UK: Governance Clutter

Last Updated: 15 February 2017
Article by John Stittle

There is room for improvement in annual reporting

Perhaps Mark Twain should have been an accountant or chartered secretary. He neatly summed up his distaste of rambling and lengthy writings: 'I didn't have time to write a short letter, so I wrote a long one instead.' His sentiments could equally be applied to the annual reports of many companies. It is often much more difficult to write concisely and in a focused manner.

Admittedly, a significant proportion of the content of annual reports is prescribed by legislation, regulatory requirements and accounting standards, nevertheless, there remains excessive financial and governance 'clutter' being presented, with much being of questionable value.

FRC report

A recent FRC report, examining the quality of corporate reporting, runs to over 56 pages. Some of the issues raised in this report are significant and useful, but like many annual reports themselves, the FRC's own evaluation report could have been more focused and reduced by more than half of its length.

The FRC's Annual Review of Corporate Reports for 2015/16 identifies nine characteristics of good corporate reporting. Among this list includes the importance of identifying risks, providing clarity and being consistent in using performance indicators. Significantly, the report also states the need to 'cut the clutter' – where important and relevant information is 'obscured by immaterial detail.'

For some organisations, such as banking groups, the FRC still has considerable work to do.

Wordy reports

The most recent annual report for HSBC Holdings plc is a massive 502 pages, which includes over 35 pages devoted to explaining the directors' remuneration policies. Other banks produce a (comparatively) slimmer version – Barclays at 356 pages and Lloyds at 311 pages. The Annual Report and Form 20-F 2015 of the oil giant BP is (relatively) slimmer at 266 pages.

Even so, compared with the length of annual reports over the last decade, the annual report and accounts of most companies have been growing substantially both in length and detail. Some of the content is necessary because of the ever-growing and onerous legal, regulatory and accounting requirements but, increasingly, the content of many sections have become unnecessarily verbose, meandering and add little of meaningful value.

In some cases, both the regulatory requirements and especially the voluntary content are almost designed not to convey useful corporate information and provide transparency to investors.

Hiding trees in forests

The vastly detailed content of many annual reports is now seen as the ideal place to 'hide' unfavourable and unhelpful accounting figures. There is often a temptation for accounting numbers that have resulted from poor management decision making or reflect embarrassing failures in corporate strategies, to be 'hidden' or 'camouflaged'.

What better hiding place is there than among some of the highly detailed numerical sections of the annual report – which most users are unlikely to read. After all, the best place to hide a tree is in a forest. The FRC still has far more work to do in removing accounting and regulatory clutter from annual reports.

In its own review, the FRC also states that its mission is to promote 'high quality corporate governance and reporting to foster investment'. Strangely, the FRC initially appears to solely concentrate on highlighting shareholders – many other stakeholders have an interest in reading high quality and useful reports.

The FRC report then explains that because of the 'complexity and breadth' of corporate reporting, it is 'not possible to assess the overall quality of corporate reporting in one sentence.' Ironically, the FRC report then takes 56 pages, interspersed with photographs, to explain that the general standard of company reporting is now 'generally good' but that there is 'room for further improvement.'

Fortunately, the FRC report later states that it recognises that companies do have a wider range of stakeholders than just shareholders. It also acknowledges that shareholders are 'looking for more disclosure in relation to public interest matters.'

The FRC claims that shareholders have a 'growing appetite' for more disclosure on 'climate-related' matters and for 'an improved dialogue with companies on culture.' It states this disclosure should include a 'high quality dialogue' that includes a 'clear description' of the company's 'culture, values and behaviour expectations ...[which] can provide a valuable basis for a deeper conversation.'

Maybe some stakeholders agree with having 'a deeper conversation' – but is the annual report itself really the medium to discuss yet even more topics?

Alternative Performance Measures

More usefully, the FRC report does find more significant issues to raise about corporate reporting. Specifically, it is concerned about the growing trend for companies to report Alternative Performance Measures (APMs). The financial regulator is not satisfied about how APMs are presented in some annual reports and suggests the way these APMs relate to the financial statements can be improved.

