Featherstone Risky disclosures

Tony Featherstone says the push for boards to provide more context around financial performance and strategy in the operating and financial review increases risk.

As organisations finalise their annual reports for 2013-14, boards will be tested on the Operating and Financial Review (OFR) that appears in the directors report. The push for boards to provide more context around financial performance and strategy brings significant risks.

To recap, the Australian Securities and Investments Commission (ASIC) released guidance in March 2013 on the OFR. Its regulatory note, Effective Disclosure in an Operating and Financial Review, sets out ways for boards to provide more meaningful information to stakeholders.

The Australian Institute of Company Directors has also released a guide that helps boards understand the differences between ASIC’s regulatory guide and the International Integrated Reporting Framework (IRF). The broad thrust of ASIC’s guidance makes sense. Many annual reports have become too large, complex and unwieldy for stakeholders, especially retail investors. Anything that encourages companies to think more about how they communicate their business model, strategy, objectives and future prospects, or to provide more narrative around financial data, is welcome. The OFR is also an opportunity for boards to explain the company’s strategy to stakeholders and encourage management to make the annual report as concise, well-ordered, clear and readable as possible. Greater segment information and better notes to support accounting treatments would be well received by institutional investors.

That’s the theory. In practice, the guidance is fraught with danger. In its Comparison Guide for ASIC’s Regulatory Guide 247 and the International Integrated Reporting Framework, Company Directors encourages directors to exercise caution when finalising the disclosures within the directors’ report. I had similar concerns when analysing the changes in the OFR guidance. In Company Director (February 2014), I wrote: “For now, boards must balance the needs of an investment community that, on one hand is more vocal and litigious, and on the other expects simpler, more meaningful information in an era of enhanced disclosure and transparency. Few board challenges are as great.”

Regulators, investors and the media expect companies to disclose greater information and provide more forward-looking statements. Yet the continuous disclosure regime for listed companies, the rise of litigation funding and shareholder class actions, and the lack of an adequate business judgment rule in Australia, is understandably forcing listed companies to be more circumspect.

Company Directors has three key concerns about the OFR. The first is around forward-looking disclosures, an issue echoed by other directors in my conversations with them. The OFR encourages boards to provide information on future prospects. Although detailed financial forecasts are not required, even quantitative information, such as the board’s view on the company’s outlook, could be construed as forward-looking and open directors up to personal liability.

Company Directors wrote: “A director’s ability not to include particular forward-looking disclosures is under increased pressure in light of ASIC’s guidance on the OFR and Integrated Reporting Framework.” In volatile, hard-to-predict markets, boards could be forgiven for being uneasy at the prospect of adding forward-looking statements to their OFR.

Company Directors’ second concern is potential confusion around what is “material” for the purposes of Australia’s continuous disclosure regime and the IRF, which has a different definition of materiality. How would this play out in the OFR? If a company includes a forward-looking statement in the OFR that is material, surely it should have been released earlier when the company was aware of it?
Company Directors’ third concern was the approach of the IRF and OFR. It believes the IRF is significantly different, so cannot be submitted into OFR in the directors report. The table in Company Directors’ report that compares the differences is an eye-opener and good reason for boards to tread warily on this issue.

Even so, boards can still adopt the broad thrust of ASIC’s guidance. They can encourage their companies to streamline financial reporting and urge management to ensure annual reports are more concise, clear, and useable for readers. And they can ensure the organisation has processes to segment and understand different stakeholder groups, provide the information they need, and measure whether the annual report is achieving its purpose.

There is also an opportunity to provide basic information on the business model, strategy and key earnings drivers, and provide explanations of the accounting treatment on some of the more contentious financial items in the accounts. But providing more forward-looking, potentially material information in the OFR of the directors report is arguably too big a step for boards, for now. Without an appropriate business judgment rule for directors, regulation of litigation funding and other safeguards, boards are taking on unnecessary risks if they provide too much descriptive narrative in the OFR.