America's banking institutions, like the rest of corporate America, are subjected to excessive disclosure requirements - and recent developments in areas such as derivatives threaten to add to that information overload.
Full and fair financial statement disclosures are a major reason why the United States' capital markets are the best in the world - and why they have the most credibility and integrity. However, our present financial disclosure system doesn't attempt to distinguish between truly decision- critical information and what might be described as non-essential, compliance, and routine data.
For many years we've been following an incremental approach to financial reporting that produces a package of financial statement disclosures that by definition is always guaranteed to be more. Unfortunately, the aggregate result isn't better.
In our ever-more-complex business environment, the sheer quantity of financial disclosures has become so excessive that we've diminished the overall value of these disclosures. Users are overwhelmed. They can't find or can't recognize - in a reasonable amount of time - those disclosures that should have an impact on their credit or investment decisions.
To help quantify excessive disclosure, we made a non-scientific survey of the 1972, 1982, and 1992 annual reports of 25 large, well-known companies, including AT&T, BankAmerica, Coca-Cola, General Electric, General Motors, IBM, Mobil, J.P. Morgan, and Xerox.
We started with 1972 because two decades of change seemed like a reasonable period to make some measurements and to provide the basis for extrapolation into the future. Also, 1972 is the year before the Financial Accounting Standards Board was formed.
We measured disclosures in three ways:
* Number of total pages in the annual report.
* Number of pages of footnotes.
* Number of pages of management's discussion and analysis.
We separately surveyed the annual reports of 12 of the nation's largest banks. Six of the 12 banks in the survey were also included in the survey of 25 companies referred to above.
Banks are particularly hard hit by disclosure requirements - and our projections show banks' disclosure burden being even greater in the years ahead.
The issue of excessive disclosure is particularly timely and significant within the banking industry. For example, derivatives are under intense scrutiny by the media, various government agencies, standard setters, and the business community itself. While derivatives have proved to be effective tools for managing risk, if used inappropriately they can result in levels of risk that are unacceptable for an organization. Consequently, many new disclosure requirements are being sought by the Securities and Exchange Commission and regulators.
For example, the SEC has indicated that it wants disclosures that go beyond FASB's recent statement on derivatives. While it's not certain just what the SEC's stance will encompass, some prior comments are cause for concern. In November of last year, SEC chief accountant Walter Schuetze made a speech to a banking conference and set forth the disclosures he believes banks should provide for off-balance-sheet derivatives.
Among his items: notional amounts, strike prices, interest rates, due dates, the amounts of cash that will flow in and out depending on where interest rates go, when cash receipts will come in, when cash payments will go out.
Also: activity in contracts; unrealized gains and losses or replacement value of contracts; deferred gains and losses; when, period by period, deferred gains, and losses will be recognized in income, and the amounts thereof; the effect of those instruments on net interest income or margins; why the company is entering into such contracts; whether it will enter into such contracts in the future; what the bank is doing to prevent counterparty credit loss; and the effects of netting agreements, including disclosure about their legal enforceability.
How much space would be required to comply with Walter's list? How much time would it take to read and understand the disclosures? Recent SEC comment letters indicate their desire to see even more disclosures than the above list.
Congress and the General Accounting Office are also struggling with remedies to perceived or real risks and problems associated with derivatives. Clearly, the widespread use of derivatives creates issues that merit study, and more effective ground rules are probably needed.
But simply adding a host of new disclosure requirements to those already burdening banking and other industries isn't the answer. The sheer quantity of all that additional information may serve to further overburden the reader rather than help evaluate new risk.
What we need to focus on is ensuring the timeliness, quality, and communication of decision-critical information, as well as efforts such as establishing effective internal controls and educating boards of directors, treasurers, and other personnel so they can better fulfill their fundamental responsibilities in this area.
What's the answer? Let me offer a couple of suggestions. Maybe they'll serve as a catalyst for change.
* A mandatory five-year review, or "sunset review." This suggestion could substantially reduce the current excess of financial disclosure disclosures plus prevent future unneeded increases.
Here's how it would work: The FASB, SEC, and AICPA would authorize a comprehensive review of all disclosures every five years. The maximum length of each review would be limited to six to nine months, and well- respected outsiders would serve on the review committees. The committees would start by determining what's decision critical for the final package, and then decide which disclosure are needed for that package.
* Two-tier (differential) disclosures. This suggestion would not reduce the total number of financial disclosures now or in the future; instead it would package disclosures differently to better serve the two broad categories of financial information users.
Tier I would consist of the annual report with decision-critical disclosures that would conform to a revised GAAP with an auditors' opinion. Companies would send it to all shareholders and other with an offer to also send the Tier 2 report
Tier 2 would consist of a separate supplement report with much more disclosure for a limited circulation. It would be available on request for shareholders, analysts, bankers, and those who have time and real need for more detailed information.
Our approach would shift about 60% of today's annual report footnote disclosures to the separate supplemental report.
The United Kingdom already has a two-tier reporting system. A few years ago, it amended its Companies Act to permit public companies to send their shareholders a summary financial statement in lieu of the complete annual report. The contents of the statement are specified in the U.K. Companies Act and include principally a condensed directors' report, a list of directors, and comparative summary profit-and-loss statements and balance sheets containing only a handful of key line items.
Summary financial statements of five major companies were an average of 20 pages long, compared with 43 pages for their complete annual reports.
Because the United Kingdom's statement doesn't purport to be GAAP (that is a "true and fair view"), its disclosure reduction is more than we would be comfortable with in the United States. However, we should be prepared to accept approaches similar to the United Kingdom's, because the SEC recently approved a rule change proposed by the New York Stock Exchange to permit non-U.S. listed companies to distribute summary annual reports to their U.S. holders of securities of American depositary receipts if it is the practice in the foreign issuer's home country (for example, the U.K.-style statement).
Our SEC should allow U.S. companies to experiment with some form of summary reporting - a two-tier approach of the summary financial statement, for example - by sanctioning its use in our securities laws.
No, in financial disclosure, more is not better. The bias in disclosure standards must be changed from overwhelming to focused and decision critical, recognizing that some new developments or areas of uncertainty will always require additional disclosures. We seem to have forgotten that if the accounting is wrong, no amount of disclosure can make it right. If the accounting is right, the amount of disclosures we need can be limited to those that are decision critical.
Financial and trade organizations that agree with this viewpoint should make eliminating excessive disclosure a priority. Change will require an extensive effort and commitment. However, unless there is grass-roots demand for change, we'll continue to see more and more incremental new disclosures - or, to use a football analogy, "piling on."
Mr. Groves was chairman of Ernst & Young for 17 years, until his retirement this past September.
