After a spectacular false start, the British government has finally completed a new legal framework to improve the quality of narrative reporting in corporate financial statements.
Tougher rules for private companies, with a new layer of compliance for publicly traded companies, should improve disclosure practices, experts say. But they caution that Britain already has a complicated body of narrative reporting laws and guidance, which companies will have to navigate with care.
Lingwood
The complexity is caused in part by the way the government has gone about its reforms. It introduced one set of laws, immediately cancelled most of them, and then replaced the parts it scrapped with something else. “I don’t think we’re in a position that we would have wanted to be at if we had started with a blank piece of paper,” says Janice Lingwood, a director in the corporate reporting group at global accounting firm PricewaterhouseCoopers. “I think it has all become very complicated and has caused a lot of problems for preparers of accounts.”
The increased emphasis on narrative reporting is an important component of the United Kingdom’s new Companies Act, passed last year. When the law takes effect—likely to start with accounting periods that begin on or after Oct. 1, 2007—listed companies will have to include an expanded section in their annual reports and accounts reviewing topics such as future risks and non-financial performance, among other items.
Many listed companies have been doing something similar on a voluntary basis for years, comparable to how U.S. companies must include a “Management Discussion and Analysis” of risks in their annual reports. The best practice benchmark is a so-called Operating and Financial Review, a form of narrative report set out by the Accounting Standard Board in a paper as far back as 1993.
Brown
Nevertheless, disappointed with the quality of narrative reporting, the government decided to make publication of an OFR a mandatory legal requirement. It introduced the necessary legislation in 2005, but then, to everyone’s surprise, Chancellor of the Exchequer Gordon Brown—who oversees The Treasury, which is the United Kingdom’s economics and finance ministry—repealed the new laws before they had even taken effect, citing fears of a heavy compliance burden. After protest from stakeholder groups, the government decided to reconsider. These are the measures that have just been introduced.
Loweth
The new disclosure regime is very close to the one which the Chancellor repealed, says David Loweth, technical director of the Accounting Standards Board. “We haven’t gone back and done a line-by-line analysis of what the old OFR legislation looks like and what the new legislation looks like, but the differences are not that great,” he says.
Businesses now face two levels of compliance. The first applies to every public and private company, excluding those that are legally defined as “small”). Companies now must include an enhanced Business Review in their accounts for financial years that end on or after March 31, 2006. Previously, companies only had to include a “fair review” of the business and its situation. Now they must specify the principal risks and uncertainties facing the company, and ensure that the review is a balanced and comprehensive analysis. They also have to include “to the extent necessary for an understanding of … the business” an analysis using financial key performance indicators. Further, “where appropriate” they should include non-financial indicators, such as customer retention rates, and specifically indicators relating to environmental and employee matters. (Companies legally defined as “medium” are exempt from the provisions for non-financial indicators.)
ASB REVIEW
The excerpt below is from the Review Of Narrative Reporting By UK Listed Companies 2006, published by the Accounting Standards Board, January 2007:
Compliance
In terms of compliance with the current legal requirements, we were able to draw the following overall
conclusions;
Companies are in general complying with the legal requirements for the Business Review.
However in meeting their legal requirements, companies need to take care that there is
appropriate cross-referencing in the directors’ report to the other elements of the report and
accounts, to ensure compliance with the law.
All companies surveyed are providing a ‘fair review’ of their business.
There is a legal requirement for a ‘balanced’ analysis and in considering ‘balance’
companies need to assess what the prominence should be of reporting ‘bad’ news, where
appropriate. The achievement of the legal requirement of balance will require the exercise
of judgement by companies.
Areas for improvement
The legal requirement is for companies to describe their principal risks and uncertainties.
As noted above, companies need to assess carefully what are their principal risks and
uncertainties, rather than simply provide a long list of all possible risks and uncertainties.
Many companies are finding the disclosure of KPIs, both financial and non-financial,
challenging. While the requirement to disclose KPIs is a matter of judgement for the
directors, the lack of inclusion of any KPIs in a Business Review in the future will provide
the Financial Reporting Review Panel (FRRP) with a possible indicator that the Review
may not be compliant with the law.
The disclosure of forward-looking information is also proving to be a challenge. All the
companies surveyed met the current legal test of giving an ‘indication’ of likely future
developments, but the legal requirement will increase in the future and companies will
need to prepare themselves to be ready to disclose more forward-looking information.
