Increasing Transparency in Corporate Reporting
In the aftermath of the financial crisis, corporate governance, financial reporting and audit have fallen under the spotlight. Much criticism has been levelled at companies, particularly those in the financial sector, for failing to report effectively to their shareholders in the run up to the crisis.
Earlier this year, the Financial Reporting Council (FRC) published a consultation paper1 on effective company stewardship, seeking views on whether, and if so how, companies could improve the way in which they communicate with their shareholders.
In view of feedback received, and after an extensive process of consultation with market participants, the FRC has now announced some of the actions it proposes to take over the next year to help combat poor company reporting standards.
One theme common throughout is that the current standard of audit – in the UK, across Europe and indeed internationally – is not meeting public expectations. There is a common consensus that there is a need for greater transparency concerning the judgements made by management and auditors when preparing and auditing financial statements.
Respondents across the spectrum supported the FRC’s assessment that there is a need to improve the content and quality of narrative reporting.
There was, however, widespread opposition to the FRC’s proposal that companies should publish their annual report and accounts online rather than produce them in hard copy format. Many expressed concern that this proposal would, in practice, disadvantage smaller shareholders. While the FRC now has no plans to change the way that companies publish their annual reports, it emphases that companies should seriously consider how technology may improve accessibility to their annual reports.
The FRC notes that the Department for Business, Innovation and Skills (BIS) will soon be publishing its own proposals on narrative reporting, following its consultation that ended last year. 2 BIS has said that it will adopt a principles-based approach to regulation, and the FRC undertakes to work closely with the Government to help ensure smooth implementation of its proposals.
Meanwhile, the FRC will launch a Financial Reporting Laboratory on 14 October 2011, where companies will be able to discuss and test drive new approaches to narrative reporting with regulators and investors. It will also continue to explore the appropriateness and feasibility of developing a narrative reporting standard to apply, where appropriate, on a “comply or explain” basis.
Strategy, Risk & Going Concern
Alongside its discussion paper, the FRC also published a summary of discussions had with companies and investors over the past six months.3 While there is now greater awareness of risk at board level, it seems that there is less certainty about whether this has led to any significant improvements in practice.
Recognising that there is a pressing need to find new ways to convey more useful information, the FRC suggests that: 1) narrative reporting should focus primarily on strategic risks; and, 2) companies should be required to disclose the risks inherent in their business model, together with their strategy for implementing that business model, explaining how they will overcome any obstacles in their way. Such an approach would be consistent with a director’s statutory duty to focus on the principal risks and uncertainties facing the company.4
Earlier this year, the FRC launched an inquiry under the chairmanship of Lord Sharman of Redlynch to identify lessons for companies and auditors addressing going concern and liquidity risks. The outcome of the inquiry will no doubt inform the debate on effective company stewardship and inevitably necessitate a further revision of the UK Corporate Governance Code (Governance Code). Further, as promised, the Turnbull Guidance5 will be updated this autumn, to reflect the FRC’s most recent work on risk.6 The update will not be a “root and branch revision.” The Guidance will instead be developed to reflect improvements in practice over time and to clarify the board’s responsibilities concerning determining the nature and extent of the significant risks that it is willing to take.
The bulk of the work undertaken by the audit committee is invisible to investors and other users of financial statements. In the FRC’s view, the valuable work they do therefore goes by “unseen and unappreciated.”
Previously, the FRC proposed that annual reports should include an audit committee report setting out how they have discharged their responsibilities. A number of respondents were, however, opposed to this idea, arguing that it would be better for any expanded audit committee report to come from the board as a whole. The FRC has now refined its proposal – the audit committee should report to the board of directors and, only once that report has been accepted by the board, should it be published in the company’s annual report.
Views on the FRC’s proposal to extend the remit of the audit committee were mixed. Those against the idea argued that the proposals threatened to undermine the concept of a unitary board. With these concerns in mind, the FRC will continue to consult on revisions to the Governance Code and the Smith Guidance7 with a view to extending the remit of the audit committee to include consideration of the whole annual report to determine whether: 1) the information provided is sufficient for stakeholders to assess the performance and prospects of the company; and, 2) the report, overall, is fair and balanced. The FRC is keen, however, to avoid the production of more boilerplate text since it can easily obscure simplicity. To this end, it reassures stakeholders that any amendments made will be objectives-based in nature.
In the FRC’s view, more needs to be done to reflect the fact that auditors are in practice achieving the fundamental purpose of audit (i.e., providing a second opinion on whether a company’s financial statements have been properly prepared). To help minimise the expectation gap, the FRC proposes reviewing and revising the auditing standards governing the audit report8 and reporting by the auditor to the audit committee.9
The revisions will give more transparency to the work carried out by auditors. In every single audit report, auditors would be required to report on whether their review of a company’s annual report revealed any information which was incorrect or inconsistent with the information set out in the company’s financial statements or obtained in the course of audit. Where information is neither incorrect nor inconsistent, a negative statement should be made. At present, auditors are only required to make such a report where they do actually encounter information of an incorrect or inconsistent nature. In the FRC’s view, these revisions will therefore provide greater reassurance to the investment community.
Both the House of Lords Select Economic Affairs Committee10 and the European Commission11 have raised concerns about the length of time some companies have appointed the same audit firm to audit their financial statements, thereby calling into question the degree of institutional familiarity that has consequentially developed. Some FTSE 100-listed companies, for example, have had the same auditor for over half a century.
To address these concerns, the FRC agrees that companies should be required to put the external audit out to tender at least once every ten years or to explain why this has not been done and the reasons for not doing so. A consultation on this subject will be launched in due course.
In order to avoid making too many amendments to the Governance Code on a piecemeal basis, the FRC is seeking, so far as is possible, to co-ordinate the implementation of its proposals with those that may arise out of other initiatives currently under consideration.12 As the Governance Code has historically been reviewed and revised on a biennial basis, its next detailed review should be scheduled for 2012.
Commenting on the FRC’s plans, Stephen Haddrill, chairman of the Auditing Practices Board, stated that the reports “represent another step forward in applying the lessons we have learnt from the financial crisis, to improve the overall transparency of the reporting process and the accountability of all those involved in the financial reporting chain.”13
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