Too long, too complex, too opaque – there are a host of criticisms hurled at financial reports. But are they justified? And if so, is anything being done to address them?
Much of the length and complexity derives from the need to address the different users of financial statements. Accounting standards and company law changes have increased disclosures greatly. This caters for professional investors, but the cost can be a bewildering amount of information for retail investors, or for private companies.
Jake Green, director of financial reporting at Grant Thornton
If you enter into complex transactions, don’t expect your accounting to be easy. It’s not fair to point the finger at accounting standards. The complexity is driven by having to communicate the business model
Diverging reporting requirements have led to the evolution of two distinct reporting frameworks with three options. Listed companies and parents of a listed group have to use international financial reporting standards (IFRSs). Private companies use generally accepted accounting principles (GAAP) based on financial reporting standards issued by the Accounting Standards Board (ASB). Small private companies can use the financial reporting standard for smaller entities, or the FRSSE, a slimmed down version of UK GAAP.
The trouble with this three-tier system is that it involves two different frameworks, as UK GAAP and the FRSSE are not based on IFRSs. While there is an IFRS for small and medium-sized enterprises (the IFRS for SMEs), UK companies cannot use this as it is not compatible with EU, and so UK, law. This complexity is a particular problem for entrepreneurs. “You start a business, it grows, and then you reach a point where you have to apply IFRS and realise that the basis for some of your decisions has changed,” says Martin Cavey, partner at Cameron Cavey LLP. He estimates that 1% of his clients may need to change from small-company reporting to using IFRSs. “The current reporting framework doesn’t necessarily fit their vision for rapid growth,” he says.
Shaping a coherent approach
However, change is in the pipeline. The ASB has developed a common platform for accounting by creating a UK version of the IFRS for SMEs. The proposed standard, draft FRS 102, is more coherent, says Nigel Sleigh-Johnson, head of ICAEW’s Financial Reporting Faculty. “It makes it easier for companies to move up the scale, transitioning from one set of standards to another as they grow.”
It also addresses the issue of the differing conceptual frameworks under which UK GAAP has evolved. While some accounting standards under UK GAAP start by looking at how to deal with items in the profit and loss account, others are based on the values of balance-sheet items. The proposed FRS 102 starts from a common framework that looks at assets and liabilities. “This is better than trying to marry two sets of standards which aren’t quite working on the same principles,” says Jake Green, director of financial reporting at Grant Thornton.
FRS 102 addresses another issue with accounting standards: how well they fit the companies that apply them. Green thinks FRS 102 is “the first time that standard setters have not started at the top-end of companies, but by looking at privately held companies and asking what’s right for them.”
In designing the new accounting framework, the ASB has stuck with the current format laid down in the Companies Act. The aim is to make the move to the new UK GAAP as smooth as possible. While the current standards extend to approximately 2,500 pages, the proposed FRS 102 nips in at around 250.
“Any change involves costs and uncertainties,” Sleigh-Johnson says. “There will be broadly one regime for financial reporting, which will make it easier for training and those analysing and using accounts. There should be savings and benefits.”
Can condensing standards lead to simplified financial statements? Green says a lot depends on a company’s business. “If you enter into complex transactions, don’t expect your accounting to be easy,” he says. “It’s not fair to point the finger at accounting standards. The complexity is driven by having to communicate the business model.”
This communication is for the benefit of users, a group sometimes blamed for the growth in volume of annual accounts. The claim is that users would rather be presented with too much information than not enough, and that this has increased the complexity and opacity of financial reporting.
Paul Lee, director at Hermes Equity Ownership Services, disagrees. He says investors would like to see more thought given to disclosures, particularly in terms of materiality. “Too much of what’s in reports is not material. It’s almost as if it’s included for behavioural reasons. We don’t pay directors for anything but their ability to exercise judgement. The same goes for auditors. And yet neither party seems to be exercising the right level of judgement.”
Green agrees that this is a challenge. “Preparers have to ask: how could we make our accounts more useful and understandable? Often they look at a disclosure checklist, usually in consultation with the auditors, and err on the side of caution when deciding how much information to include in the financial statements. They tend to think ‘no-one’s going to tell us off for putting in more than is needed’. But that does not address the question of what’s useful and material to a user.”
Reporting in context
The important thing for users, Lee thinks, is that reporting is delivered in context: that it relates to the company’s business model and strategy, and to performance under that strategy. “Too much reporting seems too generic. A step change is needed in the minds of directors and auditors.”
Meanwhile, the Department for Business, Innovation and Skills (BIS) has proposed changes to the narrative reporting regime that would get rid of some disclosure requirements and move others into different reporting channels.
Lee welcomes the way the BIS proposals take the company’s strategy as the starting point for narrative reporting. “Sadly few companies base their narrative reporting on their business model and strategy implementation. The reports don’t display that level of insight that we expect. The danger is that boards are either displaying a lack of strategic thinking or failing to express their decision making. Over time, this erodes investor confidence."
Small company reporting
When UK GAAP is replaced by FRS 102 (currently scheduled to take place in 2015), small companies will have the choice of using the new standard or sticking with the current FRSSE.
“We may well need a new version of the FRSSE that will be more in line with FRS 102 but which reduces some disclosures, making it more suitable for the smaller-end private companies,” says ICAEW’s Nigel Sleigh-Johnson.
Developments in the legislative arena mean small company accounting is likely to be changing soon. A new EU directive may simplify the disclosures small companies have to make in their full accounts for members. And a member-state option in EU law permits micro companies to apply a simplified reporting regime under which they publish only a statement of position and a few simple notes. Since the FRSSE will have to change to comply with new EU laws, the ASB may review how to bring it in line with internationally based standards at the same time.