With bank bail outs in full swing, attention will soon turn to the adequacy of financial reporting and disclosure. In particular, were there aspects of reporting that failed to deliver and how can a calamity on the scale of the credit crunch have happened without even so much as a murmur in annual reports and accounts? Gary Simon, FSN’s managing editor looks at some of the issues.
Inevitably events of the last few months will generate questions about the adequacy of corporate reporting, regulatory surveillance and accounting standards. David Phillips, Partner and group reporting expert at PwC agrees. He told FSN, “There is a sense that we will have more regulation but what is needed is smart regulation not just more regulation. We need to stand back from the current situation and think through matters from the bottom up, not just add on to existing regulation which is the normal temptation”.
There is already political pressure to increase regulation and even control remuneration policy of executives in financial services, but there is a distinct danger of making policy ‘on the fly’. If the Enron experience is anything to go by then the last thing that the market needs is some hurriedly rushed and draconian response. Sarbanes Oxley was widely regarded as a sledgehammer to crack a nut and a costly one at that. It has taken a considerable period and extensive lobbying to reign it in to a more acceptable and workable solution.
“What we have learnt from past experience is the need to avoid a knee-jerk reaction. Let’s approach the problem in a considered way, not rushing it and involving the right people, such as, users and preparers of financial statements, auditors, regulators and standard setters,” added Phillips.
Isobel Sharpe, Deloitte partner, also expects more regulation. She told FSN, “I expect more regulation in terms of supervision of banks but I hope the credit crisis does not lead to more accounting rules.”
“I think that the accounting standards setters appreciate that the game is about having appropriate principles in place rather than a detailed checklist of rules. With a rules based approach you miss the next big thing that needs reporting.”
Cautioning against a rush to introduce new accounting rules Sharp said, “Accounting standards setters are committed to a principles based approach both in Europe and in the United Sates, evidenced most recently by the decision to move away from US GAAP. A knee-jerk reaction is rarely the right thing in the medium to long term.”
The difficulty of introducing meaningful change in reporting is perhaps illustrated by the mixed response to the requirements for a twice-yearly Interim Management Statement (IMS) in the UK. The new requirement came from the EU’s Transparency Obligations Directive which was implemented in the UK via the UK Listing Authority’s Disclosure and Transparency Rules (DTR) and is now in effect for all listed companies. According to research conducted by Deloitte, only 9 percent of companies “received a tick in all the compliance boxes”, which begs the question; Is new regulation going to be any more effective at providing the sort of early warning system that many consider is needed?
Commenting to FSN, Isobel Sharp said, “Only 9 percent of companies ticking all of the boxes doesn’t look good but things will improve. The IMS forces companies to keep thinking - it’s a discipline that makes them step back and think – is there anything that we should be telling the market?”
PwC’s Phillips goes further by suggesting that financial reporting in its current form may have run its course. He told FSN, “Looking at reporting in the round we demand too much from financial reporting – measuring outputs only tells us so much. The market is extremely complex and financial reporting provides only limited information around the dynamics of a business model.”
“Perhaps what we need is much more focus on explaining the front end of the business and how value is created. The Enhanced Business Review (EBR) and the Management Discussion and Analysis (MD & A) in the US are becoming a more important part of reporting,” he added.
But when it comes to reporting business performance the evidence suggest that businesses are not very good at it. The IMS, for example, requires “an explanation of material events and transactions” and “a general description of the financial position and performance” during the period covered by the report. But when it came to financial performance, Deloitte’s survey showed that 23 percent of companies sampled linked financial performance to expectations or forecasts but without the use of numeric data. Furthermore another 21 percent provided even more limited information restricted to vague comments such as “at present performing well” or “continuing to perform in line with management expectations.”
Sharp agrees that the disclosures around financial performance are “not very helpful”. Phillips adds, “We need to pay more attention to setting the context in financial reporting. For example, it’s all very well to report turnover growth of 10 percent but if the market is growing at 20 percent it gives us a very different perspective”.
The expected reaction following the credit crunch will be a clamour by politicians and public for more regulation but Phillips maintains that a “compliance mindset” is worthless. “We have to try to change behaviour, helping people to understand that companies that report well are usually well run companies. Businesses that can link strategy and KPI’s to remuneration are more able to demonstrate clarity of thinking,” he adds.
Deloitte’s Sharp added, “Whether companies, for example banks should have been saying anything else in relation to the credit crunch is uncertain. There will be post mortems, but the jury is still out,” she said.
Phillips commented, “Even if we had utopia in reporting we have to accept that companies will fail. We can’t solve the problem through reporting. The credit crunch problem suggests that there were risks in the whole system rather than individual companies. That’s why reporting needs to cover the broader context”.
Phillips is also against ‘one size fits all’ regulation, preferring compliance frameworks that are not too specific so that companies have to judge how much information to disclose. This provides more colour in reporting, he says and provides important signals to the market about the company. Nevertheless he concedes that the lessons of the credit crunch indicate that the pendulum may have swung too far in favour of companies.
“The pendulum may be forced to swing back a little but we need to be smart – providing frameworks rather than prescriptive rules”, he adds.
