Hitting the mark

Financial reporting can often be a hit-or-miss process, sometimes leaving stakeholders confused by too much information. Tony Featherstone investigates how boards can better target their communications.

The problem with financial reporting is not the “What”. Listed company financial and annual reports have generally become longer and more complex, and many are rife with repetition, jargon and poor structure. Some are almost unreadable.

The real reporting challenge is the “Why” and the “How”. Why did the company treat certain financial items that way and do the account notes sufficiently explain its position? Also, how does the company’s latest profit report relate to its business model, value drivers and strategy?

The “When” and “Where” of corporate reporting are becoming bigger issues too. The Australasian Investor Relations Association (ARIA) is urging ASX-listed companies to release profit results well before the share market opens, to give investors more time to digest information.

Where that financial information appears – for example, on global exchanges and increasingly on social media – is another growing challenge for companies that must be mindful of the threat of misinformation, the potential for a false market in their securities and the onus on them to correct it.

Compounding this challenge are a raft of reporting requirements, trends and legal cases that continually raise the bar for listed companies and their boards on information disclosure. 

The Australian Securities and Investments Commission’s (ASIC) guidance on the Operating and Financial Review (OFR), released in March last year, set out ways for directors to provide more meaningful information in the director’s report in the annual report – a move that initially concerned the director community, given requirements to provide greater context around financial performance and strategy.

For a document aimed at simplifying information in the OFR, ASIC’s 29-page regulatory guide Effective Disclosure in an Operating and Financial Review was heavy going, although it has already achieved good progress in the latest reporting period.

In the background is the global push towards an integrated reporting framework, which brings together material information about the organisation’s strategy, governance, performance and outlook in the context of its commercial, social and environmental responsibilities.

In some ways, ASIC’s OFR guidance is a stepping stone towards the controversial new world of integrated reporting.

The Global Network of Director Institutes, of which the Australian Institute of Company Directors is a member, warned in August that integrated reporting, if mandatory and overly prescriptive, would lift compliance costs and potentially increase director liability, chiefly around forward-looking statements.

And, at an International Integrated Reporting Council (IIRC) meeting in London in December, Company Directors was the only IIRC member that did not vote in favour of publishing the Integrated Reporting Framework.

While Company Directors supports many of the goals included in this framework, the last thing it wants to see is Australia’s already onerous director liability burden become heavier.

It says the lack of an effective business judgment rule in Australia is inconsistent with many of the framework’s principles and would hamper directors who may be forced to make forward-looking statements.

Anne O’Donnell FAICD expresses the frustration of many directors with reporting.

“Financial reports have become far too complex and long,” she says.

“In the push towards greater transparency and disclosure, the pendulum has swung too far towards bombarding investors with information. It’s becoming harder for the average investor to make sense of it all.”

O’Donnell, chairman of Beyond Bank and a non-executive director (NED) of Equity Trustees and Company Directors, says boards are caught in a difficult place with financial reporting.

“With the best intentions in the world, directors want their organisation to provide simple, meaningful information that better informs all shareholders. But there are so many prescriptive rules about what needs to be in there, and in what format, that the organisation ends up putting in more and more information to cover all legal bases.”

Company Directors has lobbied for a revised statutory business judgment rule in the past few years and O’Donnell says the absence of one hinders board efforts to oversee improved financial reporting.

“Because there is less protection for Australian directors compared to other countries that are moving towards integrating reporting, many local boards have to err on the side of caution, to protect the organisation and its directors against litigation risk.

“When you talk to directors in other countries about integrated reporting, they are surprised that Australia does not have a sufficient business judgment rule. Better legal protection for directors is a necessary part of the move towards integrated reporting.”

The challenges and frustrations with financial reporting might suggest boards are doing an average job on this issue.

Not quite true!

Although there is room for improvement, financial reporting standards, at least for the top 200 listed companies, have improved since the 2008 global financial crisis.

ASIC’s financial surveillance review of 30 June 2013 reports, released in December, concluded that the overall standard of financial reporting in Australia remained high.

