Accounting: The key to data

Finance directors who fail to ensure that their companies’ business review is
up to scratch could find themselves up before the Financial Reporting Review
Panel. This may be a remote possibility, but the Accounting Standards Board has
warned finance directors that while the requirement to disclose key performance
indicators is a matter of judgement for the directors, the lack of inclusion of
any KPIs in a business review in the future will provide the FRRP with a
possible indicator that the review may not be compliant with the law.

If the threat of the FRRP seems a little over the top, then it does at least
illustrate how seriously the financial reporting establishment is taking the
subject of narrative reporting. The words in the annual report have been pushed
down the agenda over the past couple of years while the focus has been on the
numbers being cranked out under international financial reporting standards.
Even so, the ASB has been persistent in its pursuit of narrative reporting,
carrying on with its Reporting Statement on the operating and financial review
despite the setback of Chancellor Gordon Brown withdrawing statutory backing for
it.

Even without the legislative support of the prime minister-in-waiting,
companies have been working at their narrative reporting. The ASB is satisfied
that companies are generally complying with the legal requirements, when
measured against the best practice recommendations set out in its Reporting
Statement, but it is determined to raise the bar.

In terms of narrative reporting, companies are measured against two
interlinked yardsticks. First, best practice – the degree to which companies are
adopting the ASB’s Reporting Statement, which is the most complete and
authoritative source of best practice guidance; and second, how companies are
performing in the light of the requirement under the EU Accounts Modernisation
Directive for companies to provide a business review in the directors’ report.

The greatest area of difficulty for companies is the disclosure of
forward-looking information. The pressure on directors to say more about the
future will grow, especially as the proposed safe harbour provisions in the
Companies Act 2006 may encourage companies to provide greater detail as
directors will receive certain protection from liability for statement or
omissions in inter alia the directors’ report.

At the moment, the legislative imperative is vague so the ASB is keen to
dispel confusion and
spell out to corporates what it expects. Companies should be assessing,
discussing and disclosing their key indicators of performance and principal risk
and uncertainties and improve their description of the resources available – in
particular, intangible items such as brand strength, corporate reputation and
natural resources not portrayed in the balance sheet. At the same time companies
need to report on the approach they have taken to the management and mitigation
of principal risk.

The study by the ASB found that the number of risks and uncertainties in its
sample ranged from four to 33. As the ASB put it: “We question whether a company
can really have 33 principal risks and uncertainties.”

In context of the current legal requirement, the business review should be a
balanced and comprehensive analysis “of the development and performance of the
business of the company during the financial year and the position of the
company at the end of the year, consistent with the size and complexity of the
business”.

The law requires that “to the extent necessary for an understanding of the
development and position of the business” and “where appropriate” the business
review must include analysis using non-financial KPIs. In the absence of any
guidelines on preparing a statutory business review, the principles outlined in
the reporting statement are being widely adopted by quoted companies as best
practice in narrative reporting when preparing their annual report. Companies
that ignore the reporting statement could find themselves tangling with the
FRRP.

Non-financial KPIs are the stumbling blocks for UK corporates at the moment.
The evidence from the independent surveys suggest that a little over half of
companies do specifically identify financial KPIs, while other surveys suggest
that many companies fail to distinguish between financial and non-financial KPIs
and over half fail to identify any non-financial information.

All the evidence suggests that narrative reporting is still evolving and that
there is a
willingness among many companies to go beyond the strict legal requirements.
Companies are good at describing their business and markets together with
strategies and objectives and are keen to report on environmental and social
issues. Where they are genuinely struggling is how to report on the future –
measures and indicators, risks and intangibles. Companies have to continue to
engage with these areas as part of the process of achieving transparent and open
communication with shareholders.