BIS: the future of narrative reporting: a consultation

Comments from ACCA to the Department for Business, Innovation and Skills (BIS), 19 October 2010.

Introductory comments

ACCA is pleased to comment on the consultation paper on the above. The consultation is very timely given the many developments that are currently taking place in this area. 

ACCA has always considered narrative reporting to have great potential for enhancing the understanding of users about the performance and financial position of the reporting entity. The issue is currently one of our priority 'thought leadership' areas of interest. The added value which narrative reporting can bring to corporate reporting is that it can communicate what the directors of the entity have been trying to do, and the relationship between plans and actual performance, and give readers essential information about what the entity is doing to manage the foreseeable trends and events which will have a bearing on its performance in the future. We consider that these matters should be of real interest to shareholders and other informed users of corporate reports, and should help to form the basis for the process of active shareholder engagement now rightly being encouraged by the Financial Reporting Council.    

In the context of creating this wider understanding of a company's position and performance, ACCA is committed to promoting the disclosure, by companies and public bodies alike, of non-financial information where this is relevant and proportionate. We believe, as a matter of principle, that to require entities to report publicly on specified matters acts as an incentive for the entities concerned to take those matters seriously and to improve their practices on a continuing basis. With this aim in mind we have campaigned over a number of years for the obligatory disclosure by relevant entities of information on social and environmental matters, and welcomed the decision to incorporate disclosure requirements on these matters in the Companies Act 2006 and the Climate Change Act 2008. We have participated in and supported the development by the Climate Change Disclosure Board of its new reporting framework, and are actively involved also in the work of the Global Reporting Initiative, Accounting for Sustainability and the International Integrated Reporting Committee. While there is much development work to do, the latter project offers the opportunity, in the medium to long term, to achieve a radical step forward in the scope of corporate reporting. 

We are, accordingly, strongly supportive of the aim of developing reporting frameworks which acknowledge the wider range of factors which have a material bearing on a company's position and performance. In the recent past we supported the development in the UK of the statutory Operating and Financial Review (OFR) and were disappointed when it was withdrawn, though encouraged that much worthwhile material was subsequently incorporated into the Business Review. We have more recently encouraged the IASB to develop its proposed accounting standard on management commentary. 

In this response we offer what we believe is relevant evidence from research we have undertaken ourselves on the perceptions of users. We go on to address the specific consultation questions posed in the consultation document but do not address those specific questions which are clearly aimed at shareholders. 

Independent research on user views on narrative reporting

ACCA is among several organisations that have undertaken research into the quality of narrative reporting and how they are viewed by relevant stakeholders. The Department will doubtless be aware separately of the 2009 study by the Financial Reporting Council and the 2008 survey by PwC, both of which provide very relevant evidence for the current exercise. We concentrate below on the independent work carried out by ACCA.  

In 2004 we commissioned research by Dr David Campbell (Newcastle University) and Richard Slack (Newcastle Business School) into the perceptions of UK market analysts of the value and relevance of narrative reporting. The focus of that project was on all the non-accounts disclosures which were at the time of the research voluntary, such as the chairman's statement, social and environmental reports and risk disclosures. While the then voluntary nature of the disclosures might have had a bearing on the extent and quality of the disclosures made by companies in the sample, the perception of analysts as to their usefulness, for their own purposes, is nonetheless still relevant to discuss here. 

Then in September this year, we published the results of an internationally-based study - Hitting the Right Notes, but What's the Tune - carried out jointly by ACCA and Deloitte's, which looked into the same issue but from the perspective of preparers, and sought to find out what they think they are trying to achieve in the drafting of their narrative reports and whether they think there are factors which either help or hinder them in their efforts. This latter study offers some interesting insights into what companies are doing in jurisdictions other than the UK and how they would like the practice of narrative reporting to evolve. We refer to relevant findings from both these studies at suitable points in this response but the executive summary of the Campbell and Slack research is attached for ease of reference as an Annex to this paper: the paper by ACCA and Deloitte has previously been sent to the Department.   

