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For yet another year, the average length of the Annual Report of listed companies has continued to increase. In many cases, while there may be increased volume of reporting, there continue to be deficiencies in compliance with mandatory disclosure requirements under International Financial Reporting Standards.

The recent financial market crisis has underlined that high quality disclosures are a critical component in maintaining market confidence. During more difficult market conditions, proper disclosure of risk areas and those sensitive to volatility is crucial for investors and other users of financial statements.

Several reports have been published in recent times commenting on the quality of financial reporting and where there is scope for improvement. Two of these are referred to here, the first a Deloitte review and the second a review carried out by The Committee of European Securities Regulators (CESR) of European financial institutions.

Finishing (in) figures

A Deloitte U.K. report, 'Finishing (in) Figures', is based on a survey of the published annual reports of 130 listed entities, including 30 investment trusts, and is the second in the series with 'Louder than Words', referred to in a previous article, commenting on narrative reporting by the same 130 entities. The report indicates that financial statements have increased in average length by 6% year on year, and by 57% since 2005. Annual reports ranged from 32 to 469 pages with the financial statements covering from 16 to 230 pages.

Increased length of reporting may not be a surprise to many observers given that difficult market conditions would have called on many companies to provide more extensive disclosure to explain the impact of increased volatility on their reported performance and financial position. However, as the length of financial statements continues to increase, there is a risk that they cease to be an effective means of communicating with investors.

Has increased length meant improved disclosure? Undoubtedly, with improved familiarity with IFRS requirements, peer pressure and market demands, many companies have improved the quality of disclosures. However, the Deloitte report highlights common issues identified in a number of financial statements reviewed, some of which are 'hardy annuals'. These include:-

  • Accounting policies - are unclear or inappropriate which may be the result of 'boiler-plating' or the retention of redundant policies
  • Management judgements - there is difficulty in understanding the extent to which directors' judgement has been applied and its effect on the amounts reported
  • Estimates - limited insight into the impact of reasonably possible alternative estimation assumptions on the company's financial position
  • Impact of economic conditions - the financial statements do not explain the impact of continuing economic, liquidity and market conditions on the company
  • Missing disclosures - the financial statements fail to provide disclosure on material balances

The report urges companies to carry out a regular review of the 'big picture' to help ensure that the financial statements are logically structured and easy to navigate, with clear and consistent linkage to the narrative reporting in the annual report. Two areas where this may be of particular significance, given that they are intended to be based on information provided internally to key management personnel (chief operating decision maker), are IFRS 7 'Financial Instruments - Disclosures' and IFRS 8 'Operating Segments'. Deloitte has a number of resources available to provide support in dealing with such issues including www.iasplus.com and the IGAAP 2010 publications which include pro-forma financial statements and other guidance.

IFRS 7 - reporting deficiencies

While IFRS 7 is of significance to all listed entities, it is possibly even of more significance to the understanding of the financial statements of financial institutions.

A recent report by CESR expresses concern that a significant proportion of companies failed to comply with mandatory disclosure requirements relating to financial instruments, for example regarding the use of valuation techniques and on relationships with special purpose entities. The CESR report is based on a review of the 2008 year-end financial statements of 96 European listed banks and/or insurers. While deficiencies were identified, a positive finding was that a significant number of financial institutions had, in addition to compliance with mandatory disclosure requirements, provided additional disclosures in line with recommendations published in late 2008 by various organisations such as the IASB Expert Advisory Panel and the Financial Stability Forum.

The review carried out by CESR was over five main headings:-

  • Categories of financial assets and financial liabilities
  • Financial assets and financial liabilities at fair value and their carrying amount
  • Risks arising from financial instruments
  • Special purpose entities (SPEs)
  • Impairment of financial instruments

Some of the more detailed findings of the CESR review were:-

  • Around 20% of all entities did not disclose the methods applied when using valuation techniques to determine fair value of financial instruments in an inactive market
  • Around 50% of all entities did not provide a fair value reconciliation between opening and closing positions
  • Around 20% of entities did not disclose how special purpose entities (SPEs) were controlled
  • Around 20% of entities have not disclosed criteria used to determine impairment losses

CESR and its Members believe that compliance with disclosure requirements on financial instruments is key for users of financial statements in understanding the financial position and performance of a financial institution, and will continue to assess compliance by financial institutions with those disclosure requirements.

Lessons learned - disclosure guidelines

The Committee of European Banking Supervisors (CEBS) has published for public consultation its draft disclosure guidelines intended to help financial institutions improve their risk disclosures in the wake of the financial crisis. CEBS believes that the guidelines can be useful when related to activities that warrant particular attention, irrespective of the economic environment. While directed towards banks and similar financial institutions, the proposed guidelines emphasise many broad principles which could provide useful direction for a wide range of entities.

The disclosure guidelines are divided into three different parts:-

  • General principles to be applied to high quality disclosures
  • Principles dealing with the content of disclosures on areas or activities under stress, with particular regard to business models, impacts on results and risk exposures, impacts on financial positions, risk management and sensitive accounting issues
  • Presentational aspects of disclosure

The general principles that CEBS has put forward are as follows:-

  • Financial institutions should provide timely and up to date information irrespective of the timing of their normal publication calendar
  • In order to enhance the quality of information, financial institutions should provide adequate disclosures on areas of uncertainty
  • Financial institutions should provide comprehensive and meaningful information that fully describes their financial situation
  • Disclosures should allow comparisons over time and between institutions
  • Financial institutions should seek to early adopt new disclosure standards and best practice recommendations from standard-setters and regulators
  • Financial institutions should specify whether and to what extent information has been verified by external auditors

In addition to the general principles, the proposed guidelines make recommendations under five headings in relation to the content of disclosures and under a further six headings in relation to presentation issues.

Financial reporting requirements continue to grow in number and complexity. Establishing a process to ensure compliance with all accounting standards, company law and, where applicable, regulatory requirements is essential. Without one there is a risk that companies fail to meet straightforward disclosure requirements and provide insufficient detail for a user to understand the impact of material transactions on the company's financial position or performance.

Brendan Sheridan, Director of Financial Reporting Services, Deloitte