More Transparent Financial Reporting Disclosures Needed to Boost Investor Trust
As accounting standard setters consider the creation of a “disclosure framework” to make financial reporting disclosures more effective, CFA Institute has contributed to the debate by publishing a report examining how investors — the main consumers of financial statements — view the effectiveness of current financial disclosures and how they could be enhanced.
The findings of the report, Financial Reporting Disclosures: Investor Perspectives on Transparency, Trust, and Volume, are based on surveys of CFA Institute members and our longstanding dialogue with the investment community. Based on these findings, the report provides recommendations on how to improve the effectiveness of financial reporting.
Impact of 2008 Financial Crisis Missing from Disclosure Reform Debate
Investors’ perceptions regarding financial reporting effectiveness have been profoundly affected by experiences leading up to, during, and in the aftermath of the 2008 financial crisis. Investors believe the financial crisis — and the five years of economic uneasiness that have followed — clearly shows the insufficiency of disclosures. Investors point to high-profile financial institution failures and bailouts in which transparency on exposures, risks, uncertainties, and leverage was clearly lacking. As noted in a recent blog post, 69% of investors who responded to a survey conducted by the Association of Chartered Certified Accountants say they are more skeptical about the information companies provide since the financial crisis.
Lack of transparency in financial reporting, especially when it occurs in financial institutions, has implications for investor trust. And without trust in financial institutions — the handmaiden to the broader economy — investment can lag in the broader economy.
Therefore disclosure reform proposals should demonstrate how they would improve the types of disclosures that were most problematic during the financial crisis (undisclosed risks, judgments and estimates, off-balance-sheet items, and going-concern issues). By establishing such a connection, standard setters would gain credibility by showing they’re working to address investor concerns to increase transparency, re-establish confidence in financial markets, and bolster investment.
Instead we find that current disclosure reform efforts — after the greatest financial crisis since the Great Depression — are more focused on reducing the quantity of disclosures rather than improving the quality of disclosures. This paradox grows when you compare current efforts to policymakers’ response to the Great Depression, which led to the passage of the Securities Acts and a substantial expansion in disclosures. Although the amount of financial reporting information available can be extensive, investors welcome useful information because they have the tools to assist them in managing the volume of data for their financial analysis.
Refocus Disclosure Reform Agenda: Investor Priorities Differ from Standard-Setter Focus
To determine what investors believe standard setters should focus their efforts on to enhance financial reporting, we asked members to prioritize a variety of potential financial reporting initiatives. This revealed that what investors believe is important (emphasizing matters of importance during a reporting period and improved financial statement presentation) is diametrically opposed to where standard setters are currently focusing their efforts (developing a disclosure framework aimed at reducing the quantity of disclosures). Standard setters should, therefore, refocus their efforts to enhancing quality and transparency in the areas that investors see of greatest importance.
Recommendations: Enhancing Financial Reporting and Disclosure Effectiveness
Our outreach to investors shows the most effective means of enhancing transparency would be for standard setters to prioritize certain financial reporting improvements. We believe these recommendations, in order of importance to investors, will go some way in addressing investor skepticism in financial reporting:
Financial Statement Presentation: Investors believe improved financial statement presentation is a key element to improving financial reporting because poor presentation limits transparency. Furthermore, disclosures are less effective when the underlying financial statements are not effective or when disclosures are meant to compensate for poor presentation.
Communication and Presentational Enhancements: Investors and financial statement preparers can find common ground in enhancing communication style and presentational changes to make information more digestible and effective in communicating the company’s results.
Most Troublesome Disclosures: The most challenging aspect of effective disclosures resides in communicating the judgments and estimates made in preparing the financial statements; providing a clear and complete picture of economic assets and obligations not included in the financial statements; and conveying the risks associated with the business. The 2008 financial crisis highlighted these as the most troublesome disclosures for investors. We underscore the importance of improving disclosures in these areas. And when necessary, preparers and auditors should go beyond required disclosures to provide investors with a complete understanding of the underlying economic effects of transactions and account balances.
Key Considerations for Standard Setters and Policymakers: The report also covers matters standard setters will need to consider — including materiality, technology, making effective cost-benefit analyses, and evaluating underlying behavioral elements — as part of any decision-making process to improve disclosures.
Disclosure Framework: Although investors support developing a disclosure framework, the majority of our survey respondents believe other financial reporting reforms are of greater priority, as outlined above. Adopting these recommendations would lead to substantial progress in financial reporting, creating less of a need for a disclosure framework.
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