Financial Disclosure Effectiveness and the FASBs Conceptual Framework
Financial Disclosure Effectiveness and the FASB’s Conceptual Framework Project Gem State Business and Accounting Conference December 2019 Katherine Schipper Duke University 1
Disclosure framework project: components • The FASB’s Disclosure Framework project – Added to the agenda July 2009; invitation to comment July 2012 • Revisions to Concepts Statement 8, issued August 2018 – Revised Chapter 3 discussion of materiality – Added a (new) chapter 8, Notes to financial statements • Standards-level portions of the project – Evaluate four standards-level disclosure requirements, with the aim of issuing ASUs to improve those requirements • Fair value measurement, ASC 820 -10 -50, issued ASU 2018 -13, August 2018 • Defined benefit plans, ASC 715 -20 -50, issued ASU 2018 -14, August 2018 • Income taxes, ASC 740 -10 -50, exposure draft issued July 2016; revised exposure draft issued March 2019 • Inventory, ASC 330 -10 -50, exposure draft issued January 2017 • Observations: – The FASB dropped its plan to issue guidance for management’s decision process in implementing disclosure requirements (March 18, 2018) – The FASB appears to be (re)considering disclosures in interim reports; no due process documents have been issued (September 18, 2019) 2
The problem to which a disclosure framework is a solution —what the FASB says • Improve the effectiveness of footnotes (disclosures) in financial statements, consistent with the objective of financial reporting in Concepts Statement 8 – Objective of financial reporting: Provide information that is useful to present and potential investors, creditors and other users in making rational investment, credit and similar decisions (para. 34, Concepts Statement 8) – Project objective: Clearly communicate the information that is most important to financial statement users (Statement on the FASB’s website; emphasis added) • Create criteria in the form of “decision questions” the FASB will apply in determining what disclosures to require – Make decisions about disclosure requirements more consistent • Clarify that management should exercise “discretion” in deciding whether a given disclosure would be material (statement of project objective, not part of Concepts Statement 8) • Possible by-product: reduced volume (Statement of project objectives, ) – Comment: Discussions of “disclosure overload” have existed for at least 20 years, typically referring to repetitious or unused or unusable or uninformative footnotes – Comment: Volume would almost surely be reduced by better alignment between SEC requirements and financial reporting (GAAP) requirements 3
The problem to which a disclosure framework is a solution —what I think (1) • Disclosure requirements historically were often considered at the end of a project, not as an integral component of the overall standard-setting project – Insufficient discipline, conceptual or otherwise, imposed on decisions about disclosure requirements – Inadequate consideration of how the disclosure requirements should/will mesh with and support recognition and measurement requirements of the standard – Disclosure is sometimes used to solve a recognition and/or measurement problem • Observation and analysis of disclosures suggests several ad hoc functions – Describe recognized and unrecognized items – Provide amounts (measures) of certain items, including alternative measures – Provide information about a future cash payment – Display management assumptions and information about measurement uncertainty – Alleviate noncomparability and/or address a problem arising from recognition and/or measurement decisions • Example 1: Free-choice disclosure alternative for the fair-value-based measurement of share based compensation (SFAS 123 • Example 2: Accounting for defined benefit pension arrangements in SFAS 87 – Para. 104 of the basis for conclusions acknowledges that disclosure is used to solve a recognition and measurement problem 4
The problem to which a disclosure framework is a solution —what I think (2) • Standard setters cannot use theory or empirical research (experimental or archival) as a foundation for disclosure requirements • Theory (from economics, finance and accounting research) does not provide a practicable basis for determining footnote-disclosure requirements – Theories of disclosure are not readily applicable to standard setting • Theory does not provide an agreed-upon objective function for required disclosures • Theory does not clearly distinguish between disclosed and recognized information (beyond positing statistical properties such as precision) • Research finds financial report users do not always use disclosed information the same way they use recognized information—but not necessarily why • Cognitive bias? • Too hard to understand/analyze? • Lower reliability (possibly referring to precision)? – The research may itself be subject to multiple interpretation issues • Some empirical-archival papers suffer from (possibly unavoidable) research design problems and compromises with the data • Example: SAB 74 (codified in SAB Topic 11 M) disclosures about the effects of a standard that is not yet effective 5 – Question to consider: What if any use should the FASB make of this research?
