Financial Reporting Brief
This month’s article 'Financial Reporting – is Europe fit?' comments on the responses to the European Commission consultation document – Fitness Check.
Our Quarterly Financial Reporting Brief for the third quarter of 2018 comments on interesting findings from surveys on lease accounting, financial instruments and segment reporting, a new UK corporate governance code, IAASA observations on financial reporting, advances on integrated reporting and company law developments.
European Financial Reporting – is Europe fit?
Earlier this year, in our March article, we commented on the European Commission’s consultation document ‘Fitness check on the EU framework for public reporting by companies’. The purpose of the consultation is to assess whether public reporting obligations, including both financial and non-financial information, are meeting the objectives of effectiveness, relevance and added value.
The ‘Fitness Check’ is one of the actions to respond to the European Commission’s action plan that builds on the recommendations of the High Level Expert Group on sustainable finance.
The replies to the consultation, which have been received in recent weeks, will feed into the process of consideration of the fitness of the EU framework for public reporting by companies, and a report is expected to be published in 2019.
This article focuses on the responses to the consultation received from three sources – The European Securities and Markets Authority (ESMA), Accountancy Europe and The Deloitte EU Policy Centre.
The general consensus of the responses is that the overall reporting framework is working well. However, there are concerns that there is room for improvement especially related to consistency, with regard to such matters as:
- The approach to the preparation and reporting of financial and non-financial information with a general absence of integration;
- Laws of member states with consequent impact on their financial reporting requirements and practices;
- Alignment of audit and assurance practices.
It is clear that there are improvements that could be made going forward, and two areas which are a focus of the ‘Fitness Check’ as being very much hot topics are integrated reporting and digital reporting. The world is constantly changing and corporate reporting needs to constantly evolve to keep pace.
It is seen as a major point of concern that the ‘Fitness Check’ appears to be ‘oddly tilted’ against the use of IFRSs as issued by the IASB, asking for example whether European listed companies are still best served by applying IFRS or whether the European Commission should be given the power to modify IFRSs as issued by the IASB. There is firm disagreement with the possible introduction of a process for modifying the extent of IFRS as issued by the IASB. One of the major reasons for this is that it would defy one of the key objectives of the IAS Regulation, namely that financial reporting standards applied by listed issuers are accepted internationally and are truly global standards. As a result, such modification of standards could hinder the capacity of European companies to compete for financial resources on equal terms in global capital markets. The importance of the EU remaining globally influential should be emphasised with regard to the development of new standards and amendment of current standards. On the same note, there is strong support for the EU endorsement criteria being retained in their present form, providing safeguards to the European public good.
Corporate Reporting Objective
The responses highlight the major question of what is the main objective of corporate public reporting? The understanding being that it is to provide future and present providers of an entity’s capital with relevant, transparent and comparable information about the entity so as to help their investment and capital allocation decision making. Corporate public reporting should also enable an assessment of management’s stewardship of the resources that have been entrusted to them. While there may be stakeholders, other than capital providers, it is considered that corporate reporting should be focussed on capital providers as otherwise there is a risk that information needs identified would be too broad and trying to address them all could hamper the clarity of the information provided to those who primarily need to make decisions.
The information provided should enable those capital providers to assess the entity’s business activities and strategy; how it creates value over the long-term; and the risks and uncertainties it faces. Corporate reporting contributes to the objectives of financial stability and sustainability and the importance of embedding sustainability factors in corporate reporting is recognised.
The Sustainability Objective
It is in question as to whether other types of policy area/requirements such as supervision, capital requirements, taxation etc are better suited as a means to addressing financial stability and sustainability objectives and to initiate changes in behaviour.
With regard to promoting sustainability, the Non-Financial Information (NFI) Directive 2014 and related Commission guidance are just being implemented so time is needed to monitor and consider their effects, but it is expected that they will bring more understanding and transparency around how companies consider sustainability in their actions. In these early days, time is needed to let things ‘bed in’ and to gather meaningful implementation and impact experience and evidence before making any fundamental changes or broadening the scope.
A European Corporate Reporting Lab is being established with its initial remit restricted to non-financial reporting and sustainability reporting although it is noted that it may be extended ‘in the medium term’ to include, for example, integrated reporting.
There is strong support for a move towards Integrated Reporting. Interconnected financial and non-financial information reporting would enable a greater focus on the long-term perspective and would assist stakeholders in getting a more complete picture of the performance of the entity. A move towards one universal principles-based reporting framework, is well supported, and the IR Framework is seen as having been a major catalyst over recent years to achieve global acceptance of value driven reporting. The importance of being underpinned by integrated thinking is emphasised, and it is considered important that it is not made mandatory to avoid it becoming a compliance exercise. A certain level of assurance over IR, including the non-financial information, would increase its benefits.
Over 1,600 major companies in 65 countries are using integrated reporting, and recently the IIRC has launched a database highlighting potential positive benefits of adopting IR and emerging best practice. Research included in the database concludes that IR leads to increased stock liquidity, better performance, higher market valuation and a longer-term investor base for the businesses that adopt it.
Corporate reporting is evolving and there are many areas of challenge. With regard to financial reporting, progress can be made in relation to those areas which are key to the understanding of an entity’s business and performance. Matters which are given particular focus include:
- Strategy/business model/value creation – there could be a better linkage between financial and non-financial reporting with perhaps Integrated Reporting providing a basis for greater understanding and better articulation of the organisation’s business model and value creation;
- Dividend distribution risks and policies are not explicitly addressed by existing legislation and are rarely disclosed in mainstream financial reports, although perhaps arising from the FRC Lab’s work and report on the topic some issuers have started communicating about this;
- Intangible assets reporting is not sufficient to provide an adequate picture of the value of intangible assets and their significance to the overall position of the entity;
- Cash flow statements are not generally required for SMEs and this is a matter which may require some renewed consideration.
There are many other areas commented on in both the Fitness Check and the responses, including the importance of digital reporting and other areas of innovation, and the need for reporting in specialised areas including banking and insurance to be fully reviewed and considered and brought up to date. It is a wide-ranging document and is sure to lead to even more thorough examination and the potential for positive change in many areas.
Sustainability and long-term investment are of prime importance to the EU economy. There is strong support for what the Commission is doing to ensure that growth is sustainable and the links between the Fitness Check and what it gives rise to and the EU Action Plan for Sustainable Growth should remain strong.
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