The views of market analysts

The Slack and Campbell research referred to above is relevant to the current exercise in that it sheds light on how useful narrative reports appear to be to this particular, and important, class of user. While market analysts are not the primary audience for the business review or for narrative reports more generally, they are nonetheless an exceptionally informed constituency who, unlike most shareholders, can be expected to read critically all aspects of the corporate report.  

The study found that analysts did not, on the whole, find the content of narrative reports useful for their own decision-making purposes, although several respondents commented that they were reassured by the fact that the information had been prepared. Respondents to the survey emphasised that their primary interest lay in the information contained in the financial statements. (It will be remembered in any case that analysts are not the primary audience for the business review). The content of the chairman's statement was considered by the analysts to be generally irrelevant to the investment decision or to any forecasting figure. Risk disclosure was generally thought of as being too general in nature to be useful. Social and environmental information was universally considered irrelevant and incapable of influencing a financial forecast: it was rarely read by analysts and any suggestion that the environmental reporting might contain disclosures germane to the description of secondary environmental risk was dismissed. Overall, they were generally sceptical about voluntary narrative reporting and were dismissive of large sections of it as irrelevant, 'useless' or worse.    

These findings are on the whole discouraging for the cause of narrative reporting although, to reiterate, market analysts are not the primary audience for such reports.   

The views of preparers

Hitting the Right Notes surveyed finance leaders in nine separate jurisdictions, covering both established and more developing capital markets. As well as a survey, the research featured interviews with stakeholders, both preparers and representatives of investor groups. The survey sample was selected specially so as to provide both a wide geographical spread and to encompass countries which are on different points on the continuum of global narrative reporting development. The object was to gauge the views of preparers as to the costs and benefits of producing narrative reports in accordance with current requirements.  

The study revealed a lack of a clear understanding among respondents as to the intended character of narrative reporting and what it is supposed to achieve.  IASB, in its recent exposure draft, considers the provision of decision-useful information to existing and potential providers of capital to be the main characteristic of narrative reports (or at least the proposed management commentary statement). But only 29% of respondents to our survey agreed that providing users with information relevant to decision-making was the most important characteristic of their reports. This result is likely to have been influenced by different domestic formulations of what the purpose of the narrative report is intended to be - the UK business review of course requires the review to be framed in way which allows shareholders to assess the director's stewardship. And while 88% of respondents agreed that shareholders (and prospective investors) were of high importance as an audience for the narrative report, 67% gave the same ranking to regulators and (interestingly given the research by Slack and Campbell quoted above) 56% to market analysts. 

While the great majority of respondents agreed that shareholders were the most important audience for their reports, legal and regulatory requirements were considered to be equally important drivers of narrative reporting. 83% of respondents claimed that they were the most important driver for making narrative disclosures - a higher figure than was given for meeting shareholder requirements. 71% of respondents thought that the main challenge of producing a narrative report was the number of requirements placed on it and the cost and time involved in preparing it. This issue, of the complexity of reporting requirements and its relationship with the guiding objective, attracted much interest in the interviews and provoked several comments, including the following quote from one CFO in Switzerland: 

'The main point is that we are asked too many details and we are missing the big picture'.  

Respondents were invited to suggest ideas to enhance the value and quality of narrative reporting, the most popular single suggestion being to reduce the amount of prescription as regards the content of narrative reports. Some claimed that if requirements were scaled back, preparers would feel able to compile their reports in a way which they felt comfortable with, rather than in way which was designed to comply with the applicable rules. An interviewee from Kenya, where disclosure requirements were very basic, made the point that listed companies do nevertheless provide very substantial disclosures in their narrative reports, and that all listed companies would be driven to do this in similar circumstances because the markets would expect them to do so. It is very interesting that 58% of respondents considered that narrative reports would benefit by becoming subject to external audit. 

