RSS feedsOne of the time honoured complaints about financial reporting is the increase in complexity and the related decrease in transparency. While many have noted that those twin evils undermine the usefulness of financial information to capital markets, doing anything about it seems about as likely as turning back the tide.
But Bob Hertz, chairman of the US Financial Accounting Standards Board (FASB), has decided to take on the role of King Canute. He is calling for structural, institutional, cultural and behavioural changes to the system of financial reporting. The truth is that the detail and volume of accounting, auditing and reporting undermines the quality and transparency of financial reporting that it was designed to support.
Standard-setters now see that the current system has engendered a check-box, form-over-substance approach to accounting, auditing and reporting by financial directors, auditors and regulators. Professionalism and judgement have gradually drained away leaving financial reporting to the technical expert, ensuring minute compliance. The retreat of professionalism and the reliance on detailed rules increases the opportunity to structure form-over-substance arrangements in a bid to get the accounting answer you want. This approach also leads to ignorance and genuine confusion among those producing financial reports.
The US has seen a number of financial reporting restatements. While some are due to fraud and lack of due care, many reflect unintentional mistakes in implementing and auditing complex accounting and reporting requirements. Financial directors face two types of complexity: “what to do” and “how to”. It is no longer simple to work out which standards, rules or regulations apply in a particular circumstance, and even when you’ve decided that, there is still the problem of finding the answer. Increasingly, reporting is relying on accounting estimates and fair measurements which, in turn, rely on complex data gathering and processing exercises.
Investors are increasingly unclear about what was done in preparing the financial statements and to what extent various treatments properly reflect the underlying business and economic realities.
This complexity arose for many reasons. Financial reporting is a mirror held up to business; the transactions are becoming more sophisticated and so the accounting reflects that. But it is more than that. Complexity has arisen as a result of conflicting perspectives and agendas of those involved in the reporting process, resistance to change, outdated legacy accounting standards, an approach to standard setting that produces compromises, exceptions, quick fixes and inconsistencies. The system is the rope in a tug of war between politicians, regulators and the profession. All three have shown themselves capable of putting self-interest above the greater good.
There is also the cultural aspect. We might all say that we want to be allowed to exercise judgement, but when faced with the threat of that judgement being challenged by a regulator, or a court, or even a disapproving audit committee then the temptation is to reach for the comfort of a rule set out in black and white.
What does reduced complexity look like? For users it could mean more financial reporting that is relevant, understandable and faithful to the underlying business it is representing. Some see fair value accounting as a way to achieve those goals. As the International Accounting Standards Board (IASB) has recently reaffirmed, it and FASB are looking at fair values as a key way to improve measurement. But others believe it introduces unacceptable subjectivity, misleading volatility and additional complexity. In other words, what may be better for users would not simplify life for FDs and auditors. We could all produce accounting rules that were simple for FDs to adhere to and easy to audit, but would convey nothing.
Some suggest that the holistic general purpose financial statement has had its day. In its stead the future of financial reporting lies in technologies such as XRBL driving information tailored to the needs of individual users at that time. Others are still calling for an expansion of the role of the reporting model to systematically cover non-financial performance indicators, risk and rewards and forward looking information, while others crave for a retreat from information and disclosure overload.
It is no accident that Hertz is starting a “cut complexity” bandwagon at this time. If US GAAP is to merge with international GAAP it would be better if fit-for-purpose systems came together instead of two which were based on a 19th century capitalist system, rather than the realities of the 21st century globalised economy. The fact that there is a call for such fundamental reforms to the financial reporting system is hugely encouraging. Others, especially the European Union, need to participate. Hertz calls the status quo neither acceptable nor sustainable. But how progress will be made and how long it will take is unknown.
