside to discuss with the auditors its own list of key matters and ensure these are properly described in the financial statements and the matters that auditors are considering for inclusion in the “Key Audit Matters” section of the audit report.
What Should be Presented in the Financial Statements?
What matters need to be communicated in the financial statements? Management should evaluate whether the financial statements and annual report consider the information needs of investors and other key shareholders. To accomplish this, management will need to consider the logical structure of the financial statements and if the information to be communicated is easy to navigate and understand.
There are several strategies available to management to communicate information more effectively and make the financial statements easy to read and follow. Management can include a table of contents, group relevant and important information together, display notes in order of importance, use boxes and shading to highlight key information, include significant accounting policies in the notes with the items to which they relate, use subheadings within notes to highlight topics of information, use plain English and remove boilerplate wording.
Well-informed and transparent financial statements will have critical note disclosures prominently displayed and all disclosures should be clearly written using plain English. Disclosures should be tailored to the entity’s circumstances. All boilerplate wording should be removed, and content pages or cross-referencing in the statements should help users navigate the important information.
For an entity to decide what to communicate to its users, the application of materiality is critical to ensure that relevant information is not omitted. Conversely, too much information might obscure the important information for users. Materiality is an entity-specific consideration of what is relevant to the decision-making needs of its financial statement users and therefore there are no uniform thresholds for calculating materiality. As a result, professional judgment is required and consultation with the auditor is recommended.
Materiality is more than just a quantitative threshold over which items are disclosed. As materiality references the size and nature of items (individually or collectively), then the qualitative nature of an item could be material even if the amount is small.
For example, related-party transactions on non-market terms may be material to users regardless of the amount. In the SEC Staff Accounting Bulletin No. 99 – Materiality, the staff stated, “A material is ‘material’ if there is a substantial likelihood that a reasonable person would consider it important.”
In its Statement of Financial Accounting Concepts No. 2, FASB stated the essence of the concept of materiality as follows: “The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.”
This formulation in the accounting literature is in substance identical to the formulation used by the courts in interpreting the federal securities laws. The Supreme Court has held that a fact is material if there is a substantial likelihood that the fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.
One issue relating to materiality is the accounting policies, estimates and judgments adopted by management in the financial statements. Management normally concentrates more on compliance with the established rules and regulations than on communicating the company’s results and performance to the readers of financial reports.
High-quality financial reports should help users understand the performance and position of the business. Instead of being a compliance tool, financial reports should tell the story of the entity’s current-year financial performance, cash flows and financial position using narrative that is specific and relevant to the entity. To evaluate what is material to present and disclose, the board will need to examine if the financial statements reflect its knowledge of the company and its performance for the year and convey the appropriate messages and the narrative in the financial statements and annual report is consistent with the financial information presented.
Investors are normally interested in having transparent financial statements in order to make rational and accurate financial and investment decisions. If a company’s bad news is obscured and not properly disclosed, the notes do not adequately explain the economic substance of transactions and performance of the entity, and the financial statements do not reflect the key decisions made by management and the board during the period, investors will be misled and risky decisions will be made by them.
In addition, the financial statements of an entity should communicate to outsiders the risks involved with that entity. The financial statement should include risk and all other material disclosures, as required by regulations, and informative documentation stating why specific disclosures are excluded.
As a rule of thumb, considering the presentation and disclosure of material items, management will need to assess the company’s materiality level to determine the appropriateness of results and disclosures. As the adopted accounting policies by the board and estimates and judgments made by management can influence these decisions, the entity will need to ensure that it is using the appropriate standards and methods to present its information.
The board will need to consider whether the adopted accounting policies are appropriate to the circumstances of the company and whether alternative policies (where permitted by the relevant framework) will be more appropriate. The accounting policies should be clear, concise, complete and appropriate for the entity. Management should regularly update accounting policies as accounting standards change and remove immaterial or no longer applicable policies. Management will need to regularly evaluate the impact of new accounting standards in advance to determine if the entity can early adopt the changes to standards or disclose the likely impact for the material impact for the entity, when adopted.
Any accounting policies that contain judgmental areas will need to be highlighted (e.g., timing of revenue recognition). The board will need to carefully consider information on accounting estimates and satisfy themselves that the judgments made by management are reasonable. It will need to evaluate if management used an objective and neutral way, and if other alternatives have been considered when they were making judgments. The board may consider engaging other parties, for example, internal auditors or specialists to analyze and evaluate these estimates and assumptions.