Why wasn’t Concepts Statement 5 sufficient? • Concepts Statement 5, Recognition and measurement in financial statements of business enterprise – Disclosure is discussed in general terms, with examples • Notes amplify or explain recognized information, and some useful information is better provided (or can only be provided) in notes (para. 7) • Examples: Accounting policies, contingencies, inventory methods, number of shares outstanding, alternative measurements (unlabled figure; note 4) – Recognition and criteria for recognition are discussed explicitly • Items meeting four recognition criteria should be recognized, subject to: – Cost-benefit constraint and materiality threshold • Recognition criteria – Definition: Qualify as financial statement element – Measurable: Has a relevant attribute measurable with sufficient reliability – Relevance: Information is capable of making a difference in user decisions – Reliability: Information is representationally faithful, verifiable and neutral Questions to consider: • Is the second recognition criterion needed? If yes, how is it linked to the fourth criterion? • Should an item that meets at least one recognition criterion (but not all four criteria) be a required disclosure? More generally, does Concepts Statement 5 place meaningful 6 boundaries on what should be disclosed?
What do we know from the FASB’s experience about required disclosures? • Example 1: Share-based payment – In creating SFAS 123 R, Share-Based Payment, the FASB assumed entities applied the disclosure requirements of SFAS 123 exactly the same way they would have applied the recognition requirements. This assumption was not correct. – The FASB issued FSP 123 R-3 to allow for a practical expedient because entities did not have and could not re-create some of the tax-effect information they would have created by applying the recognition requirements of SFAS 123 – Implication: Preparers do not implement disclosure requirements the same way they implement recognition requirements (and auditors permit this difference) • Example 2: Lessee accounting – In creating ASU 2016 -02 (ASC 842) the FASB had to reconsider the definition of a lease • The superseded standard: no recognition/measurement distinction between service contracts and operating leases. The only difference was in disclosures. • The new standard: lessee’s balance sheet shows the lease asset and lease obligation but a service contract is accounted for as a period expense – Implication: Distinguishing a lease from a service contract is unimportant if the only information provided about the contractual obligation is disclosures (no recognition of the asset and obligation) – Implication: Defining and specifying the arrangement (scope) matters more for recognition 7 and measurement than for disclosure
Chapter 8 of Concepts statement 8 • Subject to considerations of cost vs benefit and adverse consequences, notes (disclosures) should provide information about: – Financial statement line items (e. g. , nature, terms, quality of an asset or liability) – The reporting entity (e. g. , activities, special advantages/disadvantages such as legal or regulatory factors) – Past events and current conditions/circumstances that are not recognized but can affect an entity’s cash flows (e. g. , litigation/disputes, suspected or known violations, unrecognized commitments) • Notes (disclosures) should not provide: – Assumptions/expectations about uncertain future events except (a) as inputs to measurements or (b) if management’s assumptions affect presentation, recognition or measurement of financial statement items – Information that is easily obtained and not specific to the entity – Certain types of future-oriented information that could have negative effects on the cash flow prospects of the entity and its resource providers (e. g. , legal, competitive, or reputational harm) • Appendix A contains questions/examples of items the FASB should consider in setting disclosure requirements 8
Chapter 8 of Concepts statement 8 • Not part of chapter 8: management’s application of a disclosure requirement, including a materiality assessment – A dissent (R. Harold Schroeder) states in part that chapter 8 fails to address the connection (interplay) between the Board’s decision process for setting disclosure requirements and management’s process for implementing those requirements – Example: The requirement (para. D 22) that disclosures should be “relevant to existing and potential users of the financial statements of a broad range of entities…. . ” is “too blunt an instrument for guiding [the Board’s] decisions, ” resulting in a failure to require certain information that would be highly applicable to “users focused on certain entities or certain industries, ” citing inventory disclosures and fair value disclosures • Problem 1: The “generic questions” approach in chapter 8 is undesirable but “requiring industry-specific disclosure requirements is fraught with complications…. ” • Problem 2: “[T] notion of materiality [needs to] become more operable in practice” but “there are real barriers to applying a materiality notion in the current financial reporting ecosystem that includes auditors and regulators” [emphasis added] 9
