The Finance Director’s job is never done and investors are increasingly demanding that the annual report be more relevant to their needs. It is useful to consider what investors identify as their needs from the annual report.
Investor requirements
Five areas of financial statements have been repeatedly identified by certain UK based investor groups as ones which would go some way to addressing their concerns in terms of the relevance of the financial reporting information provided in the annual report.
1. Segmental analysis
Investors rely on the detail in the segmental analysis to build their forecasting models and in making comparisons between segments and other similar entities. There is an implicit assumption that the reported segments do not include dis-similar business activities. IFRS 8 Operating Segments requires segment reporting as seen through management eyes but the following information reconciled to the primary financial statements even if not reported to management is likely required at a minimum for the models investors and their analysts use:
- Revenue
- Operating profit
- Income statement data - share of results of associates and joint ventures)
- Depreciation and other non-cash expenditure
- Operating cash flow
- Capital expenditure
- Property, Plant & Equipment
- Operating net assets
- Balance sheet data - share of net assets of associates and joint ventures
- Working capital
- Debt
- Total assets and liabilities
- Capital employed
The European Securities and Markets Authority (ESMA) post-implementation review of IFRS 8, is critical of the application of IFRS 8. Four headline comments arising are noteworthy:
- “Identification of the chief operating decision maker (CODM): 41% of issuers reviewed for which such information was available identified the Board of Directors as the CODM although this body often includes non-executive members. This indicates that there might be some confusion caused with the definition of CODM in the standard;
- Aggregation of operating segments into reportable segments: ESMA observed that disclosures on aggregation of segments were explicitly mentioned by 29% of issuers only although IFRS 8.22(a) refers to this piece of information as an example that contributes to helping investors understand the entity’s basis of organisation. The level of subjectivity in deciding how aggregation should be applied may lead to diversity in practice;
- Measurement basis for information presented under IFRS 8: 93% of issuers under review used IFRS as a measurement basis for segment information and 47% presented non-GAAP measures such as EBIT and EBITDA in the segment information. In many instances, information about allocation policies of profit or loss, assets and liabilities to reporting segments, definition of non-GAAP measures and the reconciliation between segment information and the amounts reported in the financial statements were not disclosed properly;
- Analysis of entity-wide disclosures: although 58 % of issuers provided information about revenues and non-current assets by geographical area in accordance with IFRS 8, ESMA noted that the notes to the financial statements rarely present information for individual foreign countries and that there is no common understanding on how the materiality concept should be applied in this context.”
2. Net debt reconciliation
FRS 1 Cash Flow Statements requires a reconciliation of net debt year on year allowing investors assess how business finances changed over time. In contrast, IAS 7 does not have a similar requirement. In the absence of a net debt reconciliation certain financing features may go unheeded by investors such as
- the impact of FX movements arising on debt,
- the value of debt acquired or disposed of in business combinations,
- the impact of fair value and fair value hedge adjustments,
- an increase in cash balances merely reflecting an increase in debt and vice versa.
3. Debt
While IFRS 7 imposes considerable detailed disclosures, investors state that the more pertinent details are not always available to them. Given current market conditions the plans associated with servicing existing debt and risks to those plans are uppermost in investors’ minds including the ability to refinance and source new funding. Investors do not necessarily perceive that IFRS 7’s maturity buckets “less than 1 month, 1-3 months, 3 months to 1 year and 1 – 5 years” are the most helpful and a schedule of debt repayments that fall due in each year for a minimum of 5 years has been identified as one possible improvement.
Similarly IFRS 7’s maturity schedules which include gross contractual amounts have been criticised as investors cannot reconcile the disclosures to the balance sheet. Some have suggested that showing principal and interest payments separately and reconciling total gross payments to the balance sheet would be a considerable improvement in allowing investors relate maturity disclosures with balance sheet carrying values.
Investors also cite a need to see disclosure of the principal covenants – their terms and any restrictions in place along with details on the restrictions if any on the repatriation of cash that might impede the reporting entity’s ability to meet future financing needs.
4. Cash disclosures
Investors concentrate on the operating cash flow level and therefore would find further detail above the minimum required in IAS 7 helpful:
- more detailed descriptions of the adjustments made to derive operating cash flow so that they can be more easily related to items on the balance sheet (eg changes in significant components of working capital assets and liabilities, differences relating to various provisions such as pensions, asset retirement obligations, derivatives, etc);
- capital expenditure amounts split into maintenance, growth and acquisition spend;
- clarity about non cash transactions and how they affect the cash flow statement (eg new finance leases, non-cash contributions to pension trusts, non-cash consideration in a business combination).
5. Business Combinations
Investors consider that they do not always get enough information to assess the value created through business combinations and to that end suggest:
- clear disclosure of the total consideration paid for an acquisition (including the debt acquired, pension liabilities assumed);
- clear description of the intangibles acquired distinguishing between those acquired assets that have a finite life (eg a patent) and those that are sustained through expenditure that goes through the income statement (eg customer lists and brands);
- clear disclosure of the financial returns from the acquired assets or businesses and where integration means that it is difficult to identify returns specifically attributable to business combination, some insight – even if only through non-financial metrics – regarding the skill and discipline with which acquisitions have been managed.
Other potential annual report improvements
In contrast to the above requests for detailed information over and above the disclosure requirements of current standards, the IASB and others have been concerned that too much information is required in annual financial statements.