Overall conclusions
Companies should think carefully about the structure and placement of their narrative
reporting to ensure that cross-referencing is kept as simple as possible and does not
adversely impact on the flow of the narrative.
In the absence of any guidelines on preparing a statutory Business Review, the principles
outlined in the Reporting Statement are being widely adopted by quoted companies as best
practice in narrative reporting when preparing their annual report.
This acceptance is higher amongst the larger market capitalisation companies in the FTSE
100, although there are examples of good practice among companies below the FTSE 100.
As the survey shows, some companies are achieving Good or Best Practice scores across
nearly all the recommendations of the Reporting Statement.
As compliance with the Reporting Statement will in general more than meet the legal
content requirements for the Business Review, there is a practical benefit for companies in
following the statement to achieve legal compliance as well as fulfilling best practice.
The proposed additional reporting requirements for quoted companies contained in the
Companies Act 2006 should encourage even more companies to comply with the best
practice Reporting Statement. The additional disclosure requirements in the proposed
Companies Act are all existing recommendations of the Reporting Statement.
Source
Review Of Narrative Reporting By UK Listed Companies 2006 (Accounting Standards Board; January 2007)
More Compliance: Disclosing Risks
Sharp
The second level of compliance applies only to listed companies and was introduced with the Companies Act last year. These measures are aimed at improving disclosure of non-financial and forward-looking information—“two areas where companies have been less willing to provide information,” says Isobel Sharp, a partner at Deloitte & Touche and a former member of the ASB.
This new level of compliance will be effective for all periodic reports filed after Oct. 1, 2007. Companies will need to disclose the main trends and factors likely to affect the future development, performance, and position of the company’s business. They will also have to provide information about environmental matters, employees, and social and community issues, along with information about any policies they have on these topics and how effective they are. If the company decides it doesn’t want to include all or some of this, it must expressly state which parts it is not in compliance with, rather than leave readers to deduce what has been omitted.
The ASB published a review of narrative reporting at the start of the year to highlight how well companies complied with the revised requirements, and where they needed to improve disclosure to meet the terms of the OFR (see box above, right).
The greatest difficulty companies encountered was related to their disclosure of forward-looking information. In particular, companies need to consider more carefully what their principal risks and uncertainties are, and focus on reporting those, rather than listing off reams of risks, the ASB said. The ASB found that the number of risks and uncertainties reported by the companies it looked at ranged from four to 33—and tartly noted, “We question whether a company can really have 33 principal risks and uncertainties.” A recent Deloitte survey found a quarter of companies only disclosed financial risks, saying nothing at all about non-financial areas.
Lingwood, of PricewaterhouseCoopers, says one difficulty related to principal risks is that companies have become used to providing undifferentiated statements about risks in general, rather than identifying risks specific to the company. “It is more difficult to consider for each annual report which risks are the principal ones,” she says.
The other big area for improvement, according to the ASB, is disclosure of key performance indicators, both financial and non-financial. The same Deloitte survey found only 67 percent of the listed companies it examined had disclosed KPIs in their business reviews.
The ASB report noted that directors had to make a judgement call about what KPIs to include or whether to include any at all. But it also said companies that omit KPIs in the future risk being investigated by the Financial Reporting Review Panel, a sister organization to the ASB that polices company reporting.
“If there are no KPIs in the business review, what we said in our report—and we agreed the wording with the review panel—was that [omission] would provide the panel with a possible indicator that the business review might not be compliant with the law,” says Loweth of the ASB. But the panel does not have to take action, and if it does, the company may have valid reasons for not having any KPIs, he adds. “It’s not a slam dunk.”
Lingwood, however, says it is “difficult to imagine” a company not having any KPIs, so they should be disclosed; not including any would be like waving a red flag to the review panel. Determining whether a business review is fair and comprehensive in its totality might be difficult for the Financial Reporting Review Panel, she says, but “KPIs are quite an easy one for them to assess.”
Given the timing of the changes to narrative reporting law, most companies will have produced their first enhanced business reviews already. The Financial Reporting Review Panel, however, only starts scrutinizing those produced for financial years ending after March 31, 2007, which companies are just now starting to publish. That means they’ve had a year without scrutiny, to try to perfect their disclosures. If they don’t improve their narrative reporting in this second year, they can’t be surprised if the review panel calls asking why not.
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