Concepts statement 8: decision questions • Generic questions: Appendix A contains detailed “decision questions, ” organized by type of disclosure, to be used by the FASB in setting disclosure requirements – Examples (not a representative list) • Question L 2: Financial instruments, contracts and other binding agreements – Information about credit risk and counterparty nonperformance – Estimated amounts and timing of cash flows that are not contractually specified but that are anticipated or otherwise probable • Question L 4: Line items that include components of different natures – Inventories; revenues from uncorrelated sources; real estate – “Nature” refers to frequency of occurrence; probabilities of repeating; responses to changes in conditions; expected return • Question L 8: Acceptable accounting alternatives considered and not used • Question L 11: Uncommon, not apparent or otherwise hard to discern method for determining a reported amount – How the amount was determined, for example, a matrix pricing technique or an internally developed technique • Question L 14: An alternative measurement that clearly would be useful for assessing cash flow prospects – Fair value vs cost-based amounts; FIFO vs LIFO inventory amounts 10
Materiality – Legal decisions vs conceptual framework • US Supreme Court (TSC Industries v. Northway 426 US 438 (1976); Basic v Levinson 485 US 224 (1988)) A fact is material if there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by a reasonable investor as having significantly altered the ‘total mix’ of information made available • Concepts Statement 2 (1980; superseded 2010 by Concepts Statement 8) The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement (Glossary of Terms) Observations about the Concepts Statement 2 discussion of materiality • Materiality differs from relevance • • Relevance is assessed by the standard setter and refers to information that investors need to make decisions Materiality is assessed by management and refers to amounts that may be too small to make a difference • Focus on “surrounding circumstances” is broadly consistent with SEC Staff 11 Accounting Bulletin [SAB] 99’s focus on contextual factors
Materiality—Concepts Statement 8 [2010], proposed amendment [2015], amended definition Information is material if omitting it or misstating it could influence decisions that users make on the basis for the financial information of a specific reporting entity. In other words, materiality is an entity specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report. [emphasis added, Concepts Statement 8, para QC 11] Materiality is a legal concept…. [t]he Board observes that the US Supreme Court’s definition of materiality, in the context of the antifraud provisions of the US securities laws, generally states that information is material if there is a substantial likelihood that the omitted or misstated item would have been viewed by a reasonable resource provider as having significantly altered the total mix of information [footnote reference omitted; emphasis added, proposed 2015 amendment to Concepts Statement 8] Materiality is entity specific. The omission or misstatement of an item…. is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item [para QC 11, 2018 amendment to Concepts Statement 8] Also in the 2018 amendments (para QC 11 A, QC 11 B): • • Magnitude alone is not sufficient to determine materiality Materiality judgments require understanding the entity’s pertinent facts and circumstances 12 (i. e. , context)
Materiality—proposed standards level guidance • Exposure draft, Assessing whether disclosures are material (issued September 2015 (ASC 235)) contained three items: – Materiality is applied to quantitative and qualitative disclosures individually and in the aggregate in the context of the financial statements taken as a whole; therefore, some, all, or none of the requirements in a disclosure Section may be material – Materiality is a legal concept (in redeliberations, the Board decided this language should not be used) – The omission of immaterial disclosures is not an accounting error • The FASB discontinued work (March 18, 2018) • Questions to consider: – Should there be a financial reporting definition of materiality that is distinct from the legal definition and if so what should it look like? • Would a workable financial reporting definition have to be stricter than the legal definition? – ASC 105 states that provisions of the ASC need not be applied to immaterial items and SAB 99 provides a discussion of materiality—are these sufficient to provide guidance to management in preparing financial reports including notes? 13
Four-part standard setting component of the disclosure framework project • Amend disclosure requirements for: – Fair value measurement, ASC 820 -10 -50, issued ASU 2018 -13, August 2018 – Defined benefit plans, ASC 715 -20 -50, issued ASU 2018 -14, August 2018 – Income taxes, ASC 740 -10 -50, exposure draft issued July 2016; revised exposure draft issued March 2019 – Inventory, ASC 330 -10 -50, exposure draft issued January 2017; not recently updated • Amended disclosure requirements to be based on the guidance in the (thenproposed) concepts statement on disclosures – The bases for conclusions of the exposure drafts say the FASB arrived at the proposed changes after consideration of the relevant decision questions in Appendix A of the proposed concept statement – Sometimes the basis for conclusions also references a post-implementation review – However, the bases for conclusions frequently point to “stakeholder concerns” or “user desires” or “outreach” as the reasons for either or both a proposed change in disclosure requirements or (in the ASU’s) the actual change itself • Concerns/desires => Are concerns/desires new information the FASB should consider or just statements of preferences? • Question to consider: Should disclosure requirements be based on preferences/views of “stakeholders” and “users” or on concepts and analysis? 14
