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What’s Wrong (and Right) with Corporate Reporting

By Julia Penny

In October 2018 the FRC issued its Annual Review of Corporate Governance and Reporting for 2017/18. Interestingly, this was a change in title from the previous one, which was called the Corporate Reporting Review. I have no doubt that the change of title is being used to emphasise that the FRC’s role is about corporate governance as well as corporate reporting and audit. However, the FRC does not currently have a monitoring role for corporate governance statements, so the information gathered is from third party research.


The report starts on a sombre note, with a mention of corporate failures such as Carillion and continuing issues over excessive CEO pay and a lack of transparency or objectivity on judgements and estimation uncertainty. All of these factors have hit the perception of trust in business.

So, what did the FRC find in its reviews of 220 reports and accounts in the year? Not unsurprisingly disclosure of judgements and estimates, together with alternative performance measures (APMs) were the most common areas of concern. These were also identified as issues last year and were subject to a thematic review of judgements and of APMs in 2017.

As well as the continuation of issues with judgements and estimates the FRC saw a rise in basic errors, which they commented on in their open letter to FDs and audit committees chairs. These basic errors included misclassification of cash flows and errors in EPS calculations. Auditors were also criticised for not identifying these errors, which were apparent from desktop reviews of the annual reports.

The report makes clear that it expects companies and their audit committees to have sufficiently robust controls in place to avoid such errors. The FRC also expects that companies complying with the code to disclose any interaction they have had with the FRC (such as the review of their accounts). For some of the disclosures already made by companies the FRC notes that they are not fair or sufficiently detailed representations of the interaction and in future they will be writing to companies where this is the case. 

The FRC sometimes requires a reference to their intervention in the next set of financial statements for the company, in language that they agree with the company. This year there were 15 such references -a huge increase on last year where there were just three. Whether this is indicative of increasing problems with financial statements, or increasing rigour on the part of the FRC, or perhaps both, is to some extent a matter for speculation. But what were the key problems identified?

• Cash flow statements (7 companies) - misanalysis of cash flows generally to increase operating cash flows or in some cases non-cash items being included as cash flows.
• Earnings per share (EPS) (2 companies) – calculation errors
• Impairment calculations error (1 company)
• Consolidation error (1 company) – previous omission of a company under de facto control
• Other errors that the FRC required correction for included:
    - a material prior period error that had merely been recognised in the current year,
    - starting hedge accounting part way through a hedge arrangement without the appropriate conditions being met,
    - an error in classification of continuing versus discontinued activities.

The report sets out the overall findings in respect of the types of error and how they have ranked over time as follows:

 

2017/18

2016/17

2015/16

Judgements & Estimates

1

1

1

Alternative Performance Measures (APMs)

 

2

5

-

Strategic report

3

2

3

Income taxes

4

-

-

Revenue

5

6

2

Business combinations

6

4

-

Impairment of assets

6

7

4

Pensions

8

-

-

Statement of cash flows

9

10

-

Provisions and contingencies

10

-

-

Accounting policies

11

3

6

 

It is telling that despite repeated reminders, the disclosure of information about judgements and estimates still tops the table after three years. The major problem here is the lack of distinction between estimates and judgements, or an incorrect split. An estimate will require information to understand the sensitivity of the item, whereas a judgement does not. This means if an item is disclosed merely as a judgement, readers do not have sufficient information to understand the potential variability of the item.

Examples of judgements that the FRC found were missing from disclosures in the annual report included whether the company was acting as principal or agent, the nature of a pension scheme and the classification of investment property. Those preparing and auditing accounts need to carefully consider what decisions have been made that could have a material impact on the accounts if an alternative conclusion had been reached. This applies, as do many of the other points, to those dealing with UK GAAP as well as IFRS accounts.

Disappointingly disclosure of revenue recognition policies was still found to be weak in many cases. This included only having a policy for sale of goods, even though services sales were clearly significant, and/or not being specific about when revenue was recognised. It also included a lack of clarity or consideration of whether a company was acting as principal or agent.

The FRC have also published a report of their technical findings with illustrations as to the key points to help companies and their auditors improve the standard of reporting. 

The new IFRSs clearly create challenges for companies in implementation and perhaps have caused a distraction from more routine requirements. The FRC will be keeping a close eye on implementation over the coming 2-3 years. 

The FRC has followed up on its initial work on smaller listed and AIM companies and carried out a thematic review on the following areas:

i. APMs and their Strategic Reports;
ii. accounting policies, including critical judgements and estimates;
iii. pension disclosures;
iv. tax disclosures; and
v. cash flow statements.

Corporate governance and narrative reporting

Compliance with the Corporate Governance Code remains high, with 95% of FTSE 350 companies complying with all but one or two of the provisions. Full compliance has risen from 66% to 72% though this doesn’t always mean good governance.

Viability statements, which were introduced in 2014, are still not delivering all the expected benefits, as they are not sufficiently illuminating.

The strategic report guidance has been updated and there are a number of other areas, such as gender pay gap, payment practices etc where specific reporting is required elsewhere. Care should be taken in ensuring the requirements and guidance are properly reflected in the annual reports.

This year’s thematic reviews

The areas that the FRC will focus on this year include:
• Targeted aspects of smaller listed and AIM quoted company reports and accounts
• Effect of the new IFRSs in 2018 interim accounts
• Expected effect of IFRS 16 on leases
• Effect of the UK leaving the EU on companies’ strategic report and disclosures.

Given these areas of focus it will be important to ensure that those involved with preparing accounts or auditing companies affected by the above areas pay careful attention to what is reported in the accounts. 

There is, as you might expect, much more in the report which runs to 70 pages. Engagement partners and managers dealing with listed or public interest entities and to a lesser extent those dealing with large private entities, would do well to read the entire report. As always there are significant challenges in ensuring that everything is dealt with properly in the accounts. 

 

November 2018 

 

Disclaimer
This article is published with the understanding that SWAT UK Limited is not engaged in rendering legal or professional services. The material contained in this article neither purports, nor is intended to be, advice on any particular matter. This article is an aid and cannot be expected to replace professional judgment. SWAT UK accepts no responsibility or liability to any person in respect of anything done or omitted to be done by any such person in reliance, whether sole or partial, upon the whole or any part of the contents of this article.