Principles of disclosure – The role of the primary financial statements and the notes

The Project manager seconded by the Accounting Standards Committee of Germany (ASCG) introduced the agenda paper by saying that the paper would contemplate how the notes contributed to the overall objective of financial statements. He said that a common understanding about the notes was required. However, the notes only supplemented the primary financial statements (statements of financial position, comprehensive income, changes in equity, and cash flows) and, therefore, it should be examined how the notes contributed to the overall objective of financial reporting. The staff collected some views on this issue from constituent groups but did not necessarily agree with all of them; for example, staff disagreed with the view that the primary financial statements should be more important than the notes. He said that the notes provided explanatory and supplementary information. The paper also concerned the ambiguity of the term 'financial statements'. The term was used inconsistently in the standards, sometimes with the meaning of 'the primary financial statements' and sometimes with the meaning of 'a complete set of financial statements'. He said that the term 'present' usually referred to the primary financial statements whilst the term 'disclose' usually referred to the notes. In the staff’s view, this was confusing to constituents and should therefore be clarified.

One Board member said that to her the analysis on which disclosures were explanatory and which were supplementary was not helpful, but she welcomed the analysis of the objectives of the notes. The Vice-Chairman agreed. The ASCG's Project manager replied that the distinction was made because explanatory and supplementary notes had different objectives.

One Board member asked why EFRAG believed that risk disclosures were not typical note disclosures. The ASCG's Project manager replied that this was because those disclosures were not linked to specified line items. The Board member replied that the risk disclosures might be related to line items because the values reflected the risk as well. The ASCG's Project manager said that EFRAG did not intend to remove risk disclosures and neither did staff.

One Board member said that disclosures were necessary for comparability as entities would elect measurement options differently. As regards the proposed objective of supplementary information in the agenda paper, she was not sure whether risk disclosures would be included in that information. It should be clarified in the project what the scope was and what the IASB's role would be in providing information about risk. The ASCG's Project manager replied that it was not the staff’s intention to be more restrictive than the Conceptual Framework. The Chairman warned that the introduction of new terms should consider whether those terms would actually be used by constituents. He also said that he did not agree with the reference in the agenda paper that the notes were as important as the primary financial statements. A Board member agreed and said that the primary financials were like a snapshot that was displayed in detail in the notes. One Board member said that disclosures on post-balance sheet events were an exception to having disclosures only on items in the primary financial statements. He agreed that the terms 'primary financial statements', 'present' and 'disclose' should not be changed but instead clarified.

The Research Director agreed that the financial statements should be structured. However they needed to be structured in a meaningful order. He disagreed with the recommended less rigid approach with regard to the placement of information inside or outside a complete set of financial statements as he believed that constituents needed to know when a set of financial statements was complete. He said that with regard to post-balance sheet information there were three types: adjusting events relating to assets and liabilities in the balance sheet, non-adjusting events relating to balance sheet items and non-adjusting events relating to items that were not assets and liabilities yet. He therefore warned to be careful with the objective of the notes as to whether they gave information only on recognised assets and liabilities. The Vice-Chairman had the impression that what the Research Director described was already status quo. The Research Director disagreed and said that, for example, introducing guidance on the structure was very valuable as it described which information went into the primary financials. The Senior Director for Technical Activities supported that.

The Technical Principal said that they also wanted to examine what was the actual face of the financial statements and whether, for example, footnotes to the balance sheet were ‘on the face'. The Chairman said that using the term 'face' would make it easier to explain what was meant. A Board member disagreed and said that in a complete set of financial statements there were four pages with the titles 'statement of …' and therefore they should be called 'primary financial statements'. A fellow Board member agreed and said that, in addition to the comment just made, 'face' would be a difficult term to translate.

One Board member said that the biggest failing of financial statements today was that the most important information was not prioritised. Investors wanted to know what the current cash flow position of an entity was and what their cash flow-generating capabilities were. Therefore, in his view, the single biggest improvement to the notes would be a prioritisation of this information. He said that to him, as a non-accountant, the information labelled 'supplementary' in the notes was the information that interested him the most. The ASCG's Project manager clarified that the distinction between explanatory and supplementary did not mean any prioritisation. He said that staff would bring back a paper on the issue of formatting, grouping and ordering information.

One Board member said that as a former regulator he had never read the face of the financial statements as the key information for him had been in the notes. He also said that terms should not only be changed for the sake of change; therefore, he disagreed with introducing the term 'primary financial statements'.

