Accounting: Well read

From the beginning of September the Financial Reporting Review Panel started
to read directors’ reports. In what amounts to the biggest step forward in its
remit since it was founded, it now has responsibility for the words in the
annual report as well as the numbers.

The FRRP has not changed its process for selecting accounts for review.
Accounts under the FRRP’s remit are those of listed and large private companies.
But since the FRRP was beefed up in a bid to become proactive rather than merely
reactive, it has taken to announcing it will look at sectors that it thinks
warrant special mention. Under the FRRP’s risk-based approach, the five sectors
announced at the start of 2007 for special attention were travel and leisure,
retail, utility, telecommunications and media. Companies which have also hit the
media spotlight, or been the subject of a specific complaint, will also get the
FRRP reviewers opening the accounts and reading the business review along with
the rest of the report and accounts.

The FRRP is keen to stress that perusing the business review is an extension
of the scope of its review, rather than a change in its role. It will be
examined in the context of a review of the whole report and accounts.

To a certain extent, the FRRP’s stated approach follows on from the
non-mandatory Reporting Statement: Operating and financial review published by
its sister body, the Accounting Standards Board (ASB). Given that it is
non-mandatory the FRRP could, by definition, not demand 100% take up. But the
FRRP promises that where a company states that it has voluntarily complied with
the statement, it will take this into account in its review. Such a promise is
bound to increase the take up of the reporting statement by companies. The ASB
has put much thought and work into the reporting statement and has fought a long
and persistent battle since its inception in the early 1990s to place narrative
reporting higher up the financial reporting agenda. Its latest act to keep the
issue alive was publication of research into the state of narrative reporting in
the UK.

Where breaches of the Companies Act are discovered by the FRRP, its public
stance is to take corrective action that is “proportionate to the nature and
effect of the defects, taking account of market and user needs”. Where the
accounts are materially defective, the FRRP has so far been successful at
getting companies to voluntarily make good the defects. The watchdog power of
resorting to the courts has never been tested. If court action has never been
instigated over figures (even allowing for the judgement involved in arriving at
the numbers in accounts), it is hard to envisage the FRRP and a company falling
out over a narrative description.

However, company directors should not start to assume that words don’t
matter. The FRRP has highlighted half a dozen factors that it will be looking
for as it pores over the business review. In particular, the FRRP is looking for
consistency between the words in the review and the figures in the accounts. It
is warning the authors of company reports that it expects the business review to
be “balanced and comprehensive in the sense that it deals even-handedly with the
positive and the negative aspects of the development, performance and position
of the business.”

There are two main features that business reviews must now contain. First,
companies have to discuss the risk and uncertainties facing the companies and
identify to the readers which the directors consider to be the principal risks.
Second, FDs must ensure that the review contains appropriate analysis using
“those key performance indicators (KPIs) necessary to provide an understanding
of the development, performance and position of the business.”

It is the question of KPIs which is making FDs sweat the most. The early 2007
ASB research found that it was producing meaningful KPIs that companies
struggled with most. And companies can’t say they weren’t warned. When the
research was published it was made crystal clear that no KPIs in a business
review would be a strong indicator to the FRRP that it did not comply with the
law.

FDs aren’t daft. Given the solid track record of compliance with financial
reporting requirements by UK companies, it is a racing certainty that KPIs have
been carefully thought out. There is also evidence that they are making an
impact on preparers. A survey among FTSE-350 companies, published recently by
corporate reporting agency Black Sun, found that two-thirds of respondents
believe that reporting KPIs is helping the board understand which KPIs are right
for their business. And almost half said that increased transparency is leading
to better use of KPIs by the boards.

If this is true, then the FRRP oversight of business reviews could be leading
to a closer alignment of management reporting and external reporting and
improved investor and analyst understanding of the strategy of the company and
its performance. To achieve such a prize by a simple extension of the FRRP remit
words would be remarkable.