Posted by & filed under Financial Reporting and Analysis, IFRS.

Why do companies choose to disclose, or not, forward-looking information in their corporate annual? 

Accountants have long known that disclosure is important for companies and users of financial statement information. In its simplest form, the voluntary disclosure decision can be understood as managers having an incentive to disclose if the benefits of disclosure exceed the related costs. Of course, assessing benefits and costs of disclosure can be difficult, making it a challenge to predict a specific disclosure decision. This is particularly so as there is no comprehensive theory of disclosure that explains what companies disclose. 

Disclosures can be grouped into three broad categories: 

The first disclosure category  links disclosures to changes in stock price and trading volume. Studies of this type often assume investors have rational expectations about what a company will disclose, so when the actual disclosure decision is made investors will adjust the stock price for any new information contained in the disclosure. For example, based on a biotechnology company’s past disclosure practices, investors might expect an announcement about the results of testing of an important new drug at the end of March 2011. If no disclosure is made, investors might infer that the company has bad news and is delaying its disclosure. So, the share price may decline until a detailed disclosure is made about the drug test results. 

The second category of disclosure includes discretionary-based disclosure models, which examine incentives that explain why managers choose to disclose some things and not others.
The third category includes efficiency-based disclosure that help explain why disclosure exists in the first place (e.g., the role of disclosure in perfect markets and in imperfect markets with information asymmetry where some investors are better informed than others).
Discretionary Disclosures: 

A good way to illustrate the discretionary disclosure conundrum faced by managers with conflicting incentives about whether or not to disclose is to consider two extremes: disclose all the information that might be useful to investors versus disclose nothing (or at least nothing beyond what is required by law). If managers choose to disclose nothing, the level of information asymmetry between the manager and potential investors would be very high, and research suggests the cost of capital would rise prohibitively. On the other hand, if managers disclose too much information, it may cause them to incur significant proprietary costs, helping their competition and hurting the company’s business prospects. 

Mandatory vs Voluntary Disclosure: 

Recently the debate over disclosure has focused on mandatory versus voluntary disclosure. For public companies, there are many mandatory disclosures such as disclosures within financial statements (and related notes), MD&A and disclosures about corporate governance. However, many of the disclosures made in annual reports are not required in the strictest sense. It has been argued that most theories of disclosure ignore the simple notion that many items are disclosed because managers have a duty to disclose material information. In short, materiality is   a key factor in determining what is required to be disclosed under GAAP or IFRS, and by the Ontario Securities Commission (OSC), SEC and other regulators. Consequently, it can be argued that only when managers determine that a piece of information is immaterial, or when the firm has no affirmative duty to disclose the information, is a disclosure truly voluntary. So managers must balance their obligation to disclose material information with their disclosure incentives; this should be kept in mind when evaluating disclosures in the MD&A and other sections of annual reports. 

MD&A disclosure requirements
The OSC suggests that the MD&A focus on material information. Deciding what is material requires professional judgment. To assist preparers, the OSC suggests information be considered material if a reasonable investor’s decision whether or not to buy, sell or hold securities in the company is likely to be influenced or changed if the information in question was omitted or misstated, a definition that is similar to CICA Handbook requirements. In addition, the OSC suggests the MD&A should address company performance and other factors such as liquidity, capital resources, off-balance sheet arrangements, transactions with related parties and key fourth-quarter events. Most importantly, from the perspective of our study, the MD&A should also include a discussion of the company’s future prospects, including trends and risks that are reasonably likely to affect financial statements in the future. Similarly, a key objective of the MD&A is to provide information about the “quality, and potential variability, of [the] company’s earnings and cash flow, to assist investors in determining if past performance is indicative of future performance” (OSC, FORM 51-102F1, Part 1 (a)). From a user’s perspective, it may be useful to contrast the required disclosures in the MD&A and the voluntary disclosures that may be made in the MD&A and elsewhere in the annual report. The former may be driven by materiality, while the latter are more likely to reflect a manager’s bias and the disclosure incentives discussed above.
 

Conclusion:

As we look to future trends, research suggests that voluntary disclosures may decline, reducing the benefits of any increase in required disclosures under IFRS. This is based on the expectation that different countries’ legal environments and political situations will continue to have a significant effect on disclosures. If Canadian companies do not perceive that a level playing field exists in terms of disclosures made by their competition internationally, they may be willing to provide only required (material) disclosures. 

See complete article written by: Merridee Bujaki, CA,  and Bruce McConomy, CA Magazine

Discussion Questions: 

1. Should all material information be disclosed , even if it creates a competitive disadvantage? 

2.What process should be put in place to ensure that all material disclosures are disclosed to the investing public? 

3. Is it fair to assume  that too much disclosure puts the company at an unfair competitive disadvantage?
 

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