Financial Reporting - Reflect economic conditions
The extent and speed of deterioration of economic conditions has heightened the need for companies to consider in great detail and perhaps refresh and possibly change their view and approach to areas of their financial statements which are subject to estimation and judgement. Particular attention also needs to be given to areas which are sensitive to changes in underlying assumptions that may impact an entity’s reported performance. Greater attention is also warranted in many cases to the disclosure and description of principal risks and uncertainties in the directors’ report, writes Brendan Sheridan.
Looking forward to 2009 reporting by listed companies it is without doubt that those companies that achieve a high level of quality and transparency of financial reporting, particularly in those areas where the factors referred to above are fundamental, will have a better chance of retaining the loyalty of investors and engaging successfully in capital markets.
Brendan Sheridan
Brendan Sheridan

In recent weeks, the U.K. Financial Reporting Review Panel (FRRP) published its Activity Report for the year to 31 March 2009, covering the review of financial statements for financial periods ending from December 2007 to June 2008.

The report summarises the findings of the FRRP’s reviews in the context of the continuing dislocation of the markets and the impact that this has on financial reporting.

Many of the comments are similar to those of the Irish Auditing and Accounting Supervisory Authority (IAASA) in its 2008 Annual Report which was published in June. This covered the first period that annual and interim financial statements were subject to review by IAASA and, as stated in its report, the scope was limited by this as the annual financial statements of many companies, including those with December year ends, were not subject to review in 2008.

FRRP Activity Report - Overall Summary

The FRRP reviewed 326 sets of financial statements, 281 annual and 45 half-yearly and letters were issued in 112 cases.

While a number of issues were raised by those reviews, the FRRP concluded that the current standard of corporate reporting in the UK remains good with evidence of continuing improvement in the general quality of IFRS financial reporting. Market pressure and peer consensus coupled with increased familiarity with reporting requirements are seen to have encouraged the development of good practices.

The FRRP reports draws particular attention to the following areas of disclosure:-

- Principal risks and uncertainties
- Liquidity
- Management judgements and key estimation uncertainties
- Capital
- Impairment of assets

It also comments on a number of other financial reporting matters and for the purposes of this article the focus will be on the annual financial statements.

Areas of Particular Attention
Each of the areas, as listed above, are of particular significance in times of economic difficulty and the FRRP justifiably expresses its expectation that disclosures should be rather more detailed than in periods of economic growth.

Principal Risks and Uncertainties
In its report issued in October 2008 the FRRP noted that such disclosures were likely to warrant greater attention during the forthcoming busy season, including December 2008 year ends, with some companies considering risks that it had rarely if ever previously encountered. The FRRP raised concerns with a number of entities regarding the adequacy of disclosures in their 2008 annual reports. A small number of companies did not appear to give any clear information, or provided a list of risks without any proper description. In some cases the description was sometimes generic and the amount of detail provided insufficient to enable users to appreciate the specific nature of the risks that companies faced and the impact of any of them crystallising.

The disclosure provided by non-financial companies about the types of risks they are exposed to and the ways in which they are managing them tended to be ‘boiler-plate’. This is particularly unsatisfactory given that the summarised quantitative information given about exposure to risks e.g. credit, liquidity and market risk should be based on the information provided internally to key management personnel.

The report comments on a number of specific disclosure areas raised with companies where there is considerable scope for improvement. These include ageing and quality of financial assets, sensitivity analysis and the amount of impairment loss for each class of financial asset.

Management Judgements and Key Estimation Uncertainties
This areas was considered to have somewhat improved since the previous year reported by the FRRP. However, the FRRP continued to challenge directors where they had clearly applied judgement in areas that were very significant but which did not appear to be appropriately highlighted in the report.

The FRRP also commented in a number of cases where disclosure was considered inadequate to explain and provide sensitivity analysis of key assumptions and other major sources of estimation uncertainty that have a significant risk of causing a material adjustment to the carrying amount of assets and liabilities in the next financial year.

Amendments to standards require additional disclosures to help users of financial statements evaluate the company’s objectives, policies and processes for managing capital.

The FRRP considered that compliance with these requirements was poor except for financial services companies. Some companies had overlooked the disclosures entirely. Others did not first establish what they manage as capital which meant that the subsequent disclosures were not particularly meaningful. There was also some evidence of ‘boiler-plating’ which is particularly inappropriate given that the disclosures are required to be based on management information used by the company.

Impairment of Assets
The Financial Reporting Council (FRC) reported in October 2008 regarding the results of a study of information published by a sample of UK companies about their assessment of and disclosure regarding impairment of goodwill.

The FRRP announced in December 2008 that it was conducting a targeted review of impairment disclosures in 30 pre-selected companies and in July 2009 announced the completion of this review with 22 of the 30 companies improving the quality of disclosures particularly regarding reasonably possible changes in assumptions that could trigger an impairment charge.

- The FRRP general review identified a number of shortcomings
- Absence of disclosure of growth rates used in cash flow projections
- Vague information on key assumptions used
- Reference to reasonably possible changes to the assumptions leading to future impairment often tended to be generic rather than company-specific.

There continues to be scope for considerable improvement in this area.

Annual Financial Statements - Other matters

Some of the other matters commented on in the report include:-
Scope for improvement in disclosure of accounting policies in terms of removing boiler-plate narrative, eliminating redundant policies, and ensuring that policies are disclosed in respect of all material items
Adequacy of policies to explain basis on which management recognises its significant revenue streams
Explanation of rationale and judgements applied where the status of an investment changed, including special purpose entities

The period covered by the review was a period of severe deterioration in capital markets which increased the challenges facing directors preparing company financial statements. The robustness of corporate strategies and the fundamental assumptions on which financial statements are produced have been significantly tested and questions do exist as to whether the marketplace has been adequately informed regarding the extent of change that this has brought about and, in many cases, the deterioration in financial condition that many entities have suffered.

The FRRP report, together with that of IAASA, draws attention to areas of financial reporting where there is significant scope for improvement. Companies which make the effort required to ensure that their financial statements are presented in a clear and transparent manner increase their possibilities of being rewarded with the trust and support of investors and other stakeholders.
Brendan Sheridan is technical director at Deloitte.