ASIC’s focus areas for 31 December 2013 reports included OFR disclosures (following its guidance note); off-balance sheet arrangements; impairment tests for goodwill and other assets; and tax accounting.

Investors, too, trust the general standard of financial reporting by larger listed entities.

Indeed, the Australian Council of Superannuation Investors’ Board Confidence Survey last year confirmed that institutional investors had confidence in the boards of S&P/ASX 100 companies. “Oversight of financial reporting” achieved the third-highest confidence score across 17 board issues.

Jan McCahey, a partner in PwC’s assurance division, says it is timely for boards to review their organisation’s efforts to streamline financial reporting and make their accounts more meaningful for investors. McCahey is the former chief accountant at ASIC and a prominent expert in her field. She is helping drive PwC’s guidance on streamlined financial-reporting techniques for larger organisations and meets NEDs and CFOs on this issue.

“ASIC’s OFR guidance sensibly encouraged directors to put more thought into the communication of the company’s strategy, business model, objectives and future prospects,” says McCahey.

“Although this guidance initially concerned boards, by and large, companies implemented the OFR requirements well in the FY13 reporting period. ASIC essentially asked boards to put the same sort of narrative companies use in investor presentations in the OFR, to give more context around financial data.

“The challenge now is for boards to build on the good early work with OFRs and encourage the CFO and the finance team to consider how information can be conveyed more simply and have well-written narrative. Changing the structure of reports and re-ordering information, so that the most important is presented at the front, and the least important at the back, is key to this.”

McCahey says there are significant “reporting wins” available for companies with the foresight to eliminate jargon, unnecessary information and poorly structured information.

“Nobody says this is easy, but from my discussions with NEDs and CFOs, there is a real appetite to rethink the current presentation of financial reports and restructure them. The days of using the same template, year after year, and having an important note to the accounts buried on page 172 of the annual report, because it always goes there, are long gone.”

McCahey’s conversations with analysts and institutional investors have indicated a desire for simpler financial reporting.

“There’s a perception that the investment community wants as much detailed information as possible in financial reports. But the reality is that professional investors want information, such as segment information, to be given more prominence in reports and better explanations in the notes as to why an asset was impaired or treated as a non-recurring item, for example.”

McCahey cautions that ASIC has clear expectations about financial reporting.

“It rightly expects companies to prepare detailed information to support the accounting treatment of potentially controversial accounting or disclosure approaches. Their analysis needs to explain why the company believed the accounting treatment was the proper course of action and if it considered other scenarios.”

McCahey says ASIC expects the board to have reviewed this explanation.

“Nobody expects directors to debate  every tiny detail in a financial report, but they should have formed a view on the accounting treatment of contentious financial items and have asked management to explain its position. If problems arise, ASIC typically asks for management’s detailed papers and evidence there was adequate oversight of financial reporting by directors.”

The big hope for the 2013-14 reporting cycle, says McCahey, is faster progress towards streamlined reporting.

“ASIC’s recent positive report card on financial reporting did not surprise me. Australia’s corporate community is generally very compliance-minded. And, for all the early concerns about the OFR guidance, including a report, approximately 10 pages long, that challenges directors to ‘tell the company’s story’ and be more open about financial performance is a useful exercise.”

Providing such information is easier said than done. The availability of litigation funding to pursue shareholder class actions is putting more disclosure pressure on boards and increasing legal risks for directors.

ASX Guidance Note 8, released last year, gave important clarification of when ASX-listed companies need to release information, but continuous disclosure remains a complex issue for boards, and breaches of disclosure requirements remain fertile ground for the growing number of litigation funders and law firms willing to pursue such cases.

Improved regulation of litigation funding in Australia, and enhanced protections for directors, would go a long way to enabling boards to become more confident about simplifying the reporting financial information and believing in the motto that “less is often more”.

But for now, boards have to 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.

