Full Disclosure Principle
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The full disclosure principle states that any future event that may or will occur, and thatwill have a material economic impact on the financial position of the business, should be disclosed to probable and potential readers of the statements. Such disclosures are most frequently made by footnotes. For example, a hotel should report the building of a new wing, or the future acquisition of another property. A restaurant facing a lawsuit from a customer who was injured by tripping over a frayed carpet edge should disclose the contingency of the lawsuit. Similarly, if accounting practices of the current financial statements were changed and differ from those previously reported, the changes should
be disclosed. Changes from one period to the next that affect current and future business operations should be reported if possible. Changes of this nature include changes made to the method used to determine depreciation expense or to the method of inventory valuation; such changes would increase or decrease the value of ending inventory, cost of sales, gross margin, and net income or loss. All changes disclosed should indicate the dollar effects such disclosures have on financial statements.
Ask investors what kind of financial information they want companies to publish and youll probably hear two words: more and better. Quality financial reports allow for effective, informative fundamental analysis. The word “transparent” can be used to describe high-quality financial statements. The term has quickly become a part of business vocabulary. Dictionaries offer many definitions for the word, but those synonyms relevant to financial reporting are “easily understood”, “very clear”, “frank”, and “candid”. Consider two companies with the same market capitalization, same overall market-risk exposure, and the same financial leverage. Assume that both also have the same earnings, earnings growth rate and similar returns on capital. The difference is that Company A is a single-business company with easy-to-understand financial statements. Company B, by contrast, has numerous businesses and subsidiaries with complex financials.
Which one will have more value? Odds are good the market will value Company A more highly. Because of its complex and solid financial statements, Company Bs value will be discounted.The reason is simple: less information means less certainty for investors. When financial statements are not transparent, investors can never be sure about a companys real fundamentals and true risk. For instance, a firms growth prospects are related to how it invests. Its difficult if not impossible to evaluate a companys investment performance if its investments are funneled through holding companies, making them hidden from view. Lack of transparency may also obscure the companys level of debt. If a company hides its debt, investors cant estimate their exposure to bankruptcy risk.
High-profile cases of financial shenanigans, such as those at Enron and Tyco, showed everyone that managers employ fuzzy financials and complex business structures to hide unpleasant news. Lack of transparency can mean nasty surprises to come. The reasons for inaccurate financial reporting are varied: a small but dangerous minority of companies actively intends to defraud investors; while other companies may release information that is misleading but technically conforms to legal standards.
The rise of stock option compensation has increased the incentives for companies to misreport key information. Companies have increased their reliance on probable future earnings and similar techniques, which can include hypothetical transactions. Then again, many companies just find it difficult to present financial information that complies with fuzzy and evolving accounting standards.
Furthermore, some firms are simply more complex than others. Many operate in multiple businesses that often have little in common. For example, analyzing General Electric, an enormous conglomerate with dozens of businesses, from GE Plastics to NBC, is more challenging than