Sources of Reporting Complexity
The Task Force initially focussed on identifying the main sources of financial reporting complexity. Accepting the premise that complexity is inevitable in the short term, and in those circumstances the need to manage complexity is for most businesses a 'reality', the Task Force has identified the following key sources of reporting complexity.
1. Increasingly complex business operations
Businesses have used structures and financial instruments, often in complex ways, to more actively manage their operations and exposures. Risks and rewards are parsed and apportioned in ways not seen in past decades. This increased complexity in business has contributed to the need for more complex reporting requirements.
The Task Force believes it is important to see the rapid changes in the increasingly complex international and domestic reporting requirements (including those in accounting standards) not as the primary source of complexity, but rather, as a consequence of this complexity.
2. Complexities in the regulatory framework
The current regulatory framework is not optimal. Many regulators, in Australia and elsewhere, sometimes require General Purpose Financial Reporting for entities or circumstances for which that form of reporting was not created, or else confuse their special purpose needs with those of that reporting. The recent KPMG Confronting Complexity report (May 2011)1, found that 41 per cent of Australian businesses nominated 'rules and regulation changes' as the biggest driver of rising business complexity in the past two years.
Additionally, the Task Force has concluded that there are some specific aspects of the current accounting standards framework which are adding to reporting complexity:
- the current body of financial reporting requirements is a shifting mix of principles and rules, too often complicated by exceptions. The Task Force appreciates that the International Accounting Standards Board (IASB) is seeking to rationalise those requirements and promote professional judgement. However, in the meantime, we see cries for interpretation, complexity from options and exceptions, and a 'layering on' of new disclosure requirements;
- the current accounting 'hybrid measurement framework' of historical cost and fair value;
- where fair value impacts reported profit there have been concerns expressed about volatility and the obscuring of trends. Added to those concerns have been those related to dividing effects between profit or loss, and other comprehensive income. Many calls have been seen for rationalisation of performance reporting;
- the requirement for IFRS to be applied, with very few exceptions, to all Australian reporting entities (including large proprietary companies, the public sector, and private not-for-profit sector). This is unique compared to other jurisdictions. The extent of application of IFRS in Australia amplifies the concerns with complexity; and
- despite the drive towards a common international accounting framework, there are instances where significant valuation differences have been placed on similar, if not identical, assets and liabilities. There has also been debate as to the extent to which valuation differences are a result of the subjectivity of the valuations, and the extent to which they are the result of a lack of scepticism by preparers and auditors. The subjectivity required in some valuations highlights the importance of disclosing key assumptions.
Furthermore, there are reactions to the financial crises and scandals that flow into reporting requirements (sometimes largely for political reasons) in ways that are not always logical and which add complexity. Anti-abuse type provisions in laws are often difficult to understand or work with, especially if the original political motivations lose relevance over time. One example of financial reporting complexity is that arising from remuneration reporting. Many of the reporting obligations in relation to remuneration reporting are not required by accounting standards, but they add to the volume of disclosures in financial reports. Those disclosures are often complex because they need to explain the outcome of many different remuneration schemes and often the disclosures are not readily reconcilable to the accounting results.
3. Changing attitudes of businesses and stakeholders
Another key area giving rise to reporting complexity is the increased aversion to risk by company directors, preparers and auditors n response to a more litigious business environment. This has led to the behaviour of some key parties, particularly preparers and auditors, of 'when in doubt, disclose'. The consequences of this mindset are:
- an increase in both the number and volume of additional financial and other disclosures presented;
- the inclusion of immaterial disclosures, which may detract from material disclosures, and confuse and/or deter proper review of these financial reports by targeted users and corporate stakeholders; and
- a lack of understanding by preparers and auditors as to which disclosures are material, with the result that material disclosures may be omitted from financial reports and immaterial disclosures included. The International Auditing and Assurance Standards Board (IAASB) issued a consultation paper directed at this issue in early 20112.
Often company management and the users of these reports view the key financial data points presented in the financial reports as not telling the 'real story' of the company's financial performance or position. This has led increasingly to what might be termed 'shadow reporting' as seen in the disclosure of an increasingly large volume of 'non-IFRS'-defined financial disclosures such as 'underlying' or 'adjusted' earnings, and profit outcomes that differ significantly from the profit based on the application of accounting standards, and frequently are adjusted for selected changes in fair value.
