From the point of view of CFOs and other senior finance executives at public companies, the issue of what and how much to reveal in the financial statements has become a game of chicken. Regulators, moving toward a wholesale cleanup of the massive factual and analytical disclosures that have accumulated over many years, are encouraging filers to preemptively step forward and make the edits themselves. The problem, though, is that lawyers have long been counseling companies to do just the opposite: err on the side of insignificant disclosures and repetitive boilerplate to make sure they don’t break laws or get sued for omitting a detail or two.
That tendency has led in large part to what many call a state of “disclosure overload,” burdening corporate preparers, confounding investors, and overwhelming regulators. Over the past two decades, the average number of pages in 10-Ks devoted to footnotes and the Management’s Discussion and Analysis (MD&A) has quadrupled, according to a 2012 report by Ernst & Young. At that rate, in 20 years companies will be devoting more than 500 pages of their annual reports to footnotes and the MD&A. “We don’t see how this volume of disclosure would be helpful to financial statement users,” said the authors of the report.
The issue is not exactly new. In an October 2013 speech declaring that disclosure improvement “is an important priority,” Securities and Exchange Commission chair Mary Jo White noted that the Supreme Court tackled “overload concern” more than 35 years ago in the case of TSC Industries v. Northway. White cited a passage written by Justice Thurgood Marshall for the Court that might well ring as true today as it did in 1976: “[M]anagement’s fear of exposing itself to substantial liability may cause it simply to bury the shareholders in an avalanche of trivial information — a result that is hardly conducive to informed decision making.”
But removing the dross and presenting investors with the easily read, visually punchy narratives that regulators are clamoring for will require a good deal of intestinal fortitude on the part of finance executives. Marc Siegel, a member of the Financial Accounting Standards Board, recalls a story told by a participant at a FASB forum on disclosure a few years ago. A company had tried to scale back some insignificant disclosures to make its reports more effective, and when company representatives were asked what it took to accomplish that, the answer came back: “courage.”
In reenergizing a five-year-old disclosure framework project that focuses on the footnotes to the financial statements, FASB is indeed “trying to do [its] part to help companies take advantage of flexibility and discretion,” Siegel notes. “But I think it’s going to take companies having the courage to try it out and work harder, frankly, to think through their disclosures and make them more effective.”
A Top Priority
The disclosure framework project recently rose to near the top of FASB’s priorities list in the wake of the failure of the board and the International Accounting Standards Board to come to terms on a number of ambitious convergence projects (especially those concerning leasing and financial instruments). The boards’ parting of the ways on fundamental accounting matters has freed up time for FASB to pursue smaller-bore and more-domestic efforts.
Another reason for FASB’s newly kindled interest might be that the two boards have found it easier to come together on disclosure than they have been of late on more fundamental accounting matters, according to Joyce Joseph, a Standard & Poor’s managing director who oversees the rating agency’s global accounting and governance group.
The inability to meld parts of U.S. generally accepted accounting principles with parallel portions of international financial reporting standards has also spawned a need for disclosures that enable investors to compare divergent standards, Joseph says. She cites the recent agreement between the IASB and FASB on disclosures related to financial instruments, in particular the offsetting of assets and liabilities related to derivatives transactions.
“For several years both FASB and IASB struggled to bring harmony in the netting of financial assets and financial liabilities on the balance sheet,” Joseph says. Under IFRS, the results of derivatives deals are reported on a gross basis, while companies must report them on a net basis under GAAP.
“After failing to achieve convergence in the accounting, they were successful in coming up with disclosures that could make it easier for investors and other financial-statement users to make those valid comparisons between U.S. and European bank balance sheets,” Joseph says, noting that she would have preferred a converged accounting solution.
Four Disclosure Areas
Perhaps responding to such needs, on March 4 FASB issued an exposure draft of its “Conceptual Framework for Financial Reporting: Notes to Financial Statements,” a framework intended “to improve the effectiveness of disclosures in notes to financial statements by clearly communicating the information that is most important to users of each entity’s financial statements,” as the board stated on its website. According to Siegel, the board has decided to zero in on four specific disclosure areas: fair value measurement, defined-benefit plans, and income taxes in 2015; and inventory after that.
Up for discussion will be how much of the robust disclosure of annual reports should be carried over to the necessarily more limited revelations in interim reports like 10-Qs. As part of the fair value deliberations, the board is also likely to tackle the question of whether companies should continue to be required to roll forward valuations of assets and liabilities from one quarter to the next, according to Siegel.
Concerning disclosures involving defined-benefit plans, “there’s a requirement to disclose your current contribution for next year, and the board is considering whether or not” to continue the requirement, Siegel says.
