Torturing Ourselves With Repetition And Complexity In Accounting Disclosure

November 2011

Accounting firm KPMG and the Financial Executives Institute sponsored a study of the complexity in U.S. financial reporting. Aptly entitled “Disclosure Overload and Complexity: Hidden in Plain Sight”, the report found that there was ample reason for changes in accounting disclosures. This is hardly a revelation to anyone involved with either preparing this information or using this information for financial analysis. Nevertheless, a formal study is useful because those who are creating the numerous requirements want a rigorous study to justify any movement from the status quo.

Surprising to this author, lawyers did not have as great of an impact on applying the numerous underlying rules to their client’s financial statements as might have been anticipated. This is unfortunate, since sound legal judgment would likely help the accountants understand that their mechanical implementation of the rules is going beyond what is actually required, and is not actually decreasing the risk that proper disclosure has not been made.

The report’s analysis is based on the following:

“Our research into disclosure overload and complexity consisted of three major activities:

1. Reviewing relevant academic and other literature

2. Reviewing annual reports on Form 10-K filed by 25 FORTUNE 100 companies

3. Sending a survey to 6,500 financial executives.”

Each of these three segments found reason for change. Here are the headline results:

“An important finding in the academic research indicates that disclosure has grown in volume and complexity and that it poses a dilemma particularly for smaller investors who may make suboptimal investment decisions due to the inability to absorb the volume and complexity of literature.”…

”The results of the Form 10-K filing review confirm that disclosure has expanded approximately 16 percent overall during the six-year period and footnote disclosure has grown 28 percent over the same period. Footnote disclosure has grown at a faster pace than overall disclosure and has been particularly acute in the pension and post-retirement benefits, fair value, financial derivatives and hedging areas.”…

“The survey results from financial executives were consistent with our observations in the review of the annual reports. Respondents indicated that …

1. Complexity of accounting standards and volume of mandated disclosure are the most significant contributors to the issue of disclosure complexity. Footnotes are the most significant source or cause of disclosure complexity. Fair value, derivatives and hedging are the most significant sources or causes of disclosure complexity under specific GAAP requirements.

2. Potential objection by the SEC and other regulators, including state regulators, or by external auditors, may cause companies to provide disclosure that is otherwise immaterial.

3. Counsel is most likely to be involved when Risk Factors is the topic associated with disclosures included in a filing with the SEC or footnote to financial statements. Many say their inside or outside legal counsel does not direct disclosure in some or all parts of public filings or footnotes to financial statements.

4. Financial reporting preparation and review time are most impacted by expanded disclosure requirements.

5. Overall, SEC initiatives (e.g., the plain English initiative) to reduce disclosure complexity have not had much impact.

6. FASB and SEC should undertake incremental procedures and processes as part of improving the cost-benefit analysis while developing proposals for new accounting standards.

7. Most companies have not taken steps to reduce disclosure complexity in their financial statements.”

Some of the increase in volume is not additional complexity, but is instead both mindless repetition of existing information that the SEC is mandating, and description of information that is so basic that it is already understood (without being mentioned) by anyone with even the most rudimentary knowledge of business or accounting. The report provided multiple examples of silly disclosures made by some of the largest public companies in the U.S. The report indicated:

“Substantially all companies had some level of cut-and-paste redundancy throughout the Form 10-K. It appears that SEC guidance to provide disclosure of critical accounting policies has led to repeating a large part of the significant accounting policy footnote in MD&A [Management Discussion & Analysis]. Disclosures that address aspects of the business description are repeated throughout most documents. Business description appears in the introduction to each document as required by Item #1 of Regulation S-K. Parts of it are then repeated in MD&A and footnotes including segment footnote and risk factors.”

Based on the research results, the report made the following eight recommendations to address the disclosure complexity and volume challenges:

1. “The SEC should issue an interpretive release to address the permissibility of cross-referencing and manner of addressing immaterial items to reduce redundant and unnecessary disclosures.

2. Summaries of significant accounting policies and discussions of newly implemented or soon to be implemented accounting policies should be streamlined to eliminate unnecessary redundancy and patently immaterial disclosures.

3. Preparers should expand their use of tabular and graphic information delivery formats.

4. The SEC should move forward with its 21st Century Disclosure Project to enable greater use of technology to avoid unnecessary repetition of information in multiple filings.

5. The FASB should accelerate consideration of the Disclosure Framework to establish a systemic approach to disclosure that properly balances disclosure considerations.

6. Preparers should confine disclosure of risk factors to company specific unique risk factors as contemplated by Item 503(c) of Regulation S-K.

7. Accounting standards that mandate disclosure in interim period financial statements should include provisions similar to that found in Regulation S-X that specifically permits omission of disclosure where there has been no significant change in the item since the date of the latest annual financial statements.

8. The FASB and SEC should undertake incremental procedures to ensure that there is an appropriate and adequate cost/benefit analysis in support of all new disclosure requirements. This should include expanded field testing of disclosure proposals.”

Item 5 above probably deserves additional explanation. The FASB Disclosure Framework project might assist the disclosure overload if it were worked on as part of the International Financial Reporting Standards (IFRS) convergence project. However, because the IFRS effort contains many disclosure aspects, and the FASB is focusing on IFRS to the exclusion of the Disclosure Framework project, no meaningful benefit will probably occur unless the projects are considered together.

Of course, some of the complexity occurs because certain transactions are indeed difficult to understand. But, if less space was given to simple items of little merit, more attention can and will be spent on the complex transactions that really matter. We would all be better off with this result.

Fulcrum Inquiry performs forensic accounting services and special purpose audits.