Consider a NED who sits on the boards of four listed companies and each year has to read 600 pages (or try to) of dense annual reports, hundreds of pages of interim and full-year profit reports and all the company announcements, investor presentations and out-of-cycle guidance announcements in between. Making sense of that information, let alone overseeing efforts to restructure it, is a daunting challenge.

A useful starting point is understanding the information needs of readers of the financial reports, assessing how they view the company’s current financial reporting practices and policies and measuring their views.

For listed companies, this means better understanding and segmenting the shareholder base and more frequent dialogue between the board, usually led by the chairman, and key institutional investors, proxy advisers and retail shareholder representatives.

Pru Bennett, BlackRock’s director of corporate governance and responsible investment in the Asia Pacific, says not enough boards understand their shareholders’ information needs and the varying types of information they need.

“There is a difference between a fund manager who is a ‘stock picker’ and who will typically focus on financial data, strategy and face time with management, compared to an indexed or passive manager. Many long-term investors might also wish to focus on governance policies and processes. 

“A deeper understanding of the share register would help companies better present information to key investors.”

Bennett, a former proxy adviser, has led Blackrock’s efforts in the Asia Pacific to engage companies on their corporate governance practices and policies. As the world’s largest fund manager, and an investor in large and small ASX-listed companies, BlackRock has a strong interest in governance and devotes considerable internal resources to assessing companies on this issue and engaging those companies.

“The recurring problem with reporting is the ‘Why’,” says Bennett. “Why did the board choose a particular benchmark for executive long-term equity incentives? Why is the board composed in a certain way? Boards of larger companies mostly do an okay job of explaining what they did, but too few sufficiently explain the rationale behind it.

“I’m not suggesting boards need to explain their every action, but many could better communicate their position and policies to investors. Smaller listed companies in particular can improve in this regard.”

Bennett, a leading governance analyst who recently relocated to BlackRock’s Hong Kong Office, is concerned about the attention paid to executive remuneration by investors and the media. 

“Executive remuneration gets all this focus, but the amount of write-offs in asset values in the past five years has dwarfed CEO pay,” she says.

“But too few boards explain their processes behind approving acquisitions or whether those processes will change in light of failed transactions.”

Martin Lawrence, research director at proxy adviser Ownership Matters, says a better explanation from boards on asset writedowns is warranted.

“I have observed a tendency among boards to view impairments as an artifice of accounting standards. The board approved the acquisition in the first place and then approved the write-down in the value of goodwill, which is based on expected returns from the asset. Yet investors usually receive insufficient information from boards on their view of the impairment.”

Lawrence says boards also need stronger oversight of the reconciliation between the statutory net profits and underlying cash earnings that exclude extraordinary gains or losses not related to ongoing business activities.

“The interpretation of whether a particular item is recurring or non-recurring often favours the executive team,” he says.

“Remuneration is usually linked to underlying cash earnings, so executives are incentivised to get as much junk out of the underlying cash earnings as possible and present the organisation’s earnings in the best light.”

Some non-recurring items are questionable, says Lawrence.

“Take restructuring costs. In many companies, these costs are genuine one-offs. Yet in larger companies that seem to continuously restructure, the cost is arguably a normal part of business that should be included in underlying cash earnings. Boards need to satisfy themselves that all excluded costs are non-recurring.”

Lawrence says other inconsistencies occur in the recognition of extraordinary items. “For example, a company will sell an asset, pay down debt and incur a significant break fee for repaying debt early. The cost is rightly treated as a non-recurring item, but the interest savings from repaying debt early are represented in underlying cash earnings from day one. These inconsistencies frustrate investors.”

“I would hope boards vigorously question management on the most contentious items in the financial report,” adds Lawrence.

“By and large, Australian companies tend to provide pretty good reconciliation of their different earnings numbers, but fund managers prickle when there are inconsistencies and the rationale is not sufficiently explained.”

Querying the accounting treatment of financial items might seem daunting to directors who do not have strong financial backgrounds.

Boards rely on the executive team to prepare financial accounts, on the judgement of the external audit firm and on the board audit committee to provide sufficient oversight of reporting policies and practices.

