Forward-Looking Information in Financial Disclosures — Necessary to Disclosure Effectiveness
Bloomberg BNA recently conducted an e-mail interview with Sandy Peters, CPA, CFA, head of the financial reporting policy group at CFA Institute, about forward-looking information in financial disclosures. CFA Institute’s recent report, ‘‘Forward-Looking Information: A Necessary Consideration in the SEC’s Review on Disclosure Effectiveness,’’ provides investor perspectives on forward-looking information and determines whether a dividing line can be drawn between the forward-looking information that belongs outside and inside financial statements.
Bloomberg BNA: What is the current status of the SEC’s consideration of forward-looking information in financial disclosure statements? What prompted this discussion about forward-looking information in companies’ financial disclosures?
Peters: The SEC is reviewing the effectiveness of Regulation S-K and Regulation S-X disclosure requirements, to consider ways to improve the scope of disclosures for the benefit of both companies and investors.
Investors believe that the SEC review needs to include consideration of the degree to which forward-looking information belongs within or outside the financial statements. In late 2012, Paul Beswick, the SEC’s chief accountant, indicated that the Commission intends to focus on the dividing line between what should appear in financial statements versus the broader financial reporting package. Broadly defined, a forward-looking statement includes statements containing projections of financial matters, plans and objectives for future operations or future economic performance … as well as the assumptions underlying or relating to such statements.
At the CFA Institute, we think this conversation has arisen, in part, because of the Financial Accounting Standards Board’s (FASB) efforts to improve the measurements and disclosures for financial instruments, impairments, liquidity and interest rate risk, going-concern status, and other note disclosures more broadly.
The FASB recently advanced several proposals that have been derailed by significant opposition from companies and preparers, who argue that because such information is forward-looking, it does not belong in the financial statements. Notably, investors do not object to the inclusion of this information, and in fact, the findings of our CFA research indicate that they see considerable value to greater disclosure of forward-looking information in financial statements.
BBNA: What is ‘‘forward-looking information’’ and when are companies required to disclose it?
Peters: Forward-looking information has been broadly defined in various ways by the SEC, and protected under the safe harbor rules most recently amended by the Private Securities Litigation Reform Act of 1995 (PSLRA).
Broadly defined in the PSLRA, a forward-looking statement includes statements containing projections of financial matters, plans and objectives for future operations or future economic performance (such as statements contained in the issuer’s MD&A), as well as the assumptions underlying or relating to such statements.
We believe part of the issue at hand is that there is no definition of ‘‘forward-looking information’’ or ‘‘forward-looking statement’’ under U.S. GAAP. Historically, the understanding has been that these disclosures will be made outside the financial statements on a mostly voluntary basis. Given that current standards encourage the disclosure of (rather than require) certain forward-looking information, and provide safe harbors to it outside the financial statements, most companies use their discretion when deciding where to place this information in the financial statements.
BBNA: What is the disadvantage to this voluntary approach? Why should forward-looking disclosure be required in the financial statements?
Peters: There are several disadvantages to the voluntary approach from an investor perspective. Given its discretionary nature, this approach can sometimes be skewed towards the delivery of positive information. Taking into account the realities of both human nature and the corporate mindset, it’s likely that what is disclosed may skew toward the positive. Also, if companies are not required to disclose such information in a quantitative manner, they may opt for easier but less useful qualitative characterizations.
Investors are rightfully wary, due to the global financial crisis — and before that the collapse of Enron and other scandals — and have little reason to rely on the voluntary disclosure of matters such as risk and fair value. If anything, in the view of most investors, the financial crisis highlighted the increased need for forward-looking information, and they would prefer to see the requirement of more explicit and qualitative disclosures.
Requiring this sort of disclosure would not only give investors additional tools for understanding measurements, risks, and uncertainties, but also put a greater onus on management to enhance its own assessment, understanding, and monitoring of risks.
BBNA: Why is this type of information useful to investors?
Peters: We’ve all heard that past performance does not guarantee future results. Investors need ‘‘decision-useful’’ information. Measurements and disclosures based on current values and expectations of the future are inherently more relevant to investment decision-making than disclosures based on historical measures — which may be highly reliable but lack relevance because of their inability to provide insight into current or future expectations of cash flows.
Investors believe that financial reporting’s objective is to provide ‘‘decision-useful’’ information. Hence, it seems self-evident that financial statements meet this definition when they incorporate forward-looking information.