A Board member expressed concerns about the interaction of the role and the definition of financial statements. He asked whether, for example, the decision about a lease commitment being on-balance or off-balance was made based on the role of the financial statements. The ASCG's Project manager negated that and said it would instead depend on whether the lease met the definition of a liability. The Senior Director for Technical Activities added that all important information would be in the summary. He welcomed the proposed changes to definitions as in his view; IAS 1 was inconsistent and therefore needed redrafting. The Chairman agreed.

A fellow Board member said that the Discussion Paper should discuss whether guidance on the format of financial statements should be detailed and prescriptive or flexible and based on objectives. She said that prescriptive guidance would be easier to apply. She said that input to that should be gathered at an early stage. The Chairman concluded that no vote was needed on this agenda paper.

Principles of Disclosure – Communication principles

The purpose of this agenda slot was to obtain the IASB's tentative views on whether additional guidance that promotes good communication was needed in IFRS and, if yes, what that additional guidance should be.

The Vice-Chairman questioned whether the principles in paragraph 34 of the agenda paper needed to be included in a standard, noting that most of them were pretty self-evident, but noted that there was no harm in including them. He raised the question of how the principles would be included in a document, noting that they were more good guidance on financial reporting than requirements that must be complied with.

The Chairman noted that he agreed with the Vice-Chairman that most of the principles seemed self-evident, but based on the content of some financial statements he had seen, did not believe it was superfluous to tell people to use simple and direct language, and that making this explicit could help.

An IASB member noted that there was nothing in the principles that he could disagree with, and that he believed they would be very helpful. He noted that in the cases where there had been very significant high profile frauds, the notes to the financial statements of the companies involved included sentences that ran on for paragraphs and made absolutely no sense. He provided note 16 to the 2000 10-K of ENRON as an example, which was literally a run on sentence for a page and a half that made absolutely no sense. Accordingly, he noted that it was useful to reinforce this. He also suggested that it could be added that it was important to highlight the most important thing a reader needed to know about each section, for example, pension liabilities or loans, first.

Another IASB member noted that he agreed with most of the principles, but that he believed that it would be difficult for a preparer to comply with certain of them; for example, if the IASB were to require the most important information to be highlighted, should the assessment of what is most important be performed from the entity's or the users' perspective? He questioned how these principles would work in practice in general, both from the perspective of the preparer, and of auditors and regulators trying to enforce them. Another IASB member expressed similar thoughts, adding that compliance with the principles would be difficult to enforce as they were subjective.

The Executive Technical Director added that he believed it was very important to encourage preparers to pass the tests [set out in the principles], and accordingly, that it would be useful to embed the principles in a Standard. He used compensation disclosures as an example, noting that in the financial statements of large companies, those disclosures ran on for as long as 20 pages and it was almost as though there was a desire to obfuscate the information that was there. He added that including a really strong hook to encourage preparers to clearly communicate their point could only be helpful.

With respect to the placement of the principles, one IASB member noted that he believed at most, only one sentence should be included in IAS 1, and that the IASB should produce a practice statement that could be much more flexible and detailed, that would essentially be an education document. He believed the requirements with respect to the notes in standards should be to require a reconciliation of this, a disclosure about or a roll forward of that, or a disaggregation of something else; and that effective communication was how they were put together. He believed that the effective communication aspect was educational and that it also applied to the whole contents of financial reporting, including the management commentary. He further noted that including these principles as part of an educational document would be a far better way of achieving an improvement in financial reporting.

The Senior Director for Technical Activities highlighted that the message here was that the financial report was a communication document not just a compliance document.

Another IASB member noted that he disagreed with going down the path of including the principles as part of an educational document as CFOs could argue that, because it was only educational guidance, they were not required to follow it. He noted that it was important to include a hook in the standards to make it abundantly clear to preparers that they could not deviate from the principles.

The Chairman observed that including all principles in the standard would be going too far, but suggested that some of them could be summarised and included.

Another IASB member noted that communication vs. compliance was the big dilemma for preparers, as, for example, trying to comply with everything could result in information becoming obscure, and good communication may not always result in compliance with all the rules. However, he noted that he believed the principles should be included in the standard.

Another IASB member noted that he agreed with the guidance and recommendations, but had mixed feelings as to the placement of the guidance. He suggested that for the purposes of the Discussion Paper, the IASB should recommend inclusion in a standard, either IAS 1 or another standard, and then ask the question what would happen in situations of non-compliance, and obtain feedback on that point.

