Financial Reporting Brief February 2017

Insights

Financial Reporting Brief

February 2017

Our featured article for February is 'Financial Reporting - Incremental Improvement' – with Brendan Sheridan commenting on the vital role financial reporting plays in the capital markets and some of the continuing efforts to enhance the quality in reporting.

Financial reporting - Incremental Improvement

Financial reporting plays an integral role in the capital markets, and efforts to enhance its quality are vital. Everyone has an interest in achieving high quality financial reporting and mitigating against the risks of deficits in reporting which may ultimately lead to repeated scandals and failures of financial reporting. The building of trust through good governance and transparent reporting is fundamental to the success of individual businesses and to a healthy economy.

There are matters to be considered and resolved regarding accounting and auditing standards to be applied into the future and the relationship between Ireland and the UK, and their respective accounting supervisors and regulators. Irrespective of the direction taken it will continue to be of value to Irish reporters and analysts to be aware of and consider the work being undertaken by the UK Financial Reporting Council (FRC). While there is much FRC activity in the areas of audit and corporate governance, we shall focus on financial reporting developments.

FRC – Objectives and Programme
The purpose of the FRC is to issue accounting standards which apply to all entities that prepare financial statements that are intended to provide a true and fair view. In recent years the most significant development in Irish and UK GAAP has been the suite of standards published to introduce ‘New GAAP’ – FRS 100 – 104. The FRC has emphasised its commitment to improving the effectiveness of corporate reporting and there is significant untapped opportunity to improve. In 2011, the Financial Reporting Lab was launched by the FRC where investors and companies come together to develop pragmatic solutions to reporting needs.
FRC’s Clear and Concise Reporting development programme is aimed at ensuring annual reports provide relevant information for investors and the achievement of higher quality corporate reporting. Some of the projects being undertaken as part of this programme are broad-scoped by nature and include:

  • Digital Reporting – looking at how technology changes might drive future change in corporate reporting and the transformation of reporting; and
  • The Disclosure Framework which is generating thought about disclosures in a broader context and co-relates with providing input and influence to various activities of the International Accounting Standards Board (IASB).

The FRC and its Lab have been involved in recent times in a number of specific projects, with some of the more significant being:

  • Business model reporting 
  • Disclosure of dividends – policy and practice
  • Improvements to cash flow statements

Business Model Reporting
The Report on Business Model Reporting provides insight for companies on the importance of business model information to investors, and the type of information they are seeking. The Lab found:

  • Business model information is fundamental to investors’ analysis and understanding of a company and the lack of good disclosure in the business model may raise concern over the quality of management;
  • Where a company operates a number of business models, disclosures of each significant business model is desired;
  • Investors are looking for natural linkage of business model information to other sections of an entity’s narrative reporting and consistency with disclosure elsewhere in the annual report;
  • Investors are looking for more detail than is currently provided by most companies. In particular, investors find disclosures are often lacking information that answers questions such as:
     - What are the key revenue and profit drivers and how do profits connect to cash?
     - What are the key asset and liability items that support the business model?
     - What is the company’s competitive advantage?

At a more detailed level, most investors want a company to include:

  • What it does and where it sits in the value chain;
  • Key divisions and their contribution and legal structure;
  • Key markets and market segments;
  • Key inputs (assets and liabilities, relationships and resources) and how they are maintained/enhanced;
  • Key revenue and profit drivers; 
  • Value created for other stakeholders that supports economic value generation; and
  • Statistics to indicate relative importance of elements.

Many investors also want information on market share and direct threats to the stability and development of the business. In reality there is no limit to the extent of the information which can be provided. The question becomes one of differentiating between voluminous data which may tend to confuse and providing information to investors and other stakeholders of value to them in making investment and other economic decisions.

Cash Flow Statements - Improvements
Improvements to the Statement of Cash Flows are proposed in a consultation launched by the FRC. The Statement is important to investors because it tells them where their company’s cash has come from and where it has gone, which provides an insight into the quality of earnings. The paper is divided into five sections:

  1. The usefulness of information about cash flows – includes questions about how significant non-cash transactions should be reported;
  2. The classification of cash flows – with particular focus on operating activities with, for example, the suggestion that operating cash flows should include capital expenditure;
  3. Cash equivalents and the management of liquid resources – such matters as the management of liquid resources, the treatment of cash equivalents and permitting the netting of cash flows are discussed;
  4. Reconciliation of operating activities – proposing that the statement should always include a reconciliation between operating profit and cash flows from operating activities irrespective of whether the direct approach or the indirect approach is adopted; and
  5. Direct or indirect method? – The paper does not express preference but does support the mandatory disclosure of certain key items.

The discussion paper includes eleven specific questions relating to those sections but also invites any other comments on issues relating to possible improvements to the statement of cash flows. 

The consultation period closes on 31 March 2017.

Disclosure of Dividends
In November 2015, the Lab published a report as to how companies have responded to investor calls for better disclosure of dividends in its report “Disclosure of Dividends – Policy and Practice”, with some of the key findings being:

  • Good dividend policy disclosures should provide:
     - An understanding of the board’s considerations in setting the policy;
     - The rationale for the approach selected; and
     - Sufficient detail to understand how the policy will operate.
  • Good dividend policy disclosures should provide:
     - The key judgements and constraints considered by the board in applying the dividend policy;
     - The availability of resources (cash and distributable profits) to pay dividends; and
     - Clear linkage from the disclosed policy to the application of the policy in the period.

In addition, disclosure on the availability of resources needed to pay a sustainable dividend stream is considered useful information to investors. 

The Lab undertook a substantial review of FTSE 350 companies’ annual report disclosures following the November 2015 report and commented further in December 2016 on the manner in which companies were responding in practice to the recommendations made.

Two of the more significant comments emerging from the Lab review in December 2016 on areas in which further enhancement could be made were as follows:

  • More detailed disclosure of how dividend policies operate in practice, with more clarity on factors considered in both the setting of the policy and in dividend declaration; and
  • Disclosure of risks and constraints where they impact dividend policy and declaration decisions (e.g. pension deficits, potential impact of Brexit) and other factors that may have a bearing on capital management decisions.

Conclusion
All three projects are very much geared towards the objective of raising the bar for higher quality reporting which is fundamental to the analysis and understanding of a company and its performance. 

All involved in the financial reporting, auditing and regulatory processes must be vigilant in their commitment to ensuring high quality standards.

The work being carried out by the FRC and its Lab are a very important factor in the drive for continuous improvement of financial reporting in a practical way.

Financial reporting Brief - Incremental Improvement
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