Cutting disclosures
The IASB commissioned a report from the Scottish and New Zealand institutes on reducing disclosures and that report, “Losing the excess baggage - reducing disclosures in financial statements to what's important”, is currently under consideration by the IASB. The report provides a detailed summary of changes to various standards, which if implemented, would have the effect of reducing the volume of disclosures in financial statements by up to 30%. Click here to access the report.
The FRC published “Cutting the Clutter” in April 2011 defining clutter as comprising two problem areas:
- immaterial disclosures that inhibit the ability to identify and understand relevant information; and
- explanatory information that remains unchanged from year to year.
The report suggests some steps that could be taken to reduce “clutter”.
Front half and back half – annual report improvements
Finance teams will be conscious that while they have robust systems developed over many years supporting the “back half” or financial reporting part of the annual report, often another team within the organisation will have the primary responsibility for the “front half” or narrative reporting in the annual report. Key areas for narrative reporting in 2011 include consideration of the developments in corporate governance and integrated reporting.
Corporate governance
Listed companies with 31 December year ends are required to report on their compliance with the UK Corporate Governance Code and the Irish Stock Exchange’s annex in their 2011 annual reports. The main changes from the 2008 Combined Code can be summarised at a high level as follows:
- To encourage boards to be well balanced and avoid “group think”, there are new principles on the composition and selection of the board, including having due regard for the benefits of diversity, including gender diversity.
- To promote proper debate in the boardroom, there are new principles on the leadership of the chairman, the responsibility of the nonexecutive directors to provide constructive challenge, and the time commitment expected of all directors.
- To help enhance the board’s performance and awareness of its strengths and weaknesses, the chairman should hold regular development reviews with each director and board evaluation reviews should be undertaken.
- To increase accountability to shareholders, all directors of FTSE 350 companies should be re-elected annually and chairmen are encouraged to report personally on how the principles relating to the leadership and effectiveness of the board have been applied.
- To improve risk management, the company‘s business model should be explained and the board should be responsible for determining the nature and extent of the significant risks it is willing to take.
- Performance-related pay should be aligned to the long-term interests of the company and its risk policies and systems.
Details of the ISE’s annex are available on its website and in the main require certain corporate governance disclosures to be “meaningful”. Mike Duignan Head of Reporting Supervision at the ISE wrote to company secretaries during 2011 offering some clarification of the ISE’s intention behind the use of the word “meaningful” in its Annex:
“The use of the word “meaningful” has led some to question what exactly the ISE expects and how it will seek to determine whether or not a description is indeed meaningful or not……We expect meaningful descriptions of audit committee and other board activities to result in differences in emphasis and content, both between companies and often year on year. But there are some common themes that we suggest boards consider when deciding what they should include in any descriptions they provide:
- The description should properly inform shareholders. However, it is not expected to be a blow by blow account of every event or every aspect that has been considered by the Board or a Board committee
- The description should set out a fair reflection of the work carried out by the Board or committee
- The description should give a balanced view on the level of activity and significance of the various issues dealt with by the committee
- The degree of detail provided should be appropriate given the activities of the company. The ISE would expect the degree of emphasis on each subject area to reflect the Board’s and committee’s own opinions on the importance of each issue to the company.”
Integrated reporting
There are heightened expectations for transparency about how business plays its part in society and the world, with profit being only one of many criteria by which contribution is measured. The impact a company has on its employees, society, and the planet is gaining increasing importance with a wider group of stakeholders. Integrated reporting, which encompasses elements of traditional financial, sustainability, and governance reporting, represents a growing trend that responds to these new expectations.
As integrated reporting becomes more mainstream, finance teams now need to consider investors’ expectations and what the team should be doing to meet those expectations in their next annual report. More and more investors and others are demanding reporting on sustainability covering areas such as carbon (greenhouse gas emissions), energy efficient technology, water use, cleantech, and biodiversity.
Some companies voluntarily produce reports that have some of the characteristics of integrated reporting, but few jurisdictions require this (South Africa and some European countries are exceptions). There are no mandated reporting standards or frameworks in place, but a number of initiatives are under way by governmental and non-governmental groups to develop such frameworks, principles, codes, and management systems. Significant among these groups is the International Integrated Reporting Committee, which holds the promise of increasing collaboration, convergence, and conformance among the emerging frameworks and standards. In the absence of a generally accepted framework, companies that wish to move towards integrated reporting may encounter several dilemmas around relevance, assurance, scope, and other issues.
Helping the Board understand its overarching responsibility for the annual report and financial statements
The article “Can directors rely on experts?” in the current edition of Accountancy Ireland (December 2011) written by Niamh Brennan, Michael MacCormac Professor of Management and Academic Director for the Centre for Corporate Governance at University College Dublin could be considered required reading for all members of the Board in advance of approving the annual report on financial statements. It highlights the board’s overarching responsibility for financial reporting and the author concludes notwithstanding some recent confusing case law: “Once appointed by the shareholders, directors cannot afford to leave any stones unturned in terms of understanding the business right down to the small print and technical knowledge of fine details”
The central message being that while the Board may delegate the preparation of annual reports and financial statements it may not delegate its responsibility for ensuring that the resulting product is in compliance with law and the fundamental requirement for financial statements to give a true and fair view.
Oliver Holt, FCA is Director Financial Reporting, Deloitte