How financial reporting can help promote public confidence and trust

Financial Reporting Brief December 2019

This article 'Financial Reporting – Promote Public Confidence and Trust' considers the importance of financial reporting to the public perception of business and current developments in reporting.

The financial reporting process helps to create trust, but it, in turn, has to be trusted. The importance of trust needs to be recognised by those engaged in financial reporting. There remains considerable scope for companies to improve their reporting to address matters of increasing concern to investors and enhance public trust in business.

The Irish and Accounting Supervisory Authority (IAASA), established under Irish Company Law, has a number of primary objectives, with a key one of these being to support and enhance public confidence in the accountancy profession and in financial reporting through the promotion of adherence to high professional standards and the provision of high quality advice to the relevant Minister. It aims to achieve this through effective, independent supervision and, where appropriate, enforcement action.

IAASA’s enforcement priorities, policies and methodologies are aligned with the enforcement priorities set by the European Securities and Markets Authority (ESMA). ESMA is an independent EU Authority that contributes to safeguarding the stability of the European Union’s financial system by enhancing the protection of investors and promoting stable and orderly financial markets. It achieves this by assessing risks to investors, markets and financial stability, completing a single rulebook for EU financial markets, promoting supervisory convergence and directly supervising credit rating agencies and trade repositories.

ESMA leads a European System of Financial Supervision (ESFS) which operates through a decentralised network of National Enforcers. Each EU Member State has its own National Enforcer, with IAASA and the Financial Reporting Council (FRC) holding the position in Ireland and the UK respectively. National enforcement activities reflect both national and European common enforcement priorities.

With the year end almost upon us, the reporting season will be moving up gear for many companies and there is a lot happening in terms of new standards and other developments that companies need to deal with in their annual corporate reporting. It is important to be very much aware of what the supervisors are highlighting as priority areas both with regard to here in Ireland and at the broader European level. For many reasons, it is also of value to consider what is coming through from the relevant UK Authority, the Financial Reporting Council (FRC).

Common Enforcement Priorities
ESMA issued a public statement in October setting out its common enforcement priorities that European enforcers will consider when examining the 2019 annual financial reports of listed companies. These are:

Specific issues related to the application of IFRS 16: Leasing
Follow up of specific issues related to the application of IFRS 9 ‘Financial Instruments’ and IFRS 15 ‘Revenue’
Specific issues related to application of IAS 12, including IFRIC 23 ‘Uncertainty over Income Tax Treatments’ and considerations regarding recognition of deferred tax assets

ESMA also highlights the potentially significant implications of transition from one interest benchmark rate to another.

Various other key topics are highlighted including:

Risks and uncertainties associated with Brexit
Focus on environmental matters, including climate change
Alternative performance measures

These topics are generally common themes to both IAASA and the FRC also and have been the subject of much of what has been published in our Financial Reporting Brief series during 2019. We focus in this article on some other matters which are highlighted in the Enforcers’ reports as being priority issues.

Non-Financial Reporting
ESMA expresses the need in its Public Statement to reiterate some general principles with the aim of promoting improvements in the quality of public reporting of non-financial information in relation to social aand enviromental challenges. A prime example of this is Climate Change.

These include:

Materiality: issuers are encouraged to explain how they have determined what is material when preparing the non-financial statement with consideration of both the impact of the non-financial matters on the issuer, including any dependencies, and the impact of the issuer on non-financial matters.
Completeness: issuers need to ensure that the material disclosures address as a minimum each non-financial matter referred to in the Accounting Directive. For each of those matters, the required disclosures include the description of the business model and of the non-financial policies pursued, the related due diligence processes, outcomes of those policies and the principal risks identified.
Balance and Accessibility: ESMA recommends that for all non-financial matters addressed, issuers should provide a balanced depiction of the performance, position and impact of their activity, providing a fair and balanced understanding.

Together with the above-mentioned principles, ESMA also recommends that issuers consider the following specific areas when preparing their non-financial information:

Environmental matters and climate change
Disclosure of relevant key performance indicators
Use of disclosure frameworks
Supply chains

Supplier Financing and Cash Considerations
An area which is receiving heightened attention is supplier financing arrangements, and at a broader level the adequacy of how issuers are reporting on cash, its availability, generation and uses. Both IAASA and the FRC comment in their reports on supply chain financing, including non-recourse factoring or reverse factoring. In its Observations document IAASA notes inadequacies in reporting by those using such financing arrangements including:

Absence of an accounting policy, including the basis on which the associated accounts receivable or accounts payable are recognised and derecognised
Lack of clarity as to the terms, risks and uncertainties connected with such financing facilities
Absence of clarity as to how such facilities are reflected in the cash flow statement

The FRC expresses similar concerns in its report, adding:

Whether the liability is included within KPIs such as net debt
The existence of any concentrations of liquidity risk which could arise from losing the facility

IAASA calls for adequate disclosure of such arrangements and the financial reporting treatments applied so that users have a full appreciation of the impact of such financing solutions.

The FRC makes reference to its Lab report published in September, ‘Disclosures on the Sources and Uses of Cash’, in which it explains that investors want cash disclosures that:

provide a clear description of the drivers of current (and future) performance and position, in the context of cash, supported by appropriate metrics;
explain the sources of cash and the ways in which cash is used; and
describe the processes, controls and sources of assurance in place in relation to cash.

The report encourages companies to look beyond the disclosures that relate to the cash flow statement and address areas such as business model disclosures, capital allocation frameworks and reverse factoring arrangements.

The FRC also expresses concern at the basic errors it continues to see in cash flow statements, with most relating to cash flows being misclassified between operating, investing and financing activities.

Judgements and Estimates
The perennial topic of significant judgements and estimates is here again.
IAASA reiterates the point made before that more detailed and burdensome disclosures are required to meet the requirements in IAS 1.125 that an entity shall disclose information about the assumptions it makes about the future and other major sources of estimation uncertainty which are in respect of those that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year.

In its report, the FRC expresses some satisfaction that there has been improvement with regard to:

Fewer companies failed to clearly distinguish judgements from estimates
Fewer instances of boilerplate or unclear wording
Fewer cases where matters were not disclosed as key judgements or areas of significant estimation uncertainty in the financial statements despite indicators to the contrary elsewhere in the annual report

The FRC expresses hope that there will be continued improvement in these and other related areas. The most frequent area of challenge is a lack of, or inadequate, sensitivity analysis or information about the range of possible outcomes for areas of estimation uncertainty.

The FRC comments that many of the most complex cases raised in recent years relate to consolidation judgements and specifically the question of control over another entity. The FRC emphasises the need for companies to have a full understanding of the rights and obligations – both contractual and constructive – arising from arrangements, in order to assess the criteria for control of another entity and determine correctly whether or not it should be consolidated.

Conclusion
Recent changes to reporting requirements, combined with risks emanating from economic, political and social threats mainly because of Brexit and heightened protectionist policies particularly in the USA, will impose significant challenges on those involved in the preparation, approval and/or review of issuers’ financial reports.

To protect public trust and confidence in business, the quality of corporate reporting together with its transperancy and balance are of paramont importance.