The Chairman noted that he had previous experience as a regulator, and noted that the organisation required insurers and banks to write information to customers in clear and simple language, and enforced that. An IASB member noted that there was a question around what was considered 'clear and simple' language; for example, he noted that widely understood trade technical jargon might be a very useful shorthand way of saying something, whereas internal acronyms were not. He noted that he believed it would be hard to enforce, as some of these things were elements of preference and style.

Another IASB member noted that she believed the principles in paragraph 34 were helpful and should be captured in the IASB's authoritative material. She commented on item a(vii) which stated that entities should make disclosures that 'do not obscure useful information', and suggested that an explicit statement be included that the disclosure of immaterial information can obscure material information, and noted that this could be a hook for getting rid of immaterial items. With respect to placement of the principles, she believed that they were more consistent with the level of discussion in the Conceptual Framework, and questioned whether these could potentially be included as a late addition to the Conceptual Framework Exposure Draft. Another IASB member pointed out that the Conceptual Framework was not primarily for preparers. A further IASB member noted that established disclosure language was very difficult to change in companies, and while he agreed that these principles belonged to an extent in the Conceptual Framework, thought there was an advantage to including some of the guidance at the standards level.

Another IASB member noted that she also believed the principles in paragraph 34 should be captured somewhere in the IASB's literature. In terms of placement, she noted that, even though it seemed a good idea for them to be included in a standard for enforceability reasons; she pointed out that with some standards, for example, IFRS 7, which is very objective-based, she had heard a lot of negative comments in terms of the quality of the application of that standard despite the IASB's best efforts. Accordingly, she noted that she did not believe that it necessarily followed that, merely because something was in a standard, it would be applied and enforced in a good way. With respect to placement and how the IASB could get a good result, she noted that the Enhanced Disclosure Task Force had set up a number of recommendations that did not have formal status, and working in partnership with regulators and audit firms and users of financial statements had created a sort of market momentum that resulted in good application even though it was not mandatory. She also noted that in the disclosure forum, people had told the IASB that they needed to take the lead but were only a part of the picture, and that she thought this was a good opportunity to produce a new sort of document where the IASB tried to work with others to get some good behaviour.

In bringing the discussion to a close, the Chairman noted that it was clear from the discussion that the IASB did not agree with including all the principles set out in the agenda paper in a Standard; however, a number of IASB members had suggested including just a general principle in a Standard. He further noted that there was further work to be done outside the formality of standard setting, and that a variety of suggestions had been made during the discussion about how this could be carried out.

The Technical Principal clarified that the principles would be included in the Discussion Paper, and a question asked about how they might be best implemented, either in a standard, or as another type of guidance.

The Chairman agreed.

Principles of Disclosure – Issues relating to cash flow statements and related disclosures

The last session was devoted to a paper that presented a summary of issues relating to cash flow statements and related disclosures, prepared by staff of the UK Financial Reporting Council (FRC). Their Director of Research, Codes and Standards introduced the agenda paper. He highlighted that the purpose of the session was to obtain the IASB's views on the direction of travel, and that the IASB was not being asked to vote on any matters.

One IASB member noted that he thought the paper presented was very good. He questioned whether some current practices, such as the free cash flow concept, would be included as part of this project. He noted that often investors wanted different cash flow information, and that many global companies were providing such information. He questioned whether or how the project would deal with these changes in the market. The FRC's Director responded noting that this was reasonably consistent with what he had heard in a discussion with the Capital Markets Advisory Committee. He noted that they felt the IASB were being rather timid in discussing free cash flow, noting that one reason they had been timid was because they felt this could be similar to the situation with earnings where everyone was going to have their own idea as to what would be included in free cash flow.

Another IASB member expressed concern that the paper implied that in order to solve some cash flow issues, a number of other controversial issues that had been around for some time, would need to be addressed, for example, defining operating income. He cautioned that the IASB could be seen to be trying to back door some of the items that proved to be most controversial in the previous financial statements presentation project. She noted that if the IASB believed these issues needed to be addressed, they should be addressed straight on, rather than as 'buried' discussions in relation to cash flows. She also noted that it would be good to have a discussion about whether the IASB would be proceeding with the principle of cohesiveness.

The FRC's Director emphasised that he believed very strongly in some notion of cohesiveness, although not exactly how it was set out in the earlier Discussion Paper. He was very keen that people could cross refer all information and that things stacked up together.

Another IASB member observed that moving cash flows to acquire PPE from investing to operating expenses was easy, but cautioned that the difficulty would be the financing side, as PPE could be financed differently, and it would be hard to draw a line between what was operating and not.

