Question

textbook- Financial Accounting Theory 8E - William Scott

The Disclosure Principle states that managers will release all information, whether good or bad. Researchers have explored this issue, and found that in the real world, the disclosure principle is not always followed.

Required:

2      a) Explain assumptions that underlie the disclosure principle.

4      b) Several studies are described in the text that show that in specific situations, management does not release all available information. Select two studies that are presented in the text, and explain why in each situation, the disclosure principle was not followed.

Answer 1

Financial accounting theory focuses on the “why” of accounting – the reasons why transactions are reported in certain ways.

The majority of introductory accounting coursescover the “what” and “how” of accounting. These include hundreds of journal entries, gaining familiarity with all the common accounts that companies use, learning how financial statementsare put together, and how to calculate the proper debit and credit amounts.

A key factor of accounting involves the transmission of financial information to anyone who may need the information. These people then use the accounting information to make business and investment decisions. However, in order to make proper decisions, the information being provided needs to be reliable and relevant.

In financial reporting, we commonly encounter a phenomenon called information asymmetry. This is a situation in which one party has more or less information than another party. There are two types of information asymmetry pertinent to financial accounting theory:

Adverse Selection	Moral Hazard
Hidden Information	Hidden Action/Behavior
One party has an information advantage over another party	One party can observe the actions while the other party cannot
Hidden information from the past and present	Hidden future action
Example: buying a used car	Example: instructors assigning a higher weighting on exams than homework

A) Full disclosure principle is relevant to materiality concept. It requires that all material information has to be disclosed in the financial statements either on the face of the financial statements or in the notes to the financial statements.

Examples

1. Accounting policies need to be disclosed because they help understand the basis of accounting.
2. Details of contingent liabilities, contingent assets, legal proceedings, etc. are also relevant to the decision making of users and hence need to be disclosed.
3. Significant events occurring after the date of the financial statements but before the issue of financial statements (i.e. events after the balance sheet date) need to be disclosed.
4. Details of property, plant and equipmentcannot be presented on the face of the balance sheet, but a detailed schedule outlining movement in cost and accumulated depreciation should be presented in the notes.
5. Tax rate is expected to change in near future. This information needs to be disclosed.
6. The draft for a new legislation is presented in the legislative of the country in which the company operates. If passed, the law would subject the company to significant cleanup costs. The company has to disclose the information in the notes.
7. The company sold one of its subsidiaries to the spouse of one of its directors. The information is material and needs disclosure

B) Activity considered in the Discussion Paper
Develop guidance for the Board on developing disclosure objectives and requirements
The Discussion Paper did not specifically discuss developing guidance for the Board
on developing disclosure objectives and requirements. However, the Discussion Paper suggested ways in which the Board could improve how it develops and drafts disclosure objectives and requirements.

Respondents’ comments, other research findings and conclusions
Almost all respondents to the Discussion Paper suggested that the Board could contribute to solving the disclosure problem if it improved the way in which it develops and drafts disclosure objectives and requirements in IFRS Standards. For example, stakeholders said that a lack of specific disclosure objectives, overly prescriptive language and unclear or duplicate requirements in some IFRS Standards contribute to the problem.
The Board concluded that developing guidance that it could use would be an effective way to help address this element of the disclosure problem. Such guidance would cover both:
• how to develop disclosure objectives and requirements—for example, how to best use stakeholder outreach to develop effective disclosure objectives; and
• how to draft disclosure objectives and requirements.

Develop centralised disclosure objectives
Many stakeholders indicated that a lack of clear and specific disclosure objectives in IFRS Standards contributes to the disclosure problem. The Discussion Paper considered whether the Board should develop a central set of disclosure objectives (centralised disclosure objectives) to provide a basis for developing more unified disclosure objectives and requirements in the Standards. Centralised disclosure objectives could help to address the disclosure problem by enabling stakeholders to better understand the disclosure requirements in IFRS Standards.
Some respondents to the Discussion Paper questioned whether it is possible for any centralised disclosure objectives to be specific enough to have a practical effect on the disclosure problem.

The Board concluded that developing specific Standards-level objectives would be more effective than developing centralised disclosure objectives. Consequently, the Board decided not to develop centralised disclosure objectives.

Activity considered in the Discussion Paper

Develop principles of effective communication
The Discussion Paper described principles of effective communication that could help entities apply better judgement about financial statement disclosure. The seven principles considered in the Discussion Paper said that information in financial statements should be:
• entity-specific;
• described as simply and directly as possible;
• organised in a way that highlights important matters; • linked, when relevant, to other information;
• not duplicated unnecessarily;
• provided in a way that optimises comparability; and
• provided in a format that is appropriate.

Respondents’ comments, other research findings and conclusions
Many respondents thought that principles of effective communication would be somewhat helpful to stakeholders. However, many also thought that any principles would be too generic or high level to make any real practical difference to the disclosure problem. Respondents also reported that entities in some jurisdictions have already improved the communication in their IFRS financial statements over recent years applying existing requirements and guidance.
In October 2017, the IFRS Foundation published Better Communication in Financial Reporting— Making disclosures more meaningful. This report used case studies to illustrate how some companies have improved communication in their IFRS financial statements using principles similar to those considered in the Discussion Paper. The Board developed the report to illustrate the principles helping companies better communicate information in financial statements. The Board concluded that further developing the principles is not the most effective way it can help to address the disclosure problem at this time.
Develop educational materials
A few respondents to the Discussion Paper suggested that the Board should consider developing educational materials in addition to, or instead of, any standard-setting activities. Such materials might include webinars, articles, or other types of non-mandatory guidance.
The Board has already prepared non-mandatory guidance and other educational materials as part of the Disclosure Initiative (see page 4) and will continue to develop educational material when it is helpful to do so. However, the Board observed that developing new educational material may not be the most effective way to address the disclosure problem at this time and decided to prioritise other activities.