For many years, most companies were generally content to conform to accounting rules, which generally only required the presentation or calculation of a limited number of financial performance indicators. These indicators were largely based on operating profit, profit before tax, profit after tax etc, and in providing the basic (and sometimes diluted) earnings per share numbers.

Overall, the past five years have seen an increasing tendency for companies to provide, on a voluntary and largely unregulated basis, APMs based on, for example, adjusted profits, underlying profits or 'look through' profits – which relate to the overall earnings-generating capabilities of a company.

For example, the 2016 annual report of Marks and Spencer Group plc starts with a brief financial overview, which immediately begins by highlighting the company's 'underlying profit before tax'. The Group then splits its annual reporting totals in the Group Income Statement into underlying and non-underlying numbers – certainly not helping clarity and in developing understanding for the interested, but not financially sophisticated, reader.

Likewise, the international drinks group, Diageo, begins its 2016 annual report with financial highlights showing (in percentage terms) both 'reported movement' and 'organic movement' in net sales – where these sales numbers are stated after excluding exchange rate movements, acquisitions and disposals. In addition, the change in earnings per share is presented on a 'reported movement' basis and also on an eps 'before exceptional items' basis.

Tesco also shows its group operating profit before exceptional items and then repeated based on statutory operating profit. But Tesco goes further than Marks and Spencer and Diageo and then introduces a further adjustment for its pension costs. Tesco shows an APM of its diluted eps 'before exceptional items and net pension finance costs'. Most of these various APMs do little to assist understanding and clarity for the reader.

FRC not impressed

The FRC's report does accept that APMs can potentially 'provide a valuable insight into a company and to the extent to which its business model is successful and its objectives achieved.' But the FRC is concerned that insufficient detail is being provided by these adjusted profit numbers and an explanation of why it was considered that the adjusted numbers were thought necessary. The FRC points out that there was evidence of 'possible bias in the choice of adjusting items, for example, to exclude losses but not apparently similar gains.'

The report provides an example of where there can be a 'lack of clarity', when an APM refers to 'profit before tax' – but then this figure is determined and shown on a non-GAAP basis. To make matters worse, the FRC suggests that companies are then portraying this APM profit before tax as being the 'true' result. The FRC is clear: 'the excessive use of underlying profit figures or inappropriate use of alternative performance measures undermine the quality of corporate reporting and erode trust.'

The FRC also examined remuneration reports and pointed out that these reports should be clear, concise and 'provide transparent disclosure' but companies should not unnecessarily add to the length of this section. It points out investors would prefer 'more clarity and brevity' in remuneration reporting. Considering the increasing length of remuneration reports, the FRC certainly has a valid point.

However, for coming financial years there may be some limited improvements in the use of APMs. The European Securities and Markets Authority has issued guidelines applicable to all regulated information, including using APMs in annual reports (but unfortunately excluding the financial statements).

In an open letter in October 2016 to Audit Committee Chairs and Finance Directors, the FRC Chief Executive, Stephen Haddrill, highlighted key aspects of annual reports that companies should try to improve in the coming year. The FRC is seeking to ensure that the strategic report is more user-friendly and presents information clearly and in a concise manner.

When reporting their principle risks and uncertainties, companies are encouraged to consider a 'broad range' of factors affecting the businesses' risks such as cyber-crime threats. Disclosure of tax information that includes greater visibility of the factors affecting taxation rates is also expected.

There is however some good news in the FRC's report. A YouGov poll commissioned by the FRC in 2016 found that, from 224 key stakeholders, 95% of auditors, 91% of directors and 73% of investors have 'high levels of confidence' in the quality of corporate governance and reporting in the UK.

Overall though, the growing danger is that the size of annual reports is becoming too onerous and even self-defeating. Companies need to avoid a cluttered and unfocused annual report with complex performance measures that few readers can understand. When it comes to annual reports, less is so often more.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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