Efforts to reduce the complexity and compliance costs of financial reporting for private companies appear poised to have a negative impact on those for whom the reports are compiled: investors. For the first time, investors’ opinions of these efforts have been made known, and they overwhelmingly say that the moves will make it more difficult to conduct financial analyses.
A report published by CFA Institute showed that some 82% of investors surveyed say moves for reduced requirements, or differential standards for private companies, will decrease comparability, 73% foresee greater complexity, and 65% say efforts will lead to a loss of decision-useful information about private companies. Titled Addressing Financial Reporting Complexity: Investor Perspectives, the report was released in May 2015.
INVESTORS AND COMPLEXITY
The implications are clear, according to the report’s author, Mohini Singh, director of Financial Reporting Policy at CFA Institute. “The report clearly shows that investors’ views of complexity are very different from those of corporate managers,” says Singh. “Investors do not want separate private company reporting. Instead, they believe that the issue of financial reporting complexity should be addressed for all types of companies. Furthermore, they think some sources of complexity are unavoidable, such as those related to complex transactions. But other avoidable sources can be reduced, particularly those complexities created by inadequate accounting standards and inadequate communication.”
For years, people involved in financial reporting have been talking about reducing reporting requirements for private companies. Organizations behind the efforts, including the IASB (the International Accounting Standards Board), which has developed separate standards for small and medium-sized enterprises, and the FASB (the Financial Accounting Standards Board), which is working on US private company standards, are responding to companies’ concerns about rising compliance costs. The IASB and FASB approach of developing reduced requirements, however, has a serious impact on investors’ ability to compare reports and get useful information, and it could lead to higher capital costs for private companies, the study showed.
“If the FASB continues to push for differential standards,” says Singh, “it should develop them on a very limited basis— for instance by reducing the disclosures about items that are recognized and measured in the financial statements or by giving private companies more time to adopt new requirements if they have limited resources.”
Overall, the underlying assets and liabilities of an entity do not change based on the type of entity or its legal structure. Similar items should therefore be recognized and measured similarly, according to Singh.
Standard setters could work to reduce two key sources of complexity: inadequate accounting standards and inadequate communication.
Problems of inadequate accounting standards include, for example, decreased comparability because of optionality and exceptions to principles.
The optionality available in current accounting standards can result in widely different financial statements, making it difficult for investors to make comparisons, which is a critical part of the decision-making process. If standard setters increase reporting options through the creation of separate private company standards, investors will face even more complexity when performing analyses.
Likewise, exceptions to principles add complexity to financial reporting. Financial reports should provide information that helps investors decide whether to invest (i.e., reports need to reflect the underlying economics of transactions and events). Exceptions to principles suggest that there is a lack of consensus on the economic substance of a transaction.
Problems of communication include, for example, management that has a lack of understanding or a lack of intent to disclose certain items, such as the risks and uncertainties faced by the business. Another problem is poor financial statement presentation that does not allow users to link income statement and cash flow captions, making statements more complex for investors to analyze.
According to a 2012 report published by CFA Institute titled “Financial Reporting Disclosures: Investor Perspectives on Transparency, Trust, and Volume,” standard setters could require improved communication to investors, including enhancing the style and presentation of information. Ideas include an emphasis on matters of importance during a reporting period, a greater integration of information within the financial statements and between the financial statements and management commentary, and entity-specific information.
Given the investor view that it is these areas of avoidable complexity that need to be addressed, and the clear statement of investors that current efforts by standard setters to create separate private company standards will actually increase complexity, it’s clear that standard setters still have work to do to find a balance between the needs of companies to cut their compliance costs and the needs of investors to receive valuable, usable information.
Rhea Wessel is a freelance journalist based in Frankfurt.