More broadly, the board will be mulling over changes in its disclosure rules that would allow reporting entities “to scale the disclosure depending on how important these areas are in their particular business,” Siegel says. “We want to think through how we can facilitate some discretion by companies.”
FASB might, for instance, ponder requiring a manufacturer with high labor costs and a big retirement plan to supply “significant pension disclosure” on its financials. “If you are a high-tech business with less labor-intensive efforts,” Siegel adds, “maybe you don’t have as much disclosure about your defined-benefit plan.”
While finance and accounting executives seem to agree with the general principle that redundant and immaterial disclosures need to be slashed, they balk at having to comply with specific changes in the current disclosure requirements.
In comment letters submitted this summer in response to the FASB exposure draft, they worried that the line between what should be included in the notes and what should be in the MD&A might become blurred. And they were especially fearful that increasing amounts of forward-looking information would be required for inclusion in the footnotes — thus making forecasts subject to an audit.
On July 11, for instance, Donald A. Zakrowski, vice president of finance and chief accounting officer at Eli Lilly, wrote that the pharmaceutical company “supports the Board’s objective to improve the effectiveness of disclosures in notes to financial statements by clearly communicating the information that is most important to users of each entity’s financial statements.”
Nevertheless, Lilly’s leadership was “troubled by the forward-looking nature of many of the indicated disclosures noted in the Exposure Draft,” Zakrowski wrote. The company was particularly bothered by a question in the exposure draft regarding the need to report the fair value of non-financial assets. (Calculating the fair value of an asset often involves making future market projections.)
Lilly’s accounting chief cited a fundamental difference between the notes and the MD&A. On one hand, the footnotes and historical data, which must be audited under the purview of FASB, can become the fodder of shareholder suits. In contrast, statements made in MD&As are protected by a legal safe harbor that enables companies to hold forth about future-oriented information without getting sued.
Regulated by the SEC, corporate reporting in the MD&A “includes unauditable, forward-looking information,” Lilly’s accounting chief wrote. “We believe the information included in the notes to financial statements should be limited to historical financial information, descriptions of management’s judgments and estimates and relevant accounting policies. Forward-looking information should be restricted to MD&A.”
Similarly, Wells Fargo controller Richard D. Levy wrote three days later that the big bank feels that there “must be a clear distinction between information that is disclosed in the notes to financial statements and the MD&A.” The bank’s leadership thinks that FASB’s plan “seems to suggest that certain forward-looking information should be disclosed in the notes to the financial statements rather than the MD&A,” Levy worried.
But Wells Fargo has concerns that go beyond the bailiwicks of FASB and the SEC. Levy urged the accounting board to “broaden the scope of the project to consider all potential sources of disclosure that adversely affect disclosure efficiency and effectiveness.”
Typical of financial services organizations in general, Wells Fargo must serve many regulatory masters. “Duplication and proliferation of public disclosures exists in part because of conflicting or redundant disclosure requirements among standard-setters, regulators and other bodies,” Levy wrote.
That problem will worsen when banks begin complying with new capital and risk disclosures required under Basel III over the next year, according to the Wells Fargo controller. Those disclosures will span a variety of sections in the MD&A and the footnotes of 10-Ks and 10-Qs, “as well as separate disclosure documents published to company websites.”
“Only a coordinated effort among standard setters and regulators will address the growing problem inherent in the current disclosure regime,” Levy wrote.
Two Roads Diverge
While FASB and SEC officials agree on the need to have a comprehensive approach to disclosure, they are hindered in that effort by the legally imposed split between their functions — a split that has led them to pursue projects separately. While FASB moves ahead on its disclosure framework plan focusing just on the footnotes, the SEC is working on its own “Disclosure Effectiveness Project,” aimed at scoping out MD&As and corporate disclosures of risk factors.
Prodded by a provision in the 2012 Jumpstart Our Business Startups Act, which mandated that the SEC report to Congress on the disclosures required from so-called emerging growth companies, the commission went much further in its December 2013 report, proposing a comprehensive review of all public companies.
But executives at some of those companies are skeptical of the SEC’s moves and wary of taking any action to trim their disclosures, according to Christopher Holmes, national director of SEC regulatory matters at Ernst & Young. Clients have told him that they “don’t want to be a first mover,” he says, adding that some wonder if SEC enforcement officials will be as committed to the idea of pared-down disclosure as the commissioners are. If that’s true, executives fear being asked about missing disclosures — and losing the game of chicken.
David M. Katz is a deputy editor of CFO.