Management Discussion & Analysis
The purpose of Management Discussion and Analysis (MD&A) is to provide investors with information that the company’s management believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations. It is intended to help investors to see the company through the eyes of management. It is also intended to provide context for the financial statements and information about the company’s earnings and cash flows.
In 2003, the Securities and Exchange Commission issued an interpretative release providing guidance regarding Management Discussion & Analysis of Financial Condition and Results of Operations. The guidance was designed to elicit more information and transparent MD&A that satisfies the principal objectives of MD&A.
In September 2010, the SEC issued guidance regarding MD&A liquidity and capital resources disclosures to advise companies to identify trends, demands, commitments and uncertainties relating to liquidity and capital resources. As described by the SEC staff, MD&A is management’s opportunity to provide investors with its view of the financial performance and condition of the company. It is management’s opportunity to tell investors what the financial statements show and do not show, as well as important trends and risks that have shaped the past or are reasonably likely to shape the company’s future.
The objective when preparing the MD&A should be to improve your enterprise’s overall financial disclosure by giving a balanced discussion of your enterprise’s financial performance and financial condition including, without limitation, such considerations as liquidity and capital resources, openly reporting bad news as well as good news.
A high-quality MD&A narrative will help current and prospective investors understand what the financial statements show and do not show, and discuss material information that may not be fully reflected in the financial statements, such as contingent liabilities, defaults under debt, off-balance sheet financing arrangements, or other contractual obligations. It should also discuss important trends and risks that have affected the financial statements, and trends and risks that are reasonably likely to affect them in the future. The MD&A should also provide information about the quality, and potential variability, of your enterprise’s profit or loss and cash flow, to assist investors in determining if past performance is indicative of future performance.
To achieve these high quality measures, the board should be up to date on any new or amended disclosure requirements, consider the balance between positive and negative news in the discussion, review information about future prospects and the degree of uncertainty attached to these prospects as actual results may differ, and ensure that the document is written in plain English and avoids boilerplate text.
By meeting with management, discussing and documenting any findings arising from the board review and the independent auditor’s assessment of the MD&A, the board will be able to evaluate the information presented in the document and if it provides the quality and potential variability of the entity’s earnings and cash flows to assist investors in determining if past performance is indicative of future performance.
An entity may face difficult economic conditions and significant adverse events that may require additional consideration and disclosure in the entity’s financial statements. Many entities now report non-GAAP financial measures as performance measures, liquidity measures, or both. A non-GAAP measure is defined as “financial information that is presented other than in accordance with all relevant GAAP.”
Many times, these disclosures tend to be boilerplate or too general to help readers understand how they should use a particular measure. The board will need to carefully consider why the alternative measures presented are useful and not misleading to investors. The board will also need to read the non-GAAP disclosures and examine the following: the presentation of non-GAAP measures is not given undue prominence (the order of presentation and the degree of emphasis) to measures calculated and presented in accordance with GAAP in the SEC filing or a press release; the non-GAAP financial measures are presented with quantitative reconciliations to the most directly comparable GAAP measures; and the non-GAAP measure that is used as both a performance and liquidity measure is reconciled with the most directly comparable GAAP measure.
Other information presented in addition to the financial statements might include summary financial statements, press releases containing financial information or a discussion of financial matters, correspondence broadly disseminated to shareholders, presentations to analysts, financial press, shareholders, and investment professionals, and information and documents filed with regulators such as proxy statements, annual reports, exhibits, etc.
The board will be required to ensure that disclosures in the financial statements and other presented information are consistent, The financial statements should reflect all the information previously released in other announcements. The financial information included in the in public announcements should be consistent with the figures or measures presented and discussed in the full financial statements.
In addition, the board will need to establish a process to ensure the information filed with regulators is accurate, consistent, and complete.
Some of the most valuable sources of information about a public company are the exhibits attached to its Form 10-K. The most significant category of these documents is material contracts, such as material contracts made outside the ordinary course of business, contracts with a director, officer or shareholder named in the reports, contracts where the entity is substantially dependent, material lease contracts, contracts involving the acquisition or sale of property, plant, and equipment for consideration exceeding 15 percent of the entity’s fixed assets, and management contracts or compensatory plans for directors or executive officers that are not generally available to employees.
The board must satisfy itself that there is a process in place to examine and ensure that all additional presented information is being prepared, approved and filed appropriately.
Ashraf Elkotaney, CPA, CFE, CMA, CFM, DipIFR, CGMA, is an accounting manager at Applied Genetic Technology Corporation in Alaucha, Fla.