Financial Reporting Brief December 2015

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Financial Reporting Brief

December 2015

Our featured article for December is 'Supervisors Help Response to Reporting Challenge' with Brendan Sheridan commenting on the recommendations made by European, UK and Irish reporting supervisors with the backdrop of the challenge highlighted by the EU Capital Markets Union.

Supervisors Help Response to Reporting Challenge

Many entrepreneurs in Europe cannot get hold of the funding they need to start or grow businesses while there are numerous European businesses heading off-shore to markets where funding is easier to come by, and where innovation is better rewarded.

Europe’s economy is about the same size as the United States of America, but European equity markets are less than half the size of US markets. In the US, SME’s get about five times as much funding from the capital markets – as they do in Europe. Clearly, benefits would accrue from building stronger more sustainable capital markets and removing barriers to cross-border investment.

Connecting the supply and demand markets better would have obvious advantages for the entrepreneur and would also have the potential to increase opportunities for many more developed entities. Additional options could be made available to people saving for the long term, and the whole financial system could be made more robust, reducing costs of capital and ultimately yielding benefit to the consumer.

The above comments are based on those of a European Commissioner on the adoption by the EU of a Single Capital Markets Union (CMU) in Europe. Arising from the CMU consultation process during 2015, there is a widely held view that initiatives are needed to render EU SME’s more attractive to European and international investors through enhanced transparency and comparability of relevant financial information.

The CMU consultation further highlights the need that has been recognised by the regulators, standard-setting bodies and supervisors to continually develop improved means of reporting to investors and other stakeholders and delivering transparent, understandable messages. This applies to all entities that are raising funds and transacting in the market place.

There are a number of initiatives currently in progress – Integrated Reporting, the IASB’s Disclosure Initiative, the FRC’s ‘Clear and Concise Reporting’ Programme and other similar initiatives. These will take time to develop and make real change to the reporting process.

For now, reporters will look to maximise the effectiveness of the current reporting frameworks to enable them deliver balanced and transparent messages to investors and other stakeholders. To assist with these efforts, the Supervisors of financial reporting have also been active in publishing recommendations on how to make improvements for 2015 reporting, which is the focus of this article.

The European Initiative
At the European level, the European Securities and Markets Authority (ESMA) has announced the priority issues that the assessment of listed companies’ 2015 financial statements will focus on, which include:-

  • Impact of financial market conditions on financial statements – there have been significant changes in the past year with some reference interest rates and market prices of a number of commodities decreasing significantly and continuing to be highly volatile while some exchange rates have fluctuated significantly. In some countries macro-economic conditions have deteriorated sharply. Issuers need to provide information about the judgements and assumptions made by management when applying accounting policies and measuring assets wherever the amounts recognised in the financial statements could be significantly affected by such financial and market conditions; 
  • Statement of cash flows and related disclosures – this must be treated as a key element in understanding and analysing an issuer’s performance and allowing users to assess the ability of an issuer to generate cash and assess its reliance on new financing. ESMA expresses concern that despite its importance, enforcers have often come across problems in the application of the IFRS requirements in relation to the statement of cash flows; and
  • Fair value measurement and related disclosures – ESMA expects issuers to provide relevant information to ensure that the objectives of IFRS 13 ‘Fair Value Measurement’ are met, and draws attention to the impact that the new standards might have on their financial statements, particularly IFRS 9 ‘Financial Instruments’ and IFRS 15 ‘Revenue’.

ESMA has published a public statement aimed at improving the quality of disclosures in the financial statements. ESMA has developed five disclosure principles they consider issuers should focus on in annual reports, as follows:

  • Telling the entity’s own story by focusing on entity-specific disclosures and avoiding ‘boiler plate’ language;
  • Providing relevant information that is necessary to understand the issuer’s financial performance and position in the financial statements in an easily accessible way;
  • Thinking about materiality and applying the IFRS materiality principle;
  • Promoting readability of the financial statements by producing information that is written in as clear and concise a way as possible; and
  • Providing consistent information within annual reports.

