Make it clearer, says Financial Reporting Council

The recent letter from the Financial Reporting Council to audit committee chairs and finance directors contains a shopping list of improvements it expects companies to make to their annual reports. The main theme, however, is clarity. This is the message it has heard from investors on strategic reports (“user friendly and more clear”), business model reports (“clarity of the explanation of how the company makes money and what differentiates it from its peers”), and all sorts of accounting policies (“more detailed disclosure of how dividend policies operate in practice”).

A strategic report, it says, can be “comprehensive if it complies with the law and explains all material matters in sufficient detail to be useful and understandable.” But it says that, in particular, there can be improvements in the reports for smaller companies, especially the discussion of their financial position and cash flows, as well as performance. In other words, what they might expect as future performance.

As regards business model disclosures, these have now become a requirement and a recent report from the FRC’s Financial Reporting Lab goes into much more detail as to what investors want to see. At the request of what was then the Department for Business, Innovation and Skills (BIS), the FRC published non-mandatory Guidance on the Strategic Report in June 2014. It recommended including the following information in business model disclosures:

how the entity generates or preserves value over the longer term;

how the entity captures that value;

what the entity does and why it does it;

what makes the entity different from, or the basis on which it competes with, its peers;

high-level understanding of how the entity is structured;

high-level understanding of the markets in which it operates and how it engages with those markets;

broad understanding of the nature of the relationships, resources and other inputs that are necessary for the success of the business.

Hierarchy of business model attributes

Most Investors want the company to include:
What it does and where it sits in the value chain
Key divisions and their contribution, and legal structure
Key markets and market segments
Its competitive advantage
Key inputs (assets and liabilities, relationships and resources) and how they are maintained / enhanced
Key revenue and profit drivers
Value created for other stakeholders that supports economic value generation
Statistics to indicate relative importance of elements
Many investors also want:
Direct threats
Market share
Some Investors also want:
Culture and values
SWOT analysis
Purpose
Investment plans
How the business model is likely to evolve
Cash flow
Capital and Assets allocated to business
ROE, ROCE, or ROA
From FRC Financial Reporting Lab: Business Model Reporting

For annual reports, not financial statements, published on or after 3 July 2016, the new European Securities and Markets Authority guidelines on alternative performance measures are now in place and companies should review their compliance with these. Risk reporting and viability statements are somewhat unsatisfactory, according to the FRC, and companies should review statements on “solvency, liquidity, or other principal risks affect the long-term viability of the business.” And it calls for disclosures on why a particular period was chosen, what qualifications and assumptions were made and how the analysis was undertaken. These risk assumptions should now, of course, include Brexit; and on a more quantitative basis than just ‘uncertainty.’

On tax disclosures, the FRC calls for “greater visibility of the factors affecting the rates and their sustainability.” It also published a comprehensive report on tax disclosures last month and refers issuers to it. While dividend disclosure law under the Companies Act 2006 does not require disclosure of figures for distributable profits, companies should listen to their investors’ views as there is further room for improvement, even under the law, such as how disclosure policy may be impacted by risks and capital management decisions. The impact of low interest rates should also be discussed. The effect of estimates should also be disclosed, with, possibly, sensitivities or ranges of outcomes based on different assumptions being given. Revenue recognition is again an issue, and the Council requests that a clear link between “sources of income described in the business model and revenue recognition policies.”

Both IAS 7, on statement of cash flows, and IFRS 15, on revenue recognition from customers, will be commencing from 1 January 2018, so comparative periods begin 1 January 2017 and the Council encourages IFRS reporters to be well on their way to implementing these standards. Currently, issuers wishing to take advantage of reduced disclosure options offered (under FRS 101, requirements for subsidiaries and parents, and FRS 102, for unlisted entities) must notify their shareholders in writing of this, but the Council is currently receiving consultation about removing this administrative burden and will issue the results of this in December this year.

On remuneration, the guidance refers issuers to the August 2016 Directors’ Remuneration Reporting guidance that calls for additional disclosures on:

the link between remuneration and strategy

justifying non-disclose of performance measures or targets on the basis of commercial sensitivity

disclosure of remuneration policy

clarification of items to be included in the single total figure of remuneration

Finally, for audit committees, the Council wants to see disclosure of specific issues that were addressed during the year, including special comments from external auditors, any interactions with the FRC’s Corporate Reporting Review team and its Audit Quality Review team.

At around the same time as the letter was published the FRC’s chairman, Sir Win Bischoff, made a speech describing, among other things, the potential effects – or non-effects – of Brexit on the financial reporting standards. International accounting standards will continue to apply:  “Investors have told us they want comparability between the accounts of UK listed companies and those listed in other countries,” he said. There is also no mood to reverse the new standards introduced in June 2016 under the European Audit Directive. And the FRC, he said, will also want to “agree arrangements for equivalence of audit qualifications and the portability of staff” within EU markets, as well as the rest of the world.