A case in point is that in the months and years preceding the financial crisis, investors would have learned nothing about the ability of large financial institutions to weather systemic disruption from looking only at historical information. They needed — and still need — ‘‘decision-useful’’ information, and that necessarily includes forward-looking statements. As technologist Herb Brody put it, ‘‘Telling the future by looking at the past assumes that conditions will remain constant. This is like driving a car by looking in the rearview mirror.’’
BBNA: What are some of the inconsistencies in classifying forward-looking information?
Peters: As there is no definition of ‘‘forward-looking statements’’ under the U.S. GAAP, accountants and securities lawyers in the United States automatically assume that such information must be included outside the financial statements. This is a basic misconception that neglects the reality that U.S. GAAP does include substantial degrees of forward-looking information.
However, due to a lack of a conceptual framework for measurement under U.S. GAAP, we find a wide inconsistency of use.
In our recent report titled, ‘‘Forward-Looking Information: A Necessary Consideration in the SEC’s Review on Disclosure Effectiveness,’’ we explored what is actually being required and disclosed, and found that in some instances, the use of estimates is obvious (e.g., amounts that are carried at fair value), and in others, the estimates are buried more deeply in the valuation process.
Our report also shows that investors see ‘‘conceptual inconsistency’’ and ‘‘contradictions’’ in the requirement to measure or disclose certain financial instruments in the financial statements. For example, they note that forward-looking measurements such as fair value are used while the disclosure of the underlying cash flows, assumptions and risks are excluded in the financial statements.
BBNA: What is an example of forward-looking information ‘‘embedded’’ in financial statements under existing practice?
Peters: The most obvious example is the case of financial instruments being measured or reported at fair value. Reporting financial instruments at fair value requires an entity to project future cash flows, often far out into the future, discounted at a rate that market participants would use to discount them. This is particularly so in the valuation of ‘‘exotic derivatives,’’ ‘‘mark-to-model’’ or ‘‘Level 3’’ instruments that do not trade on an exchange but instead are valued using an internal model.
Valuations for ‘‘Level 2’’ financial instruments also involve a fair deal of estimation because financial institutions apply ‘‘valuation adjustments’’ and other reserves to reflect their best estimate of fair value — and these estimates can provide investors important insight into a management’s views on the marketplace and its portfolio risk.
‘‘Level 1’’ financial instruments, while not developed by management, also incorporate the markets’ future expectations of cash flows and discount rates. The disclosures of fair value for items measured using a valuation basis other than fair value also result in the inclusion of forward-looking information in financial statements.
There are more examples and our CFA Institute report currently includes an appendix listing of some of the types of forward-looking information (e.g. for loans, securities impairment charges, etc.) already found in financial statements.
BBNA: Can a meaningful dividing line be drawn between forward-looking information that belongs inside versus outside financial statements?
Peters: If there ever was a dividing line, it has ceased to be relevant. Our research suggests that the ‘‘conceptual Rubicon’’ has already been crossed, and if the SEC is asking where the dividing line is, they may be pursuing a false choice.
Since the PSLRA was passed 20 years ago, financial statements have come to include more, rather than less, forward-looking information. In fact, the standards currently under development by FASB would extend the inclusion of forward-looking information in the financial statements even further.
BBNA: In light of the difficulty of line-drawing in this area, which the report highlights, what would you recommend to the SEC officials reviewing the commission’s disclosure regime? What feedback are investors providing to the SEC?
Peters: Deferring enhancements to financial reporting because of the debate regarding where forward-looking information belongs — particularly in such areas as risk and liquidity disclosures, which clearly proved problematic during the financial crisis — is not beneficial to investors who seek this ‘‘decision-useful’’ information.
We believe that the ‘‘nature of the improvements,’’ rather than their location in the financial filings, should be of principal concern to policymakers. Creating artificial boundaries regarding where to provide additional forward-looking information, such as risk disclosures, simply ends up significantly constraining needed improvements to financial reporting information.
BBNA: Should companies ever consider disclosing more in their financial statements than regulators require?
Peters: The CFA Institute has long advocated for more forward-looking measurements and disclosures to enhance the ‘‘decision-usefulness’’ of financial statements.
Relying on voluntary disclosure creates too much uncertainty for both issuers and investors. Instead, standard-setters such as the SEC and FASB should have the ability and the compulsion to require disclosures — such as liquidity disclosures —within the financial statements when such disclosures are deemed a necessary improvement to financial reporting, even though they may not relate to measurements contained in the financial statements.
Ultimately, it’s a matter of quality, not quantity.
Reproduced with permission from Corporate Counsel Weekly Newsletter, 29 CCW 43, 11/05/2014.
Copyright © 2014 by The Bureau of National Affairs, Inc.
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