Technical
2 Nov 2012 10:45am

Seeing the wood for the trees

Financial reports are created primarily with investors in mind but, asks Sally Percy, should they be reformed to meet the needs of other users?

Financial reports have earned a bad reputation over the years. Maligned for being too long and cluttered, hard to navigate and stuffed with meaningless marketing speak, these important documents of record have suffered an endless stream of criticism. In 2007 HSBC’s 454-page annual report, weighing in at 1.36kg, was even slated as a health and safety risk after Royal Mail banned its postmen from carrying more than 10 at a time for fear of back injuries.

Then the financial crisis hit. Financial reports were held partly responsible for the meltdown in the banking sector, both for disclosing too much and for not disclosing enough about the risks institutions were taking. Four years on, financial reporting remains under the scrutiny of regulators, standard setters, accountancy bodies and the government.

Financial statements may be designed with the interests of investors in mind but they’re used by a range of stakeholders (see box far right). Nevertheless, their shortcomings mean they could be failing to meet the needs of any group of stakeholders fully – investors included. “External reporting is focused largely on investors as opposed to other stakeholder groups and is mainly historic,” says Simon Bittlestone, commercial director at business analyst Metapraxis. “It has little forward-looking financial information on likely future achievement, which is vital for investor decisions. It also often lacks insight and is generally a table of numbers with little trend information or context.”

 

We hope the annual report doesn't become so unfocused it fails to meet anybody's needs

But Alison Thomas, head of global investor engagement at PwC, says the reporting model is not broken. “Investors tell us the annual report is still a valuable document. If you’re an investor and you don’t know a company, often the first thing you do is print off the annual report and read it from cover to cover,” she says.

Thomas believes annual reports give investors and other stakeholders an insight into a company’s business model, management approach and culture, as well as a solid history of financial results. Annual reports are assured by auditors, so stakeholders feel confident about the financial information in them and, thanks to IFRS, they are presented in a way that is comparable with other annual reports.

Investors arguably have the greatest need for them because of their comparative arm’s length from the company. “A lot of other stakeholders are privileged information gatherers,” says Baker Tilly partner Danielle Stewart. “Banks, creditors and employees are closer to a company than a third-party investor looking at whether to invest in it.” Banks can ask for detailed financial information from companies, such as bank statements and management accounts, she says.

Creditors, while less privileged, can also demand additional information. And employees are possibly the most privileged stakeholder group, as they know all kinds of information of which the markets are probably unaware.

So does nothing need to be done to improve annual reports and their relevance to stakeholders? “There’s always room to improve the quality of what’s in the annual report,” says Nigel Sleigh-Johnson, head of the Financial Reporting Faculty at ICAEW.

Presentation is also in the firing line. “Financial information tends to assume a good understanding of accounting rules,” says Bittlestone. “This is not always the case and can prevent stakeholders understanding what the information actually means for the business and what decisions to take as a result.”

Depending on their terms of engagement, accountants might have a duty of care to their client to examine financial accounts, such as in the case of an acquisition, for example. But they are likely to advise their client to examine the financial reports of companies with which they do business themselves, leaving them to interpret information that may seem unintelligible.

Then there’s the issue of disclosures. Seen by some as more of a hindrance than a help, disclosures play a key role in explaining financial statements. Stewart says they are the “meat and drink” of analysts as they interrogate annual reports but others find narrative reporting more accessible.

Given the political importance that financial reporting has assumed since the financial crisis, it’s no surprise there are efforts to improve it. The Department for Business, Innovation & Skills is set to reform narrative reporting to allow companies to produce a high-level strategic report backed up by an annual director’s statement available on the company’s website. The idea is to create a format that enables businesses to tell an integrated story covering their business model, strategy, performance and goals.

In July, the European Financial Reporting Advisory Group, the UK Financial Reporting Council and its French counterpart the Autorité des Normes Comptables announced a review to make the notes accompanying financial statements more transparent. The notes have become so extensive that investors and creditors can no longer “see the woods for the trees”, argue these organisations.

The Integrated International Reporting Council aims to create a global reporting framework that includes non-financial information, such as environmental and social economic costs, with financial statements in a clear, comparable format.

There is also a hunger for real-time information rather than the historic data associated with annual reports. Alex Schwendtner, managing director of credit referencing agency Graydon UK, says creditors appreciate management accounts because they are forward-looking. “They provide valuable clues about the health of a business, such as whether and how quickly the business is reducing its debt,” he says. Graydon wants government to push large companies to publish their payment terms and the number of suppliers that receive payment within those terms.

“There’s a limit to how you use annual reports,” says Sleigh-Johnson. “We hope greater use can be made of other means of communication to make sure the annual report doesn’t become so unfocused that it doesn’t meet the needs of anybody.”

In today’s internet-powered world, where analysts can deliver reports and news to clients at the click of a mouse, few stakeholders rely solely on annual reports as a source of information. That means companies should be using their website and social media presence to publish the detailed information that would otherwise clog up their annual report.

Reforming financial reporting remains a complex challenge, not least because of the diverse views on which information is relevant to different stakeholders. Use of technology is a step in the right direction, for stakeholders and postmen.


Who uses financial statements?

A wide range of stakeholders use companies’ financial statements, with some relying on them more than others.

These stakeholders include:
• big institutional investors such as pension funds and other capital providers that base investment decisions on information contained within the statements;
• banks and other financial institutions looking for reassurance that the company is a safe bet to lend to;
• analysts, who use detailed financial information on a company to analyse its competitive performance;
• creditors seeking assurance as to the company’s short-term liquidity;
• employees and potential employees who will be interested in the company’s prospects, senior management pay and pension scheme funding;
• customers and debtors that want to know if the company is likely to survive;
• the government, which will be interested in a company’s profitability for corporation tax reasons;
• media organisations that will report on the company’s financial results;
• members of the general public who may have a specific interest in the company’s activities.

 

Sally Percy

 

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