Newsflash: FRC Lab report on risk and viability reporting
The FRC’s Financial Reporting Lab has issued its latest report which focuses on the key attributes of principal risk and viability reporting, their value and use to investors. It also provides illustrative examples favoured by investors.
Investors consulted as part of the project are unanimous that understanding the principal risks faced by a company is important both before making an investment and during the holding of that investment. A change in risk faced by a company is one factor that may cause an investor to change the size of their shareholding.
In addition, investors want a better indication that companies are looking at the long term. They find that few companies currently use the viability statement as a means of communicating positive messages about the long-term prospects of the company, treating it rather as an extended going concern confirmation.
Principal risk reporting
The report draws out the following observations regarding the attributes of principal risk disclosures and the views of investors on each attribute.
Categorisation of principal risks - Clear categorisation of principal risks to identify those which are company specific and those which are more general (e.g. industry risks) is helpful.
The priority of principal risks - Where there is no obvious ordering of risks (for example by category), investors have said that they assume that the first risk on the list is the most important to the company.
Movement in principal risks - Disclosures which show only a direction of travel are commented on less positively than those which explain the context and cause of the movement.
Linkage to other parts of the annual report - It is important to show how the principal risks fit into the disclosures on business model and/or strategy.
Likelihood & impact - Many investors comment that current practices in the use of heat maps do not provide sufficiently precise information to be of much benefit and would prefer some narrative description to provide further explanation.
Risk appetite - Investors recognise that risk appetite is very difficult to succinctly articulate and say that it is possible to get a feel for a company’s risk appetite from the annual report without having an explicit statement attempting to explain or quantify it.
Presentation of risks as gross or net of controls - Investors did not express a clear preference for whether risk is presented before the application of control activities (gross) or after it has been reduced by the application of control activities (net). The emphasis from investors was that companies need to be clear about which basis they are using when disclosing information around principal risks.
Responsible party & mitigating activities - Investors like to know where responsibility for principal risks lies in the organisation as they are interested in how the board responds. Companies should pay attention to how they describe mitigating activities.
Brexit, cyber and climate change - Investors want to understand how longer term risks such as these might impact the company, but they should only be included as principal risks if they are genuinely principal risks for this company.
The Lab’s suggested questions for companies on their principal risk disclosures
- Does the description of principal risks identify how they are specific to the company?
- Is it clear how the company categorises and prioritises principal risks?
- Are movements in principal risks, including movements into and out of the principal risk classification, explained?
- Is it clear how the principal risks link to other parts of the annual report and accounts, in particular the viability statement, business model, strategy, KPIs and the risk reporting in the financial statements?
- Do the mitigating activities include specific information that allows the reader to understand the company’s response?
Viability statement reporting
The report draws out the following observations regarding the attributes of viability statements and the views of investors on each attribute.
Time horizons - Investors are looking for information which is consistent with other time horizons in the annual report, e.g. strategic and business cycles, debt repayments, lease periods, goodwill amortisation, capital investment periods and technology development periods.
Work performed - Some companies include disclosures in their annual report which describe the work performed by the directors around the viability statement. Investors highlight this type of disclosure as helpful in providing context for the disclosure and understanding the extent of oversight from the board on the assessment process and annual report disclosure.
Prospects - The sustainability of the business model is a key consideration for longer term prospects and investors expect the directors to be able to discuss its resilience to risk and adaptability to market challenges. Investors also highlight the various timescales discussed by companies in annual reports, investor presentations and during other meetings, and want to understand how these relate to the assessment of prospects.
Stress and sensitivity analysis - Most investors highlight that disclosures around stress and sensitivity analysis are useful although current practice is often too high level. Investors are particularly positive about disclosures that provide specific insight into the scenarios considered, including how they link back to the principal risk disclosures.
The Lab’s suggested questions for companies on their viability statement disclosures
- Does the disclosure differentiate between the directors’ assessment of long term prospects and their statement on the company’s viability?
- When disclosing the long-term prospects has the board considered their stewardship responsibilities, previous statements they have made, especially in raising capital, the nature of the business and its stage of development, and its investment and planning periods?
- Does the viability statement disclose any relevant qualifications and assumptions when explaining the directors’ reasonable expectation of the viability of the company?
- Is the link between the viability statement and principal risks clear, particularly in relation to the scenario analyses?
- Are the stress and scenario analyses disclosed in sufficient detail to provide investors with an understanding of the nature of those scenarios, and the extent and likelihood of mitigating activities?
The description of prospects over the business and investment cycle will challenge companies and auditors alike, but presents the opportunity to comment on positioning against industry trends and draw out other, longer-term, company-specific matters, such as debt financing maturities, technology disruption, pension funding and the like. Careful thought will be needed to navigate between inadvertent assurances about the future but also to avoid generic, bland disclosures.
The full Lab report is available here and for a comprehensive picture of narrative and financial reporting trends for UK listed companies, together with ideas to help improve annual reports, please access our Annual report insights 2017.