Going through audited financial statements nowadays is like reading through a long technical paper. It has become more difficult for management to prepare, more cumbersome for auditors to audit, and more complicated for users to understand for their management and investment decisions.
The financial statements are getting lengthier over the years as the new financial reporting standards (i.e. the Philippine Financial Reporting Standards or the PFRS) are introduced or amendments to existing ones are made.
Moreover, the regulatory agencies such as the Securities and Exchange Commission and the Bureau of Internal Revenue require additional disclosures. Of course, disclosures are required for good reasons: to respond to more complex business models and transactions, and to meet the investors’ need to understand them.
Unfortunately, many investors complain that these result in cluttered financial statements where the truly important information is hard to find.
Lately, however, there has been some good news. With encouragement from regulators in big economies and from the International Accounting Standards Board (IASB), the global standards setting body, companies around the world are making innovations in their financial statements. Every company is doing so in its own way, in order to better tell its own story. The goal is to refocus the communication objective without losing sight of the need to comply with the technical requirements.
Grant Thornton, one of the world’s leading accounting and auditing, tax and advisory firms, has taken an active role in this project. It has identified four themes—or best practices—that companies who are preparing the financial statements may follow. The four best practices are interdependent; each should be used to a greater or lesser extent depending on your circumstances. These are:
Comply but communicate
The disclosures in PFRS are voluminous. Some are labeled as minimum requirements while some standards set out a disclosure objective, along with examples of the types of information that might meet the objective. While you need to comply with these standards and regulations, you also need to ensure that your financial statements become an effective part of your broader communication with your stakeholders. We suggest that you take a holistic approach where you consider your annual report as a whole with a consistent and coherent message throughout. More importantly, we suggest that you keep it simple; by providing commentary on more complex areas in plain language. For example, in defining a derivative, the disclosure can start with, “A derivative is a type of financial instrument the Company uses to manage risk. It is something that derives its value based on an underlying asset.”
Omit the immaterial
Traditionally many companies have taken a checklist approach. It may seem easier to simply include a disclosure than to make a difficult judgment about whether it is material. With the risk of regulatory challenge, companies have traditionally taken a ‘safety-first’ approach and opted for greater disclosures. But there are new developments; the new consensus is that including immaterial information is not only unnecessary but actually reduces the usefulness of your financial statements. Information should only be disclosed if it is material. It is material if it could influence users’ decisions based on the financial statements. While the disclosures in PFRS are voluminous, there is a drive to disclose information only if it’s material.
Rethink the notes
Companies are challenged to reevaluate how the notes to the financial statements are organized to improve their effectiveness as a communication tool. There are ways to do this: (1) Integrating the notes – combine your notes to achieve a more effective communication. For example, integrate your main note of a line item with its accounting policy and any relevant key estimates and judgment. (2) Reordering the notes—move away from the traditional order of the notes by grouping notes into categories, placing the most critical information in a prominent position, or a combination of both. (3) Using signposting—assist users in navigating your financial statements through the use of effective signposting, cross-referencing and indexing.
Prioritize the policies
The aim of accounting policy disclosures is to help your investors and other stakeholders to properly understand your financial statements. To make accounting policy disclosures effective you should: (1) Disclose only your significant accounting policies by removing insignificant disclosures that do not add any value. Use judgment to determine whether your accounting policies are significant by considering not only the materiality of the balances or transactions affected by the policy but also the other factors including the nature of the company’s operations. (2) Make your policies clear and specific—reduce generic disclosures (for example, those that summarize the accounting standards) and focus on company’s specific disclosures that explain how the company applies the policies. (3) Articulate key estimates and judgments –use effective disclosures about the most important estimates and judgments to enable investors to understand your financial statements. For estimates, focus on the most difficult, subjective and complex. Include details of how the estimate was derived, how the key assumptions were involved, how the process for reviewing and sensitivity analysis was chosen, how the sufficient background information brought on the judgment, and how the judgment and conclusion were reached.
In making these changes, one thing does not change. Financial reporting is a regulated activity and compliance with the requirements is a must. Getting it right requires professional expertise, care and attention to detail, proper planning and project management and fit-for-purpose systems and controls.
Mabel Comedia is a Partner for Audit & Assurance, and Partner-in-charge of Technical Standards and Quality Control of P&A Grant Thornton. P&A Grant Thornton is one of the leading Audit, Tax, Advisory, and Outsourcing firm in the Philippines, with 20 Partners and over 700 staff members.