Features
2 Mar 2016 11:50am

Improving annual reports

Annual reports have undergone significant evolution, growing in size, but also complexity. Sandra Haurant looks at what’s driving the changes and what the next stage will bring

The annual report is changing. Its purpose may be the same as ever – to inform shareholders and other interested parties about a company’s performance. But its style and content have altered significantly.

These days, annual reports are frequently a company-wide endeavour, which present not just legally-required facts and figures, but also the firm’s story, business model, strategy and ethos. In smaller firms with relatively limited resources, the challenge is often to produce a report. For big companies, it is a mammoth task gleaning information from multiple parts of the business, selecting what to include and producing a compelling, good-looking document. As many as 150 people can be involved in the production of an annual report in a large firm, including operations chiefs, directors and the CEO. Spare a thought for the investor relations manager faced with herding all those egos to meet the deadline.

Without a formula similar to that used in the US, the 10-K form upon which annual reports must be filed, UK firms are free, to a large degree, to present narrative information as they wish. Some argue that there is a need for greater standardisation, at least for unifying points that make it easier to compare annual reports. Others claim that this flexibility allows firms to tell their unique story in their own way. After all, a pharmaceutical company is completely different from a mining operation, which is different again from a drinks supplier.

Although not standardised, annual reports all contain two key elements – financial and narrative. Both areas have evolved over recent years thanks to changes to the regulatory framework dictating what an annual report must cover.

“One of the main changes was in 2012, with the Corporate Governance Code, when we introduced a requirement for annual reports to be fair, balanced and understandable,” says Deepa Raval, project director, accounting and reporting policy, at the Financial Reporting Council (FRC). “Then in 2013, there were changes to company law, including the introduction of the Strategic Report in annual reports. This was a really welcome development and has resulted in more investor-focused reporting,” she explains.

There have been other changes too, for example the inclusion of remuneration reporting, which was also written into UK law, and in 2015 the requirement for a viability statement became effective.
All these extra factors have led to changes in the way that annual reports are written. It’s a subject that Professor Martin Walker of the University of Manchester and Professor Steven Young of the University of Lancaster have been studying closely for some time.

Working in association with ICAEW and the Economic and Social Research Council, they are carrying out in-depth analysis of around 14,000 companies’ financial reports, going back to 2003. Their research has used sophisticated software to analyse the linguistic content and other elements of the documents.

One of the most immediately noticeable changes is in the size of the annual report. “We have seen enormous growth since 2003,” says Prof Young. “They used to be around 50 pages, and now they are around 70 pages long.” Some are far bigger – such as HSBC’s at 300 pages. Average documents have grown from just over 25,000 words to a novel-like 50,000 – around the length of The Great Gatsby.

This is partly due to the additional financial information required at the “back end” of the report, the section that has grown the most, but the front end, where narrative reporting sits, is also bigger. Performance commentary (incorporating business reviews, operating reviews, financial reviews, CEO reviews), strategic commentary, governance, and residual sections, which cover risk and CSR statements, are all longer now. The only unchanged area is the chairman’s statement.

Nigel Sleigh-Johnson, head of the Financial Reporting Faculty at ICAEW, reckons the increase in word count can have a negative impact on the standard of reporting: “We have seen significant year on year improvement in terms of quality, overall, but also growth in length, and they are pulling in different directions.” Too much information can make it hard to find the most relevant points.

Use of language is also a challenge. The researchers’ software gives scores on readability, and it has shown that annual reports have grown increasingly hard to decipher. “We have found that in many cases you would need a master’s degree level of education in order to understand them,” says Prof Walker. “They are, on the whole, not written for ‘normal’ people, and are more targeted to a professional audience.” Certain companies, though, have an incentive to make their reports easier to understand. “We interviewed [companies] and some said that, where they have a significant set of retail investors, they would use more accessible language.”

Part of the problem, says Prof Young, is that reporting is “inherently complex”. “When you come to talking about how you have made money, it is hard to keep things simple. So I don’t think it is unreasonable to expect a level of sophistication.” However, he adds: “But you also see some that are extremely badly written.”

And this, says Sleigh-Johnson, must be addressed. “Companies need to be able to take the key components and turn them into a coherent narrative,” he says. “There needs to be an emphasis on a really good, clear story, so that as an investor, one can get a real picture of the company and what it stands for.”

Part of that can be achieved by creating a navigable structure. Some reports do not even have contents pages, making it very hard to track down required information.

Average documents have grown from 25,000 words to 50,000 around the length of The Great Gatsby

The introduction of the Strategic Review has caused problems for some companies, too. While there are those that have embraced this way of telling their story, it seems others are simply producing the same reports they always have, but are sticking “Strategic Review” at the top for good measure.

The FRC published Guidance on the Strategic Report to support the legislation in this area, and also has an initiative on Clear and Concise Reporting. Clear and Concise is an overarching concept that the FRC is promoting by initiating activities to help companies shift the emphasis of their reports so that shareholders, and businesses themselves, get the best out of them. They should be written in a clear language – which comes back to the “understandable” element of the Corporate Governance Code – and they should make their point succinctly – tackling the growing length of documents.
With more and more information in annual reports, the FRC wants to get back to the nuts and bolts and show that narrative reporting should be about communication, not just compliance.

“One of the principles in the FRC’s Guidance on the Strategic Report is that certain information will be required by law to be included in the annual report, but there is an opportunity for other information – for example, detailed, granular information – to be included in a separate document,” it says. Good use of signposting can ensure investors find further information easily. Sustainability reports, for example, are produced by some firms to provide greater detail on the subject, and these can be pointed to within the annual report without going into unnecessary detail.

Running broadly parallel to the FRC’s guidelines is a notion with a worldwide movement behind it. Integrated Reporting is a holistic approach encompassing companies’ ethos and culture, underpinning the idea that narrative reports should be more than just about the numbers.

Jonathan Labrey, chief strategy officer at the International Integrated Reporting Council, says: “With integrated reporting we are introducing a new language, talking about capital not just in terms of financial capital, but also human capital, intellectual capital, and social capital, which are just as important.”

Annual reports will continue to evolve and, with no rigid formula to follow, to a large degree it is up to individual companies to decide how to tell their stories. For now, Sleigh-Johnson believes companies are moving in the right direction and front end, narrative reporting is becoming what it should be – a way to tell a company’s unique story in its own words and its own style.

“It’s been a long journey to reach where we are now, but we are starting to see the fruits of that effort. Particularly at the larger end of listed companies, there is some remarkably good narrative reporting.” The best, he says, is often the most creative. “There is a degree of innovation, which goes a long way to making reports a compelling read.”

Sandra Haurant

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