Risk - do annual reports have adequate disclosure?

The events of recent years have highlighted still further that investors need to have confidence in the integrity of the narrative and financial information that they receive in the Annual Report. At a time when business and the provision of finance is becoming increasingly complex and globalised, investors and other stakeholders require reliable in-depth information about the business of a company, its strategy, the risks to its success and the ways in which it manages those risks.

Comment continues on the disclosure burden imposed by accounting requirements. With many new standards on their way over the next few years, in areas such as revenue, leasing, financial instruments, consolidation and others, there is potential for still more disclosure. Even greater clutter has the possibility of undermining the clarity of the main messages in the annual report and the ability of the user to digest and understand the information provided.

Observations on selected fnancial reporting issues
The Irish Auditing and Accounting Supervisory Authority (IAASA) recently published an observations document which is directed towards issuers for financial years ending on or after 31 December 2010.

IAASA comments that the risks and uncertainties of the domestic and international economic environments place particular emphasis on the critical importance of estimates and judgements made in preparing financial reports and the role played by Boards and Audit Committees on considering and approving issuers' periodic financial reports.

Among the matters commented on in its document are two which may be considered of particular significance in this context, being:

• 'Front-end' reporting should be user-needs driven and not 'boilerplate' and should be consistent with other elements of periodic financial reports. Boards and Audit Committees are, therefore, encouraged to carefully consider the contents of their reports, in particular that they are comprehensive, balanced and reflective of the size and complexity of the business. The Practice Statement 'Management Commentary' issued by the International Accounting Standards Board (IASB) in December provides further guidance on this
• IAASA's review activity suggests that the quality of issuers' risk reporting varies across the three classes of issuer, with equity issuers in general demonstrating a higher standard of compliance. However, given the challenging economic environment IAASA will remain focused on the standard of risk reporting and, particularly, whether it addresses user needs. Some of the risk areas commented on in IAASA's observations include: 
  • Disclosure of the credit quality of assets 
  • Explanation of the entity's liquidity strategy and the risks to that strategy
  • Identification of concentration risk - type of assets held, maturity of assets, sources of funding, counterparties and others

IAASA encourages Boards and Audit Committees to be vigilant regarding disclosures provided in respect of risks to enable investors and others to properly understand the position. Sensitivity analysis based on reliable assumptions is an important part of the process. The disclosures provided must communicate clearly the principal risk exposures, changes, if any, to those risks that have occurred during the period and changes, if any, in the manner in which those risks are managed/mitigated.

The IAASA document expresses its observations on a wide range of areas where there is considerable scope for improvement, and provides useful direction for all involved in the financial statements process.

Enhancing company reporting
The U.K. Financial Reporting Council (FRC) has recently published a report outlining recommendations aimed at improving the dialogue between company boards and their shareholders. The report responds to the lessons of the financial crisis and builds on changes made in corporate governance codes in both Ireland and the UK during 2010.

Research by the FRC, which underlies the report, shows that many companies fall short of meeting reporting and disclosure requirements, with one of the major shortcomings being the reporting of principal risks and uncertainties. The FRC reinforces the understanding that directors should take full responsibility for ensuring that an Annual Report, viewed as a whole, provides a fair and balanced report on their stewardship of the business.

In recent days the UK Financial Reporting Review Panel (FRRP) has also expressed concern about how companies are reporting the principal risks and uncertainties facing their business. While the FRRP comments are addressed to UK companies, the comments made by them are equally appropriate to Irish companies.

The FRRP encourages boards of directors to consider their disclosure of the principal risks and uncertainties facing their businesses by considering the following questions:

• Do the disclosures state clearly which are the principal risks and uncertainties facing the business?
• Are those risks and uncertainties described as principal the main risks and uncertainties that currently face the business? For example, have the risks and uncertainties listed as principal been the subject of recent discussions at board or audit committee meetings? Are there risks which have been the subject of such discussions which should be considered as principal?
• Is the description of each principal risk and uncertainty sufficient for shareholders to understand the nature of that risk or uncertainty and how it might affect the company?
• Are the principal risks and uncertainties described in a manner consistent with the way in which they are discussed within the company?
• Are the principal risks and uncertainties shown consistent with the rest of the report and accounts? Are there risks and uncertainties on the list which are not referred to elsewhere or are there significant risks and uncertainties discussed elsewhere which do not appear on the list?
• Is there a description, in the directors' report, or elsewhere in the report and accounts and explicitly cross-referenced from the directors' report, of how the company manages each of the principal risks and uncertainties?

The FRRP chairman comments that Boards who retreat behind 'boilerplate' disclosure give the impression that they have not themselves understood the risks they face.

Capital management
The financial crisis has heightened the need for effective capital management and the risk of insufficient liquidity can undermine an entity's ability to develop and manage a robust business model.

Disclosures about capital and how it is managed are fundamental to a balanced and comprehensive business review. In 2009, the FRC supported this by revising the guidance for directors and auditors about making going concern assessments. In December 2010, the Accounting Standards Board (ASB) has published its findings from a study to encourage a better dialogue about capital management through improvements to financial reporting. The study carried out shows that disclosures provided by many companies in their business review were either boilerplate or scant and uninformative.

The study seeks to identify the extent of the disclosures being made by companies, to draw attention to better practices and to reduce the risks of 'boilerplate' text.

In current market conditions, for many, debt/equity ratios and the optimal levels of equity capital will be significantly influenced by a need to preserve debt ratings, protect covenant triggers and/or provide access to additional capital. Investors and users will expect disclosure of how the entity is positioned with regard to these matters.

The Deloitte publication 'Drowning by Numbers', and its accompanying publication 'Swimming in Words' are based on a survey of the narrative reporting and financial statements of 100 U.K. listed companies. While there is evidence of continuing improvement in the quality of annual reports, the publications highlight many areas where there is much still to do to avoid clutter and focus on key areas of importance to investors and other stakeholders.

It is particularly important that directors explain clearly how they identify and manage risk and it will be of interest to see whether the annual reporting season currently underway will show improvement in the quality of information.

First published in Finance Dublin online