Fair value measurement (Topic 820; ASU 2018 -13) • Examples of changes: – Remove disclosures about: transfers between Level 1 and Level 2; policy for timing of transfers between levels; valuation processes for Level 3 measurements for all entities (additional removals for private companies) – New disclosures (but not for private companies) • Changes in unrealized gains/losses included in OCI for recurring Level 3 items • For Level 3 measures, range and weighted average used to develop significant unobservable inputs • Observation and questions to consider: – In the context of Level 3 fair value measures, financial statement users said they would like information to allow them to “understand the subjectivity of the fair value measurements, adjust reported values, and compare ranges of measurements across similar entities in a sector” (para. BC 41) • To what extent should disclosures contain information to allow financial statement users to recalculate the amounts reported by management? • If extensive information about (unobservable) inputs to Level 3 fair value measures is decision-useful, why not require this information for Level 3 -type non-fair value measures such as Noncurrent asset service lives and salvage values; Bad debt expense; Deferred tax asset valuation allowance; Warranty costs? 15
Defined benefit plans (Topic 715 -20; ASU 2018 -14) • The main focus of the disclosures is the assessment of future cash flows – Removed disclosures (examples) • Amount in AOCI expected to be reclassified to net income next year • Amount and timing of plan assets expected to be returned the employer • Effects of a one-percentage-point change in assumed health care cost trend rates on benefit obligation and aggregate of service and interest costs – New disclosures • Weighted-average interest crediting rate (cash balance plans) • Reasons for significant changes in benefit obligation or plan assets • Comments and questions to consider – Some disclosures analyzed would be unnecessary if defined benefit plan accounting did not contain certain practical expedients and income smoothing options – Some disclosures might be unnecessary if the FASB reconsidered the accounting for cash-balance plans – As a more general matter, should disclosures be used to compensate for less-thanconceptually-grounded accounting? 16
Income taxes (Topic 740; revised exposure draft issued March 2019) • The main focus of the disclosures (as described in the revised exposure draft) – How income taxes affect financial statement line items and entity’s assumptions in determining those line items – Income tax components that are measured differently or could affect cash flows differently • Increased focus on deferred tax assets for carryforwards, disaggregated by time of expiration, and related deferred tax asset valuation allowances • More information about tax exposure in countries other than the country of domicile • Less focus on “indefinitely reinvested” foreign earnings – More complex and detailed reconciliation from statutory rate to effective rate, including information about whether effective tax rates are “sustainable” • Comments and questions to consider – Financial statement preparers sometimes express concerns about financial statement disclosures that could be used by taxing authorities in attempts to collect more taxes and by special-interest groups to exert pressure on entities perceived to be enjoying tax advantages • What is the responsibility of financial reporting standard setters to accommodate those concerns? 17
Inventory (Topic 330; exposure draft January 2017; last project update October 2018) • (Very) narrow scope, excluding cost of sales • Financial statement users say they focus on: – Changes in inventory balances (for example, a tabular reconciliation or “rollforward”) – Inventory by segment or location or age or measurement basis – Types of costs included in inventory • Examples of FASB proposals: – Entity-specific judgment will be required to decide what disclosures should be provided about changes in inventory, with a focus on changes “outside the ordinary course of business” – Inventory by segment if the information is reviewed by the chief operating decision maker – Description of how the entity applies the Retail Inventory Method (if applicable) – Information on LIFO replacement cost (if applicable, even if redundant with SEC requirements) • Question to consider: What are the implications of disclosure requirements based on “entity-specific judgment” (or any other subjective criterion)? – Is the requirement to apply entity-specific judgment implementable without standardslevel guidance? – How would an auditor know if a disclosure requirement is or is not met? 18
Concluding comments and questions to consider • The FASB has undertaken a multi-component project to reconsider disclosures – Conceptual basis and related disclosure criteria characterized as “decision questions” => guidance for the FASB, Chapter 8 of Concepts Statement 8 – (Apparently) will not provide guidance for the preparer’s decision process • But materiality judgments are management’s responsibility and US GAAP need not be applied to immaterial items (ASC 105) • Regardless of the FASB’s intent, will the SEC reserve the right to second-guess management’s decisions with regard to omitting disclosures deemed immaterial? – Four “test cases” in which the FASB analyzed disclosure requirements • Intended to show the concepts statement and the “decision questions” would be applied to improve disclosures • Questions to consider: – Would another expert, applying the “decision questions” criteria, reach the same conclusions as the FASB? – What are the implications for auditors and auditing standard setters? – What should be the role of “stakeholder preferences” in applying the “decision questions” criteria to determine disclosure requirements? 19
Financial Disclosure Effectiveness and the FASB’s Conceptual Framework Project 20
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