Annual Reports - A Quest for Clarity

The average length of annual reports has almost doubled in the past decade, with many annual reports extending to hundreds of pages. The longest of those surveyed by our firm in the U.K. in 2010 was 496 pages. It seems little wonder that there is a louder and louder call for a fresh look at the sheer scale of narrative reporting and disclosure included in the majority of annual reports in the current environment, and whether companies are meeting responsibilities to their stakeholders for clear communication.

A similar increase in volume may be seen in relation to interim reports with the Deloitte survey report 'Six of One' commenting that if one takes the average interim report from 1999 and multiply it by six it is shorter in length than the 2010 equivalent report.

In response to these burgeoning increases in volume and complexity, both the International Accounting Standards Board (IASB) and the U.K. Financial Reporting Council (FRC) have been active in commencing a process to address how to improve the clarity of reporting.

Losing the excess baggage
In July a joint working group comprised of senior members of both the Institute of Chartered Accountants in Scotland and the New Zealand Institute of Chartered Accountants submitted their report to the IASB - 'Losing the Excess Baggage'. The report was commissioned earlier this year by the IASB to review the disclosure requirements in existing IFRS and to recommend an approach to reduce the volume of mandatorily provided information.

The working group went about its task with a focus on (a) deleting specific requirements, and (b) enhancing the use of materiality in financial reporting disclosures, in the context of using the principles in the IASB 'Conceptual Framework for Financial Reporting.

The view firmly expressed is that disclosures in financial reporting standards should be considered in the context of meeting the needs of the maximum number of primary users. This means that they should not include extensive additional information for any particular sub-set of users, because to do so would result in lengthy detailed disclosures that reduce the usefulness of the financial statements to the majority of primary users.

Disclosures should help 'tell the story' about the performance, position and prospects of the entity and should be in clear, concise and plain language.

The application of the materiality concept should be looked at in detail and the group proposes that users of IFRS should in the future consider separately (i) whether an item is material, and (ii) whether individual pieces of information in relation to a particular item are sufficiently material to warrant specific disclosure in the notes.

While a disclosure regime based upon a single principles-based disclosure standard may be an appropriate future objective, it would seem best for now to retain a framework of detailed disclosure requirements giving more cognisance to a refined application of the materiality concept. Such a framework provides useful guidance to preparers and auditors to meet the overall disclosure objective for each standard.

The European Financial Reporting Advisory Group (EFRAG) has also undertaken a project on the process to develop disclosures with the objective to stimulate debate on how they should be made more relevant to users while at the same time only useful information is disclosed.

Cutting clutter
Earlier this year the U.K. Financial Reporting Council undertook a similar study and published its consultation document - 'Cutting Clutter in Annual Reports'. The two major problem areas giving rise to clutter are considered to be

• Immaterial disclosures that inhibit the ability to identify and understand relevant information, and
• Explanatory information that remains unchanged from year to year

In a previous FRC report 'Louder than Words' those surveyed gave a number of reasons for 'kitchen sink' reporting, most of which were the result of behavioural barriers. All of those involved in the annual report process are seen to be influenced by others' behaviours, the combined effect often being a barrier to cutting clutter. A prime example of this is a lack of agreement over what materiality means from a disclosure perspective.

The FRC has set out in its report three calls to action to relieve some of the existing barriers to cutting clutter

• Encourage continuing debate around what materiality means from a disclosure perspective
• Investigate how to tackle long-standing explanatory material in printed annual reports
• Engage with stakeholders and regulators around their information requests

The report sets out a number of recommendations and illustrative examples to assist with the process of cutting clutter. The plethora of regulation, accounting standards, big firm guidance manuals and illustrative financial statements place enormous pressure on preparers and auditors to adopt a 'kitchen sink' approach and provide detailed disclosure, sometimes in relation to items which may not be material.

In July the FRC published a document which re-iterates the fundamental principle that financial statements must give a true and fair view. It re-presents Senior Counsel opinion obtained in 2005, on introduction of IFRS, with a core principle enunciated being "It does not follow...that the preparation of financial statements can now be reduced to a mechanistic process of following the relevant standards without the application of objective professional judgement to ensure that those statements give a true and fair view, or achieve a fair presentation." The paper sets out a number of indicators as to how this may be achieved, with perhaps most critical of all being the willingness to apply professional judgement at the end of the process to stand back and critically appraise whether the accounts overall give a true and fair view.

The question that ultimately must be addressed is whether the annual report achieves its primary purpose of providing investors with the information that is useful for making their resource allocation decisions and assessing management's stewardship.

In these challenging times it is critical for companies to commit time and professional resources to ensuring that the single most important communication process, the Annual Report, upholds key business and financial reporting objectives and meets the finest quality standards.

First published in Finance Dublin Online.