Insights

Financial Reporting Brief

July 2015

Our featured article for July is 'Quality of Reporting – Needs to improve' with Brendan Sheridan commenting on the report recently issued by the FRC on improving the quality of reporting by Smaller Listed and AIM companies together with the FRC's ‘Clear and Concise’ initiative.

Quality of Reporting – Needs to Improve!

The Financial Reporting Council (FRC) is committed to improving the effectiveness of corporate reporting. It has taken a number of initiatives to move this forward in recognition of ever growing expectations of investors and other stakeholders for better quality, more transparent information and the increases in regulatory pressure. The FRC’s ‘Clear and Concise’ initiative, commenced in June 2014, is a programme of activities aimed at ensuring that annual reports provide relevant information for investors.

Consistent with this initiative, the FRC’s Annual Plan for 2014/2015 announced the launch of a project to evaluate and plan how it might assist smaller listed and AIM companies to address the quality of their reporting so as to improve confidence in the integrity of their financial statements by the market as a whole. The FRC’s Conduct Committee in its Annual Reports, draws attention to the poorer quality of reports and accounts produced by some Smaller Listed and AIM quoted companies. The first phase report has recently been published.

The Chartered Financial Analyst Institute, a recognised leader in the global investment community, has recently carried out a survey of its practitioner members which reveals that the annual report is considered to be the most important source of information about a company’s financial performance, and especially so at the smaller end of the market where information from other sources, such as analysts, is less easy to come by. The Society’s chairman urges companies, particularly at the smaller end of the market, to greater action- ‘you are missing the opportunity, your reports will not be read if they are boilerplate- grab the chance- after all we have precious little other access to company information’.

First Steps
Many smaller quoted companies are of the view that investors do not read their annual reports and therefore that the reports are of little value. As a result, the preparation of the annual report becomes a compliance exercise rather than being seen as an opportunity to provide relevant information to stakeholders. This thinking seems very different to the views being expressed by the investor community.

In its 2014 Annual Report, the FRC Conduct Committee commented that their reviews of the annual reports of the smaller entities often give rise to issues that are the result of the entity not having sufficient or appropriate resources to recognise or address accounting questions. Deficiencies mainly arose from straightforward areas of non-compliance, rather than management misjudgement of complex matters. FRC research has found that it is not clear whether such companies place sufficient value on reporting and auditing and that therefore a deficit in the confidence of investors may arise.

The project which the FRC has launched on improving smaller company reporting is aimed at achieving over a three year period, a step change in the quality of reporting by such companies. The first phase of the FRC’s work is the basis of a Discussion Paper it has published recently entitled ‘Improving the Quality of Reporting by Smaller Listed and AIM Quoted Companies’.

Focus Issues
Areas to which investors pay particular attention in annual reports and which are quite often not well attended to by smaller companies in their disclosure of relevant information include:

  • Business model, principal risks and uncertainties
  • Understanding the underlying financial performance of the company
  • Disclosure of accounting judgements and estimates
  • Accounting policies, in particular revenue recognition and capitalisation policies
  • Provisions - both new provisions and those released during the year
  • Cash flow statements

Fundamental to many of these issues is the need for investors to understand the business, its performance and its strategy for development. Business reviews are not always balanced or comprehensive and/or sometimes they appear to be inconsistent with other information in the annual report. Examples include:

  • Failure to identify the principal risks and uncertainties facing the company with little if any description of the actions taken to mitigate their effects.
  • Poor or limited explanation of performance or failure to identify components of growth or profit, for example:
    - That growth was due to acquisitions rather than organic expansion
    - That the reported profit was substantially due to a change in amortisation rates
  • Limited reference to, or inadequate analysis of, significant or exceptional items disclosed in the annual report
  • Inadequate disclosure and explanation of such items as ‘exceptional’ items, adjusted (non-GAAP) measures, discontinued operations and acquisitions which limit investors’ ability to gain a proper understanding of the underlying performance of the company.

Addressing the Issue
The FRC Discussion Paper expresses the view that resource constraints are at the heart of the challenge for smaller quoted companies. Companies that do not believe that investors read annual reports are likely to devote a bare minimum of scarce resources to their production. This is one of the main contributory factors to poorer quality reporting at the smaller end of the market.

The FRC suggests four areas where sharper focus could help smaller quoted companies improve the quality of their annual report:

  • Availability of adequate time and resources;
  • Early engagement by those charged with corporate governance;
  • Deeper understanding of relevant reporting standards and requirements; and
  • A rigorous audit process.

FRC discussions with stakeholders highlight the importance of the tone at the top with finance directors reporting that the preparation of annual reports is made easier and more effective where there is top level expertise and engagement in the financial reporting process, at executive and board levels.

Clear and Concise Initiative
The FRC’s report on improving the quality of reporting by small companies is an important development in moving forward with its development plans and meeting its objectives under its ‘Clear and Concise’ initiative. However, it is just one element of this initiative with the FRC bringing together activities from across its spectrum which include:

  • Narrative reporting – the guidance encourages companies to be innovative when drafting their annual reports and reinforces the importance of materiality;
  • Reports from the Financial Reporting Lab – which provide an environment where investors and companies can come together to develop pragmatic reporting solutions to financial reporting needs. Its recent report ‘Digital Present’ looks at the investors’ perspective of current corporate reporting processes and presentation styles and builds on earlier reports, particularly its report ‘Towards Clear and Concise Reporting’;
  • Reporting by Corporate Reporting Review committee – including its Annual Reports which provide an assessment of the state of corporate reporting in the UK based on the main issues identified during their multiple reviews, supported by illustrative case studies;
  • Influencing those setting disclosure requirements in Europe and internationally. 

The FRC is confident that the ‘Clear and Concise’ initiative is a key step towards higher quality corporate reporting.

Conclusion
Commitment to improving the annual report and to enhancing the transparency and effectiveness of key messages which companies want to communicate to investors and other stakeholders would place those who go ‘the extra mile’ in a strong position in terms of attracting and sustaining investment and support.

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