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Narrative Reporting - The Power in the Message

In the current times of economic uncertainty companies are confronted with risks and challenges that would never have been encountered in periods of robust economic sustainability and growth. It is during times such as these that the need for transparency and high quality annual reports is of a heightened level of importance to investors and other stakeholders.

The publication of a number of documents in recent times has a focus on how to improve the quality of narrative disclosure and make it more meaningful for such interested parties in making fundamental decisions on assessment of performance and allocation of resources.

Reducing Complexity in Corporate Reporting

The Financial Reporting Council (FRC) in the UK published in June a Discussion Paper (DP) "Louder than Words: Principles and Actions for Making Corporate Reporting Less Complex and More Relevant" which seeks to address growing concerns about the complexity of corporate reporting. Many people point to the increasing length and detail of annual reports as evidence that we have a problem. The DP recognises that there is no easy solution and that change will only happen if all of those involved in corporate reporting make a concerted effort.

The DP recommends a commonsense approach to reducing complexity, based on a number of guiding principles, for better communication in reports and for improving the quality and effectiveness of regulations. Some of these are:-

  • Highlight important messages - avoid distracting readers with immaterial clutter
  • Provide a balanced explanation of the results - the good news and the bad
  • Use plain language with only well-defined and consistent terminology
  • Get the point across with a report that holds the reader's attention
  • Regulations should focus on significant problems and achieve a cost/benefit balance

In pursuing these principles, the objective is to reduce the complexity of compiling reports for the preparer and achieve improved relevance and better communication for the user.

Rising to the Challenge

A report "hot off the presses" from the Accounting Standards Board (ASB) -"Rising to the Challenge" - comments on its review of narrative reporting of 50 UK listed companies in 2008 and 2009. The review found that the best reporters continued to evolve their narrative reporting, not alone commenting on financial performance and position, but also articulating clearly the strategy of the group. In overall terms, those companies with the best narrative reports were those that included clear disclosure of the business model, which became the platform for stronger disclosures in a number of key areas.

The review found that some companies continue to struggle to meet some of the requirements, notably the communication of principal risks and uncertainties. The ASB concern is that while the majority of companies are technically compliant, a number of companies resorted to providing descriptions of generic risks - "boiler-plating", which was of little practical relevance to the specific circumstances of the companies concerned. There was also much clutter in reporting in this area, which defeats the objective of providing clear disclosure, with one company having 33 risks and 8 companies 20 or more.

Some key points to assist companies in rising to the challenge of narrative reporting have been summarised in the list of "do's and don'ts" in such areas as:

  • Business model - discussion of processes, distribution methods and structure
  • Strategy - what your goals are and how you plan to achieve them
  • Principle risks and uncertainties - what is changing, are they increasing
  • KPIs - use to demonstrate progress against stated objectives and strategies
  • KPIs - include non-financial KPIs to explain how the key drivers of the business are monitored
  • Industry trends - support with objective external evidence

A Telling Performance - Survey of Narrative Reporting

A recent report by Deloitte UK based on a survey of narrative reporting in the annual reports of 130 UK listed companies supports the findings of both the FRC and the ASB reports referred to above both with regard to the length of the reports and the many areas where there is scope for improvement. It also comments on the issues encountered by many companies in relation to corporate governance disclosures. On a more positive note, it comments that on a year on year basis there has been a significant improvement in the number of companies discussing their capital structure and financing, treasury policies and current and prospective liquidity. In addition, many companies took on board voluntarily the proposals in the draft guidance on going concern published by the FRC in November 2008.

Future Developments

A number of initiatives are currently taking place which will impact on narrative reporting in 2009 and beyond. These include:-

Going Concern

In October, the FRC published updated guidance for directors of UK companies for periods ending on or after 31 December 2009, the draft of which was published in November 2008. The guidance is founded on three principles:-

  • Assessing going concern - with companies required to make and document a rigorous assessment of whether the company is a going concern when preparing annual and half-yearly financial statements
  • The review period - the review should usually cover a period of at least twelve months from the date of approval of the financial statements
  • Disclosure - directors should make balanced, proportionate and clear disclosures about going concern for the financial statements to give a true and fair view. The guidance includes illustrative examples of the nature of these disclosures depending on the particular circumstances of the company

Corporate Governance

A review of the Combined Code by the FRC is in progress to consider the positives and negatives of the application of the Code currently in place. The current approach adopted is a "comply or explain" mechanism and the effectiveness of this is a significant part of the review. A progress report was published in July 2009.

A separate review has been carried out of the corporate governance arrangements of the UK banking industry. Proposed recommendations arising from this, with an invitation to comment, were published in July 2009. These seek to address weaknesses in risk management, board quality and practice, control of remuneration and exercise of ownership rights. Final recommendations are expected this month. The application of the recommendations to non-financial companies is currently being considered by the FRC, with a view towards a revised code taking effect in mid-2010.

IASB - Management Commentary

In June 2009 the IASB issued an exposure draft of proposed guidance to assist management in preparing decision-useful management commentary to accompany financial statements. The IASB proposals are founded on the principles that management commentary should:-

  • Discuss and analyse the entity's performance, position and development 'through the eyes of management'
  • Supplement and complement information contained in the financial statements
  • Have an orientation to the future - to communicate, from management's perspective, the direction the entity is taking

The proposals are also mindful that information included in the management commentary should directly correlate with disclosures made in the financial statements "through the eyes of management" in such areas as financial instruments and operating segments.

The guidance to be published by the IASB will be non-binding which has attracted some criticism that it will not result in an improvement in financial reporting. While this is possible, it is to be expected that companies which give high priority to the information needs of their stakeholder groups will give due consideration to the guiding principles.

With many companies already planning the outlines of their 2009 annual reports, it is without doubt that those who give priority attention to transparency and high quality reporting will stand in good stead to maintain the loyalty of their investors and other stakeholders.

Brendan Sheridan, Director of Financial Reporting Services, Deloitte