Financial Reporting Brief

Insights

Financial Reporting Brief

July 2018

This month’s article 'History – Repeat Mistakes or Learn the Lessons' takes a brief look at some of the accounting/reporting lessons to be learned from economic crises and financial collapses.

History – Repeat Mistakes or Learn the Lessons?

What are investors entitled to expect from the corporate reports of those entities that they invest in and potentially invest in, primarily the annual report and the interim report? A pervasive and continuing question which inevitably will continue to exert demands and pressures on a wide spectrum of those involved, including preparers, those charged with governance, auditors, standard setters and regulators.

Much has been achieved in recent years with developments including improved financial reporting standards, convergence of standards between the world’s main standard setters, more robust regulatory requirements and enhanced corporate governance standards.

Additionally, there is increasing focus on such areas as reporting on the sustainability of the capitals that are fundamental to the success of a company’s business model, advances in processes to provide a more complete picture of an entity’s performance and position with regard to both financial and non-financial measures, and seeking improvements in the process and timeliness of how entities report to investors and other stakeholders.

With the consistent evolution of how entities report, there is one fundamental which underlies and is absolutely key to the messages to investors and other stakeholders. That is the core integrity of entities which is dependent on the culture of an organisation, including its tone at the top.

Response to Crises
Continuing improvements in the corporate governance regimes that pertain to entities is of major support and assistance to the corporate governance processes and reporting models. However, can it ever be enough?

The evolution of such advances in accounting, reporting, governance and regulation substantially in response to major financial crises, with the most noticeable being the global financial crisis of the late noughties, about which much has been written and debated.

Probably of as much significance are the numerous business and accounting scandals that have occurred over the years and continue to arise. Perhaps the most often referred to scandal is Enron, with the name continuing to hold notoriety in the investing community and the general business world. Over $60 billion in assets wiped out with utter devastation in the U.S stock markets, and more extensively. Many others have occurred over the years around the globe.

Warren Buffett, probably the most successful investor ever, made a number of comments in relation to Enron, including such notables as:

‘Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-earnings surprise environment and earnings simply don’t advance smoothly’.
‘I don’t know today what our businesses will earn next year – I don’t even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future … and we become downright incredulous if they consistently reach their dedicated targets.’

An article on the ‘Sure Dividend’ website puts forward five lessons that may be learned from the Enron scandal, much of which are pervasive to other similar debacles and are ‘red flags’ for investment decisions in general. They are:

  • Don’t invest in what you can’t understand;
  • Avoid companies that employ fancy derivatives;
  • Beware of excessive leverage;
  • Understand and assess counterparty risk;
  • The importance of management integrity cannot be overstated.

While Enron may be nearly 20 years ago, the above continue to be of relevance and significance today.

Moving forward to the current year we have experienced one of the largest collapses in UK history, Carillion, which has had extreme repercussions. This includes in Ireland where in recent weeks we have experienced business collapses as a direct result.

It is too early to directly comment on Carillion, particularly as the UK Financial Reporting Council is, together with a number of other UK bodies, undertaking investigations. The FRC is also investigating the conduct of former Group Finance Directors in relation to the preparation and approval of the financial statements of Carillion for the past number of years. There will be keen interest in the findings of these investigations when they eventually come into the public arena.

Focus on Fundamentals
The FRC did, however, publish a reminder document on the Accounting and Reporting Framework for the Construction and Business Support Services sectors. This guidance is substantially relevant to all companies. Some of the key messages are:

  • The annual report and accounts must provide sufficient, clear and relevant information segmented between business lines where necessary;
  • Users of those accounts must be able to:
     - Understand the company’s performance, financial position and prospects;
     - Assess its going concern status;
     - Assess its longer term viability;
  • The analysis presented in the strategic report must be fair, balanced and comprehensive and directors of companies applying to the UK Corporate Governance Code must ensure that is so;
  • The viability statement should preferably apply a two-stage approach:
     - Firstly, the directors should assess the future prospects of the company;
     - Secondly they should state whether they have an expectation that the company will be able to continue to operate and meet its liabilities, drawing attention to any qualifications or assumptions as necessary.
  • The viability statement should be based on a robust assessment of those risks that would threaten the business model, future performance, solvency and liquidity of the company;
  • Effective systems and balanced judgement based on all current and relevant evidence are required when estimating the costs to complete contracts and future revenue streams;
  • Management may need to quantify key assumptions underlying such estimates;
  • Clear information on the levels of net debt, cash flows and the conversion of operating profits into cash is important;
  • Complex employee pension arrangements must be disclosed in a fully transparent manner;
  • Where any material uncertainties exist, or where the directors have concluded there are none, the significant judgements made by the Directors in reaching that conclusion must be disclosed. 

Messages for Interim Reporting
As we move forward towards the peak of interim reporting season, the recently published FRC document ‘Corporate Reporting Review Briefing’ is of particular relevance. The Briefing reminds preparers and auditors about FRC expectations in respect of the new standards, IFRS 9 ‘Financial Instruments’ and IFRS 15 ‘Revenue’, and identifies areas where FRC recent monitoring activity has identified room for improvement.

The FRC Briefing expresses particular regard to:

  • The Directors’ need to make objective judgements and not be overly influenced by a spirit of optimism;
  • The need to quantify and explain the effects of the new standards, with disclosures made in a clear, concise and company-specific manner with a focus on the areas of change from the previous basis of accounting;
  • The transparency of supplier financing arrangements, with the example of reverse factoring being highlighted – with the need to disclose information that allows readers to understand the nature of and the risks around financial instruments, including liquidity risk;
  • Particular attention will be given to the impairment disclosures of companies in the FRC’s priority sectors and market sectors where there have been a number of profit warnings and asset write-downs. 
  • Compliance with relevant reporting requirements is the solid foundation underpinning high quality corporate reporting and, in light of that, the FRC highlights a number of areas identified by its recent monitoring activities.

Conclusion
Much of our ability to understand a company’s business model comes from an entity’s presentation of its business in its financial statements. Investors should be wary of any observations that lead them to doubt the accuracy of a company’s financial statements.

Quality of balanced, transparent reporting is therefore a must.

Did you find this useful?