U.K. Struggles to Improve Narrative Reporting

A war of words is brewing in the United Kingdom—about how many words should go into corporate reports.

Britain’s top corporate regulator, the Financial Reporting Council, is stepping up complaints that companies are failing to deliver informative annual reports that shareholders can use. Writers of the reports are firing back that the reports have become expensive wastes of time, since nobody reads them anyway.

The FRC most recently voiced its concerns last June in a report titled “Louder Than Words.” It said “urgent change” was needed to “cut the clutter” out of financial reports and to address growing concerns about the complexity of corporate reporting.

The Accounting Standards Board followed up with its own report in October, examining the difficulty of complying with Britain’s rules on narrative reporting. The ASB said two-thirds of large listed companies fail to meet the spirit of the reporting rules, and many are struggling to comply with new legal requirements.

The FRC paper acknowledged that increased regulation is making compliance more difficult, but also said preparers of the reports bear some of the blame because they stuff too much information into the reports. Preparers say they are forced to include more detail than they would like.

Lucinda Bell, tax director at property company British Land, made that point in a letter to the FRC; she argued that the regulatory regime actually encourages excessive disclosure. “Failure to disclose can have serious consequences but there is no equivalent for unnecessary or excessive disclosure,” she said. “This needs to be rebalanced.”

Bell had tart words for auditing firms and other outside advisers as well. “However immaterial a disclosure can be argued to be, their view would almost always be that it is better to disclose than not,” she said. “Empowering or even compelling auditors to require reduced disclosure could be an important step forward.”

“Empowering or even compelling auditors to require reduced disclosure could be an important step forward.”

—Lucinda Bell,

Tax Director,

British Land

Brian Singleton-Green, manager of corporate reporting at the Institute of Chartered Accountants in England and Wales, says it’s easy to feel sympathy for people who draft financial reports, but contends that the reports have become longer and more complex for good reason. Businesses have become more complex, and their accounting reflects that, he says.

Singleton-Green

Complexity is “part of business life now; the answer is to cope with it,” Singleton-Green says. “We are not going to say we want more complexity, but the question is for whom is it a problem, and is it such a really big problem?”

But Hugh Shields, chief economic adviser at the Institute of Chartered Accountants in Scotland, believes a more radical rethink is needed. He previously was head of financial reporting at Barclays Capital, one of the largest units in the global Barclays banking group. Since 2002, he says, the number of pages in Barclays Capital’s financial report has increased by about 50 percent.

Producing the accounts “was a big effort, and it got bigger every year,” Shields says. “The big issue—and nobody can shy away from it—is that annual reports do not tell a story. They are not an exercise in communication; they are an exercise in regulatory compliance.”

Shields has been working on a project to produce a model set of accounts for a fictional international bank. His goal is to show that an annual report to shareholders can tell a compelling story, while still including all of the key financial and accounting detail needed to support it.

Shields says he wants to “give investors everything they need to get a very good insight into what’s going on at that bank”—but he wants to do it in 30 pages, not 400. His new-style accounts would “allow people to see the wood from the trees, which is the bit that’s been missing,” he says. “Investors do not want every single note; they want specific information at that moment.”

CALL FOR ACTION

Below is an excerpt from the FRC Discussion Paper, “Louder Than Words.”

To cut clutter we need to work on making better materiality judgments and to consider whether various sources of regulation are contributing to the problem.

ICAEW Materiality Guidance

Current guidance on materiality, such as the

ICAEW’s Guidance on Materiality in Financial

Reporting by UK Entities, quite rightly focuses on

discussion of all the different factors such as size,

nature and circumstances that could cause an

error (such as omitted disclosure) to be material.

Its guidance is geared towards ensuring that material

errors are not judged immaterial, which is the

highest risk in judgments of materiality. However,

it should also acknowledge that lowering this risk

by judging everything to be material is not having

a positive impact on corporate reports overall.

Auditing standards

To focus the audit on getting the numbers right and

to address situations where fraud might be disguised

by sloppy accounting, auditing standards require

auditors to communicate all errors to the appropriate

level of management unless they are ‘clearly trivial’

Because it is time consuming to debate with the

audit committee, managers generally try to

minimize the errors that ultimately get reported

to the audit committee by making changes to the

financial statements.

Because ‘clearly trivial’ is a lower threshold than

immaterial, auditors have to operate at a very low

level of detail. Most people think of errors as being

quantitative, but auditing standards also consider a

disclosure omission to be an error. So, paradoxically,

auditing standards may be causing behavior that

results in companies making immaterial disclosures.

There is a concern that disclosure omissions may

be different in nature from qualitative errors in the

primary financial statements because they do not

necessarily add up over time. This raises the question

whether disclosure omissions and quantitative errors

deserve identical treatment in auditing standards.

Other regulations

Reports must comply with regulations from a variety

of sources, which do not always make it perfectly

clear whether their requirements apply to items

that are immaterial.

As illustrated above, clutter in reports is a multi-faceted

issue that will be very difficult to resolve. However,

some action is already in hand. In order to help

preparers make judgments and provide some

examples of obviously immaterial disclosures, the

FRC plans to conduct a review of 2008 annual reports

during summer 2009. It will publish a short paper on

its findings including, where possible, examples of

how regulations may have contributed to clutter.

Source

FRC Discussion Paper, “Louder than Words” (2009).

The bank could then publish further information online, Shields says, but anyone reading it “should be aware that management does not think it is material.”

Define ‘Use’

Many companies do this sort of summary already, producing a separate pack of data and analysis for their institutional investors. That raises a question: Just who are the “users” of accounts?

Singleton-Green says the primary user of the annual report is the institutional investor; private investors get their information via the media, their broker, or other sources of company information, he argues. But that point is up for debate. Scott Hayes, group finance controller at tobacco company BAT, says standard setters need to be clearer about whom they believe accounts are aimed at, and what that audience really wants.

“There sometimes seems to be a disconnect between what, for example, the International Accounting Standards Board quotes as users’ views and what companies actually see in their relations with the market,” he argued in a written comment to the FRC paper.

Steve Priddy, director of technical policy at the Association of Chartered Certified Accountants, says the “tunnel vision” of standard setters is what has driven reporting complexity. As a consequence, another important function of the annual report—showing how the board has exercised stewardship over the business—has become a lesser priority. Priddy says it’s time to move the debate forward, so it isn’t about “investors who want to see everything and preparers complaining about the cost.”

Standard setters “work in some kind of theoretical vacuum. They do not think enough about the impact that their standards will have,” Priddy says. Much of the complexity and disclosure rules in accounting standards are the result of a “lack of trust” between standard setters, auditors, and preparers, he says.

“A lot of regulation and disclosure is based on the premise that board directors have greater information—which they do—and are out to manipulate it to not present a true and fair view of the business,” he says.

Hayes from BAT agrees that International Financial Reporting Standards often assume that companies are out to deceive. “As long as standard setters give undue emphasis to the ‘anti-abuse’ aspects of standards, this will add to the complexity of standards, both through their content and their application,” he told the FRC.

The FRC says it is currently analyzing the response to its report, and plans to issue more guidance to companies about how to make their annual reports less complex by the start of 2010. Its first paper included tips on making accounts easier to read and a call for reporting standards in certain areas to be clarified.