ERIC Morecambe famously played all the right notes, but not necessarily in the right order. Narrative reporting – the non-financial context provided alongside financial information in a firm’s annual report – is likewise playing all the right notes, but the result is just as incoherent: it is playing all its notes at the same time. This, at least, is the judgement of over 200 chief financial officers (CFO) interviewed by the Association of Chartered Certified Accountants (ACCA) and Deloitte for a new study on the direction of narrative reporting.
Increasing regulatory complexity, confusion as to what audience the reporting serves and excessive detail have all combined to create a culture that turns narrative reporting into a deafening cacophony of noise for anyone trying to read an annual report. Information overload is seriously hampering its usefulness, claim the CFOs, leading to a “more trees than wood” scenario.
This is disappointing, because narrative reporting has an important role to play in annual reports. Unlike the numbers, the narrative section of the annual report is a company’s opportunity to tell its own story in its own words. They provide a sense of the company in a way that a balance sheet just can’t. Prose can convey a company’s values; its operating environment; corporate governance structure; and strategic direction, amongst other things.
While the narrative report is not necessarily used by the highest-level investors – who are more likely to interrogate the management themselves – it is incredibly valuable to a whole host of other stakeholders, whether they are prospective shareholders, employees or customers. A good narrative report will contain information that should affect investment decisions.
So what’s the problem? As with any information that can be of use for the general public or shareholders, there is a valid case for some form of regulation, even if only to ensure that the information is truthful and to provide a framework for comparison between reports. But the government must be careful to maintain a useful balance between regulation and discretion.
Unfortunately, something has gone wrong with the balance. The ACCA/Deloitte research asked CFOs to identify a key audience for disclosures in a narrative report: 88 per cent said “shareholders” while the figure for “regulators” was 67 per cent. However, when asked what the key drivers for preparing a report were, 83 per cent said “regulation” compared to 82 per cent identifying “shareholders’ needs”.
So, while narrative reports are still seen predominantly as a tool for shareholders, it’s the needs of regulators that are taking precedence in their preparation.
Were the regulation more flexible and balanced, then meeting both the needs of regulators and shareholders wouldn’t be so difficult. However, the regulation is having some unintended consequences. 71 per cent of the CFOs in the study consider the critical challenge in producing a report to be the number of requirements that are placed on its authors, alongside the cost and time involved in producing the report. Significant amounts of time and effort can be spent working on sections of a report to meet regulatory requirements that serve little use to anyone, either by flooding a user with impenetrable detail or, at the other end of the scale, providing nothing more than anodyne, regulator-approved corporate-speak.
The resulting compliance culture leads to reports that ‘tick boxes’ but do not actually make any worthwhile contribution to the overall value of corporate reporting. Box-ticking reports strip out all that is useful from the narrative section; reports can become interchangeable between companies, telling their users nothing new.
The problems here, particularly regarding the growing length of reports, are compounded by the fact that shareholders and regulators want different information from the same source. The CFOs in the study viewed the most important disclosures to include an explanation of financial results, risks and an outline of future plans (see box for detail).
But while all nine of the regulatory jurisdictions looked at by the report (including the US, the UK, Australia, and China) asked for an explanation of the financial results and position, the only other information that they all asked for were remuneration reports and a statement of compliance with corporate governance codes, both seen as of “high importance” to shareholders by less than half of CFOs. But if the regulation is not there to protect shareholders, what is its aim?
Writers of narrative reports are feeling under pressure to be all things to all people. Faced with different demands, they are throwing more and more information at the problem. While the information might not be false, there is too much of it, which obscures the genuinely useful information.
Financial statements themselves should essentially be aimed at providers of capital. Only if there is narrative information that is material and relevant to the understanding of the accounts, should it be included.
The opportunity for more flexibility is also high on the list of desired changes amongst CFOs. Looking to the future, 65 per cent of interviewees said that they would like a reporting environment with more discretion and less regulation. Beyond that, 58 per cent cited the inclusion of external auditor opinion, 57 per cent favoured an emphasis on forward-looking information and 51 per cent wanted International Accounting Standards Board (IASB) guidance.
Those looking for guidance from the IASB are in luck: the organisation is currently working on a framework project for management commentary, which is looking at defining the boundaries of financial reporting.
It would be fair to say that a narrow definition is something that the IASB should consider. Today’s annual reports simply have too many audiences. Almost all the right notes are being hit information-wise, but this is creating a deafening wall of noise for readers. A regulatory refocusing on greater clarity, simplicity and discretion would be welcomed by CFOs, not least because they believe it would benefit the stakeholders whom the reports are meant to serve.
Andrew Leck is head of ACCA UK.
SURVEY | ACCA/DELOITTE
200 CFOs were asked what the five most important disclosures are for shareholders in an annual report
87 per cent: an explanation of financial results and the financial position
67 per cent: identifying the most important risks and their management
64 per cent: an outline of future plans and prospects
60 per cent: a description of the business model
58 per cent: a description of key performance indicators