The principles put forward by ESMA are very similar to the Clear and Concise Initiative being carried out by the FRC. The FRC emphasises that an objective and wide-ranging assessment of what is material to investors is key to clear and concise reporting.

Financial Reporting Council – Meeting the Challenge
In June 2015 the Financial Reporting Council (FRC) published a Discussion Paper ‘Improving the Quality of Reporting by Smaller Listed and AIM Quoted Companies’. This is a first initiative in a 3 year project by the FRC to drive a step-change in the quality of smaller companies financial reporting. This paper is against the backdrop of the Capital Market Union developments referred to above and reemphasised by the OECD which reports that it considers small and medium sized companies to be critical to ensuring that economic growth is sustainable and inclusive.

The FRC’s view is that clear and concise, high quality reporting by smaller quoted companies will facilitate investment in them. In their reviews over recent years the FRC has found that whilst the system of reporting is not fundamentally flawed, the quality of reporting is lower by such companies than by larger listed companies. Investors report that good quality corporate reporting is an important factor in making investment decisions. There is a legitimate expectation amongst users that the annual report provides trustworthy information and it is therefore an important tool for holding companies to account.

In October 2015 the FRC published its Corporate Reporting Review Annual Report 2015. The Report found that the overall quality of corporate reporting remained generally good, particularly by large public companies. However, the Report also commented that while examples of good reporting by smaller listed and AIM –quoted companies were seen, there also seemed to be straightforward errors in how they applied IFRS and in some cases there was inadequate explanation of results and description of principal risks in their narrative reporting.

The FRC Report comments that 2015/16 reviews will be influenced by macro-economic factors that may affect corporate reporting in the UK:

  • Volatility in commodity prices and in equity and bond markets may affect asset valuations. Disclosure of measurement sensitivity will be particularly important, with the risk that possible changes in sensitivities could result in impairment charges; and
  • Tax uncertainties may be increasing given recent challenges by Global and European institutions and internal governments. Disclosure of tax risks, accounting policies, judgments and estimates are likely to be increasingly important. 

In November 2015 the FRC wrote to 1,200 smaller listed and AIM quoted companies with advice on ways that improvements could be made to their annual reports in areas of particular interest to investors. In particular, investors expect:

  • The strategic report to be clear, concise, balanced and understandable – dealing with how they manage the principal risks and uncertainties facing the business;
  • Accounting policies to be clear and specific, particularly in relation to revenue recognition and expenditure capitalisation – with the objective of assisting investors understand the more judgemental areas of financial statements; and
  • A clear explanation of how the company generates cash flows – investors seek to understand how a company converts its profits into cash and its overall liquidity.

IAASA – Playing its Part
In Ireland, the Irish Auditing and Accounting Supervisory Authority (IAASA) published in October its Observations document highlighting key topics to be considered by those preparing, approving and auditing 2015 financial statements.

IAASA highlights the following sections of the document as being of particular relevance:-

  • Deferred tax assets
  • Alternative performance measures
  • Judgements, assumptions, and auditors’ risks of material misstatement 
  • Avoiding the use of ‘boilerplate’ disclosures in financial reports.

IAASA comments that part of the evidence of the economic recovery is the level of acquisition and merger activity reported by issuers or planned in the near future. It draws attention to the fact that the level of goodwill on issuers’ balance sheets is high, equating to over half of total equity. IAASA counsel that directors and audit committees should closely examine the basis upon which identifiable intangible assets acquired in a business acquisition are recognised and measured, together with the disclosures related to same.

IAASA has also recently published the results of a desk-top survey it has undertaken into the critical accounting judgements made by company directors, together with a comparison of the assessed risks of material misstatement identified by those companies’ independent auditors.

Conclusion
The quality of financial reporting and the balance and transparency of messages delivered to investors and other stakeholders is fundamental to the strength and robustness of capital markets.

All involved have a critical role to play in achieving high standards and continually looking at how the bar can be raised to improve the delivery of quality information.
 

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