This is giving rise to additional significant financial reporting and commentary outside of the statutory financial reports, and is an issue that the Australian Securities and Investments Commission (ASIC) have identified. In response, in December 2011, ASIC released Regulatory Guide 230 'Disclosing non-IFRS financial information'.
4. Developments in Integrated Reporting
The Task Force notes the current international work on developing integrated reporting, and welcomes this interest in improving the communication between companies, their shareholders and other stakeholders. The development of integrated reporting remains in its early stages, with a small number of Australian companies being involved in an international integrated reporting pilot program during 2012. Integrated reports aim to 'demonstrate the linkages between an organisation's strategy, governance and financial performance and the social, environmental and economic context within which it operates.'3 As such, integrated reports will draw on existing Management Discussion and Analysis contained in company publications, on sustainability reporting, and on reporting on governance.
The Task Force hopes that integrated reporting will be able to provide guidance that assists companies to bring together these existing reports, and possibly some new information, in a format that reduces the current reporting burden. However, there is the potential for integrated reporting to become yet another complex set of requirements with which companies must comply. In the view of the Task Force, Australia should monitor developments in this space with a view to encouraging adoption only of that which clearly provides a pathway to simpler reporting that communicates better with stakeholders. The Task Force will liaise with the FRC Integrated Reporting Task Force to assess what further action might be possible on this matter.
Complexity in the Presentation of Results
One particular area of complexity in financial reporting is in the presentation of results. Listed companies generally aim to provide a clear explanation of their results when they present to the market. Recognising that users may not have the necessary time, or the necessary accounting training, to fully read the financial report and analyse the result, companies often highlight key financial matters in an investor presentation.
The investor presentation is a key method that companies use to assist readers and management to manage the complexity of the financial report, and to follow movements in key items that are used to predict the future results of the company. For example, the investor presentation may highlight the following financial data, which while based on the financial report, is not always shown separately therein:
- the impact of one-off transactions that are unlikely to recur (for example sales or acquisitions of part of the business);
- events that are unusual because of their size (for example a large asset impairment, impact of a flood on operations, restructuring costs);
- key ratios that assist in analysing the particular business (for example cost/income, EBITDA4, unit cost of production, leverage); and
- past capital expenditure (for example explain where and how the capital expenditure for the period has been spent).
Additionally, the investor presentation may include more information than is required in the financial report, such as:
- committed funding lines, the extent to which each line has been drawn on, and their key terms;
- a time series of several years showing how profit/revenue/expense figures, and key ratios for the company, have moved over a period in excess of the two years shown in the financial report;
- safety statistics; and
- future expansion plans (for example projected spend on capital investment)
Much of this data is important for the prediction of future cash flows of the company, and accordingly is relevant to users of the financial report.
However, there can be considerable variation in the way the same term is used by different companies. The Task Force suggests that a common cause of confusion, and perhaps concern about corporate reporting, is that often the same or very similar sounding financial terms or ratios are used, but are defined in different ways by different companies.
In the absence of specific definitions in a company's report, analysts may find it difficult to compare one company with another. For example, LTIF (Lost time injury frequency) rates in Australia are normally based per million hours, but in the US the basis is per 200,000 hours, thus making Australian LTIF appear five times worse. Another example is leverage ratios. Debt-to-equity ratios may use financial liabilities as the numerator, or may deduct cash and cash equivalents, or may add the net impact of any derivatives related to the financial liabilities and cash.
ASIC Regulatory Guide 230 Disclosing Non-IFRS Financial Information does not apply to ratios that include the use of non-financial information (such as sales revenue per unit, LTIF), and notes that ratios such as debt-equity may be useful. It does not however explore the various ways in which these useful ratios may be defined.
1 KPMG, 'Confronting Complexity: Research Findings and Insights', Issues and Insights (2011)
2 International Auditing and Assurance Standards Board, 'The Evolving Nature of Financial Reporting: Disclosure and Its Audit Implications', Consultation Paper, 2011
4 Earnings before interest, tax, depreciation and amortisation