Some high-performing boards ask management to identify and explain the most contentious issues in the report.

A leading director of an ASX 50 company told Company Director: “We put the onus on management to defend any potentially controversial items in the accounts and we put ourselves in the shoes of investors.

“Does the explanation make sense? Is the information supporting that explanation in the notes to the accounts sufficiently clear? Are directors satisfied in the accounting treatment? Is the board comfortable that everything has been done to verify the financial report’s accuracy before signing off?”
Lawrence says some boards need a better understanding of consensus market information.

“Occasionally, you encounter directors who are unaware about the company’s latest earnings guidance or market expectations for its profits, he says.

“Directors obviously cannot go to every analyst meeting, but they must be acutely aware of what their company is saying to the market and what the market expects of the company’s next earnings.”

Ian Matheson FAICD, CEO of AIRA, believes poor internal systems are usually responsible for financial-reporting problems, continuous disclosure breaches and the resulting litigation.

“Boards needs to be very confident that their organisation has robust management reporting systems and the right people providing financial information to them. The reporting goal should be ‘no surprises’. Yet time and again, we see listed companies shock the market with an unexpected earnings downgrade because they were not on top of their financial information. The natural inclination of investors is to sell first, ask questions later.”

Matheson says boards must also be satisfied that their organisation has skilled investor relations (IR) executives who can handle an increasingly complex, important function.

“Many top 100 ASX-listed companies have very good IR people, but you don’t have to go far beyond the top 100 to find organisations without a dedicated IR professional.

“There are even a few companies within the top 100 without dedicated IR staff. It creates a significant risk that the organisation’s financial reporting will be not be communicated effectively to the market.”

Matheson says sporadic communication of financial reporting is still too common.

“Some companies lob their report to ASX at whatever time its suits them, often late in the day, and completely ignore the needs of professional investors who want as much time as possible to digest the information and compare it to consensus forecasts. It makes the company look uninformed and unprofessional.”

An AIRA survey in October overwhelmingly found investment professionals wanted important profit announcements made public before 8.30am, as occurred in foreign markets. A logjam during reporting season and the need for ASX to cite each report can slow their publication.

Many boards also meet on the morning of the result’s publication, usually to agree on the declared dividend, before signing off on the accounts. In theory, this practice protects the board against the risk of material information emerging overnight that could affect the accounts, but it can delay the report’s release.

Matheson says this practice may be redundant after ASX Guidance Note 8, which clarifies the term “immediately” to mean “promptly and without delay”, giving boards greater scope to sign off on the accounts after the market closes the day before, facilitating earlier publication the following day. Should material information emerge overnight, companies could then update the market “as quickly as it can be done in the circumstances (acting promptly) and not deferring, postponing or putting it off to a later time (acting without delay).”

Matheson believes that publishing a transcript of analyst and media questions in the conference call for the financial report should also be considered.

“I understand CEOs who don’t want every word of the conference call in black and white, and the time and money required to produce and check transcripts. But publishing the CEO’s answers to questions from professional investors better informs the market and ensures the company is not in breach of continuous disclosure obligations.

“Adding an audio file to PowerPoint company presentations that are published as ASX company announcements would also help investors by providing commentary to explain the slides.”

Matheson says the biggest shortcoming in financial reporting is still too much short-term focus.

“More commentary from companies about how the latest profit report aligns with the long-term strategy and business and the real drivers behind its profitability is needed.

“If investors better understood the big picture and where companies were heading, there would be fewer surprises in good and bad times.”

Matheson adds: “In fairness, the line of sight of companies these days with earnings can be pretty short and boards are understandably reluctant to look too far ahead with guidance, or outline too much of the strategy for competitive reasons.

“Even so, there is a lot of scope for companies to provide more context and better explain their results.”

Or, put another way, there is a significant opportunity to improve the “Why”, “When”, “Where”, “How” and “Who” of financial reporting, so that investors better understand “What” is trying to be achieved in the long run, without exposing the company and its directors to higher legal risks.