Extensions to Taxonomy: Evaluating the Advantages and Disadvantages

Should a regulator such as SEC permit extension of taxonomy while preparing financial statements in XBRL format? Should they not?

Before deciding on which is better, let us go back to basics to throw some light on the debate.

1. Users of financial statements like two features in financial statements: Clarity and comparability.
2. Clarity is achieved when every piece of financial data is associated with one element in the taxonomy (taxonomy being the dictionary of accounting terms used in a GAAP; be it US GAAP or IFRS). All users get an identical and consistent understanding of what the financial data is. In other words, clever semantics cannot present EBITDA as Net income after taxes.
3. Comparability is achieved when users are able to rapidly and quickly compare financial data of various companies competing for investors Rupees.
4. On some occasions there can be a conflict between clarity and comparability.
5. If a Company has a unique piece of financial data that cannot be easily associated with any element in the accounting taxonomy, the company has three choices:
   1. Apply to the Accounting profession to add new elements to the taxonomy.
   2. Associate the financial data to the nearest best element in the taxonomy or
   3. Extend the taxonomy by one more element; define it and associate the unique financial data to that new element.
6. Associating to the nearest best element is a compromise. There could be a loss of clarity and the financial data could get misunderstood. However, there is a high degree of comparability. Financial data that are slightly diverse from each other still get compared across companies without the end user having to read and make their own adjustments for comparison.
7. Extending the taxonomy and associating with a precisely defined new element retains the accuracy of financial disclosure. However, comparability could be lost. Users of financial data would have to wade through foot notes to understand how this unique piece of data is different from that of competitors and make their adjustments (that could be right or wrong).

If a regulator permits no extension of taxonomy, easy comparison could be achieved at the cost of oversimplifying financial data and not recognizing the unique elements of a business enterprise. On the other hand if a regulator permits extensions, companies can extend taxonomy without reason or limit and render the financial statements incomparable with that of peers and competitors.

A regulator would have to strike a fine balance between permitting extensions to recognize unique information about a company; and yet not permit a very large number of extensions to defeat the purpose of comparability with benchmarks and peer performance.

In the United States, though the US GAAP has more than 35,000 elements in the accounting taxonomies, companies find them rather insufficient and are quite liberal in extending the taxonomy to include company specific line items. To an extent, this defeats the purpose of XBRL itself by rendering the numbers incomparable.

In the United Kingdom, though the UK GAAP has around 4,000 elements in the accounting taxonomy, companies are strictly prohibited by HMRC from extending the taxonomy. To an extent, this also defeats the very purpose of XBRL by rending the statements on occasions inaccurate (since companies tend to choose an inappropriate taxonomy element).

The right approach lies somewhere in between.

When one has to make a choice between choosing no extensions and too many extensions, choosing the former is better. Though this is would result in short term pains, it is sure to provide gains in the long run since there would be a pressure to amend the taxonomy at a global level, which would achieve both accuracy and comparability.

DataTracks converts thousands of financial statements in the US and in the UK for companies filing with SEC and HMRC. Our approach has been to avoid extending the taxonomy unless it is absolutely necessary. Most of our clients encourage us to pursue this approach (though the clients remain firmly in control in how financial data get associated with taxonomies).