With respect to taxes, another IASB member noted that he fully endorsed tax being its own section, but asked the FRC's Director to elaborate on how tax paid during the year would be presented, whether it would be one line, or broken down between, for example, amounts related to prior year audits and operations. The FRC's Director responded and noted that he had not thought beyond having one number for taxes paid, but added that more detail could always be required.

Another IASB member commented in relation to the paragraphs in the paper on liquidity. He noted that he believed this worked for separate financial statements, but was questionable for consolidated financial statements, because the location of the cash was different in the consolidated financial statements. He noted that a parent company could have a liability of CU100 and a subsidiary cash of CU100, which resulted in the group looking okay from a liquidity perspective; however, pointed out that the subsidiary could be a 51% owned subsidiary or a foreign subsidiary. He questioned whether there had been any discussions on such situations. The FRC's Director responded and noted that the staff had not discussed this particular issue, but referred to section 5 in the paper where restrictions on cash had been identified as an area for further work. The IASB member, noted that while he still believed the cash flow statement was useful, cautioned that the cash amount shown in the cash flow statement was not always available for immediate payment and did not describe the liquidity issue so well.

Another IASB member commented on a few points in the paper. Firstly, with respect to Tentative View 10, where it was suggested that providing information as to whether expenditure on PPE represented 'replacement' or 'expansion', he noted this was useful, but would be better included in management commentary than in the notes to the financial statements, as it required a lot of discussion, especially where it was difficult to assess which category the expenditure fell into. Secondly, with respect to Tentative View 11, where it was suggested that cash consideration paid to acquire a business should be reported as a cash outflow from investing activities, he noted that this would be appropriate in most, but not all cases, for example, where the substance of the transaction was that it was an acquisition of PPE, and noted that one needed to look at substance over form. Thirdly, with respect to Tentative View 9, he suggested that it should also be stated that cash outflows to acquire investment property should be reported as a cash outflow from investing activities.

Another IASB member noted that, like others, he thought the paper was very good, and hoped that the content could be included in the Discussion Paper. He also provided some comments on the paper. Firstly, he noted he was while he acknowledged there were challenges in applying it to the cash flow statement, he agreed with the concept of cohesiveness. He observed that a problem that currently existed was the different ways in which operating cash flow was defined, and the lack of linkage with any notion of operating profit and operating assets in the balance sheet, which could be very confusing. Secondly, he emphasised the importance of linking cash and non-cash items when trying to understand cash flows in a cash flow statement. Thirdly, he noted that Tentative View 6 noted that 'operating activities' should be defined or described, and questioned whether the IASB was going to define operating activities. The Senior Director for Technical Activities noted that it would not be as part of this project.

The FRC’s Director highlighted that the staff had deliberately added "and related disclosures" to the title of the paper. He noted that cash flow statements and reconciliations were two prime examples of things that needed to be addressed at the same time as the IASB was thinking about information on cash.

The Technical Director present commented with respect to the reconciliation of operating cash flows, noting that the financial statements presentation project involved some research on the type of reconciliation users found easiest to process, with the research finding that users found it easier to process using cash as a starting point and moving to profit, rather than the other way around. He noted that this was something that the staff might want to consider.

He also observed that in the list in section 5 of the agenda paper, it was implied that there could be follow up work that looked at whether the cash flow statement should be tweaked for financial institutions. He questioned whether there was a plan to look at whether cash flows statements were useful at all to financial institutions. The FRC's Director responded, noting that while the intention was not to look at this aspect, he agreed that one conclusion could be that a cash flow statement was not needed at all. Another IASB member added an observation, that most regulators preferred to have a cash flow statement for financial institutions, and require use of the direct method, because the indirect method is not useful as it only provides one number as a proxy for cash flow whereas the direct method provides the components of inflows and outflows, which is really the most useful information. He further noted that insurance companies in the U.S. were required to report cash flows from operating activities using the direct method. A further IASB member questioned whether research could be performed on this issue.

The Senior Director for Technical Activities thanked the FRC's Director for his paper and contribution, and the UK Financial Reporting Committee for releasing him to work with the IASB on the project.

In closing, the FRC's Director asked the IASB members whether they felt there were any additional issues that were not listed in section 5 or elsewhere in the paper.

One IASB member suggested that, if the IASB was to try and do something different with financial institutions, they would need to think about how this would be scoped, given industries are not usually defined. Another IASB member added the he believed the way to do this was to have an alternative to a cash flow statement that an entity could choose to use, accompanied by some guidance about circumstances in which it might be useful. He noted that a balance sheet roll forward or type of funds statement came to mind.