BUS601: Financial Management

The concept of full disclosure is a well-established principle that has been broadly recognized as an essential component of financial reporting models. The principle is derived directly from the economic concept of the efficient securities market. A semi-strong efficient securities market is a market in which securities trade at a price that reflects all the information that is publicly available at the time. Although there have been many studies over the years that question the true level of efficiency in securities markets, strong evidence suggests that share prices do respond quickly to new information. Thus, from the perspective of a financial statement preparer, full and complete information should be disclosed in order to meet the needs of the readers. This will help engender a sense of confidence not only in the individual company, but also in the market as a whole, and will help alleviate the problem of information asymmetry.

One way that accountants contribute to the process of full disclosure is through the presentation of financial statement notes. The notes include additional explanations and details that provide further information about the numbers that appear in the financial statements. This additional information can help readers understand the results more fully, which can lead to better decisions. The notes also contain a description of significant accounting policies. These disclosures are very important to help readers understand how accounting numbers are derived. In making investment decisions, readers may wish to compare one company’s performance to another’s. Because accounting standards sometimes allow choices between alternative accounting treatments, it is important that the readers fully understand which policies have been applied. The concept of the semi-strong efficient market presumes that readers of financial statements can determine the effects of different accounting policy choices, as long as the details of those policy choices are disclosed. The principle of full disclosure also presumes that readers of financial statements have a reasonable knowledge of business methods and accounting conventions. Thus, the accountant is not required to explain the most basic principles of accounting in the note disclosures. As businesses have become more complex over time, note disclosures have become more detailed. The accounting profession is sometimes criticized for presenting overly complicated note disclosures that even knowledgeable readers have difficulty understanding. This criticism is a result of one of the trade-offs that the profession often faces: the need for completeness balanced against the need for understandability.

Most companies will disclose significant accounting policies in the first or second note to the financial statements. A retail company, for example, may disclose an accounting policy note for inventory as follows:

Review the accounting policy notes of Canadian Tire Corporation’s 2015 annual financial statements. 

The significant accounting policy note begins on page 66 of the document and continues for ten pages. Canadian Tire Corporation has fully disclosed all the significant accounting policies to help readers understand the methods used to generate the amounts that appear on the financial statements.

Aside from descriptions of accounting policies, the notes to the financial statements contain further details of balance sheet and income statement amounts. For example, the property and equipment account on Canadian Tire Corporation’s 2015 balance sheet is disclosed as a single item. However, Note 16 (page 86 of the document) contains further details of individual classes of assets and movements within those classes, including opening balances for each class of property and equipment, additions and disposals during the year, reclassification to or from the "held for sale" category, depreciation, impairment, and other changes. This level of disclosure helps readers better understand the asset composition and capital replacement policies of the property and equipment account.

Aside from the financial statements themselves, companies provide further disclosures in the annual report and in other public communications. Canadian Tire Corporation’s 2015 Report to Shareholders (Canadian Tire Corporation, 2016) is 118 pages long, including the financial statements. Aside from the financial statements, the annual report includes messages from the Chairman and the President/CEO, listings of the Board of Directors and Executive Leadership Team, and a section entitled "Management’s Discussion and Analysis" (MD&A), on pages 3 to 54. The MD&A is required disclosure under Canadian securities regulations. Similar disclosures are required or encouraged in other jurisdictions, although they may bear different names, such as Management Commentary or Business Review. The purpose of MD&A, and similar disclosures, is to provide a narrative explanation from management’s perspective of the year’s results and financial condition, risks, and future plans. The guidelines encourage companies to provide forward-looking information to help investors understand the impact of current results on future prospects. MD&A should help investors further understand the financial statements, discuss information not fully disclosed in the financial statements, discuss risks and trends that could affect future performance, analyze the variability, quality and predictive nature of current earnings, provide information about credit ratings, discuss short- and long-term liquidity, discuss commitments and off balance sheet arrangements, examine trends, risks and uncertainties, review previous forward-looking information, and discuss the risks and potential impact of financial instruments.

The objectives of MD&A are clearly aimed at helping investors link past performance with predictions of future results. Although this type of information is consistent with investors’ needs, there are some limitations with MD&A disclosures. First, although the general elements are defined by securities regulations, companies have some discretion in how they fulfill these requirements. Thus, some companies may provide standardized disclosures that change little from year to year. Although the disclosures may meet the minimum requirements, the usefulness of these boilerplate, or generic and non-specific statements, may be questionable. Second, MD&A disclosures are not directly part of the financial statements, meaning they are not audited. Auditors are required to review the annual report for any significant inconsistencies with the published financial statements, but the lack of any specific assurance on the MD&A may result in investors having less confidence in the disclosures. Third, the MD&A contains more qualitative information than the financial statements does. Although this qualitative information is useful in analyzing past, and predicting future, financial results, it is not as easily verified as the more quantitative disclosures.

One interesting effect of the qualitative nature of MD&A is that companies may either deliberately or inadvertently provide signals to the readers. A number of studies have examined the use of language and the presence of tone in the narrative discussion of the MD&A. Although the research is not always conclusive, there is evidence to suggest that the word choice and grammatical structures present in the reports may provide some predictive function. The language choices may reflect something about management’s more detailed understanding of the business that is not directly disclosed in the information.

Although there are sometimes suggestions of information overload levied against the accounting profession and securities regulators, the continually expanding volume of financial and non-financial disclosures does suggest that there is a demand for this in-formation and that readers are finding some value in the disclosures.