Conclusions on the research

The above two studies were undertaken at different times and involved different samples. But some overall conclusions from the two studies can be offered for the purpose of the current exercise:

  • For analysts, much of the information provided in narrative reports was  seen as not being useful for their specific purposes. But their negative views about the usefulness of narrative information need to be read in conjunction with specific comments made to the researchers, namely about the size and complexity of the annual report and the feeling that the information disclosed on key issues such as risk was defective, either because it was too simplistic, too complex, or perfunctory. Many of the individual comments made by analysts in the report criticised not so much narrative reporting itself, but what was seen as the poor quality of the information being provided. This feedback could be interpreted as suggesting that it is not necessarily the concept of narrative reporting that is at fault, as far as the analysts are concerned, but the fact that the information it contains is too often not sufficiently relevant, detailed and focused. (The introduction of standardised reporting requirements on these matters since the research was carried out may lead to different conclusions now)
  • From the perspective of preparers, finding a way to satisfy both shareholders and regulators, and to do it in a way which still provides a coherent picture of the company's performance and future prospects, seems to be the big challenge. There is a widely-held feeling among CFOs that too heavy an emphasis on prescription is producing reports which are mingling regulatory disclosures with information which is likely to be useful to shareholders, and in the process creating unsatisfactory results. This feedback should be seen in the context of the increasing concern, recognised by the ASB, over the growing complexity of corporate reporting and the implications this has for the understanding of users. This suggests that a better way needs to be found of getting companies to give the required wide-ranging, strategic account of their position. 

Comments on specific consultation questions

Our comments on specific questions posed in the consultation document are as follows. 

Q1  Are company directors providing useful and relevant information on the company's i) forward-looking strategy and ii) principal risks and uncertainties?

The 2009 report by the FRC suggested that there were 'significant opportunities for improvement in the reporting of principal risks' and trends and factors [likely to affect the future of the business], as well as non-financial KPIs and contractual and other arrangements. 

Our own study Hitting the Right Notes found that the great majority of preparers of narrative reports were attaching greater importance to the reporting of risk and future prospects post-financial crisis. 78% of those surveyed said they were disclosing important risks and their management. 72% of respondents said they discussed forward planning and prospects. In both these respects, the report found increased interest and coverage since the financial crisis. 78% perceived increased interest on the part of shareholders in the disclosure of important risks and their management, and 66% said they had seen increased interest in the disclosure of future plans and prospects. 

Preparers also considered that disclosures on these issues were rated as important by shareholders. When asked which disclosures, among a given selection, were likely to be considered of high importance by shareholders, 67% of respondents pointed to 'risks and their management' and 64% pointed to 'future plans and prospects'. (These figures were however well below the 87% who thought that shareholders considered the explanation of the company's financial results and financial position as being highly important to shareholders.) 

These results (and those of the PwC study) do suggest that there is a clear and accelerating trend towards the acceptance by companies of the need for them to disclose information on their future plans and risks. 

Q2   What are the constraints on companies providing information on these issues?

With respect to the disclosure of prospective information, this was always likely to cause entities problems because of the inherent uncertainty associated with future events and the concern of reporters not to mislead users or to be seen, in retrospect, as having made incorrect assumptions. These will remain concerns for reporting entities. 

As regards the reporting of risk, it has now been very widely accepted that companies' arrangements for the management of risk have been defective. If risk has not been properly identified and mitigated within the company then it perhaps follows that their reporting of it in the business review may not have been adequate. Following the revision of the code of corporate governance, and the recommendations of other reviews that companies need to rearrange their risk management procedures with a view to giving risk a higher status and authority within the company, it should be expected that the quality of the reporting of risk will improve.   

Q7  Is there scope to reduce or simplify the requirements on which companies report?

One of the main conclusions reached in Hitting the Right Notes is that many preparers of narrative reports would like to see less prescription and more freedom of manoeuvre for them to frame their reports in the way they think most apt. The thinking behind this suggestion is that, if the content of narrative reports were not prescribed to the extent that they currently are, companies would respond by preparing reports which were more 'personal' and creative and which could be geared more towards fulfilling the communication function of the report. 

The obvious concern is that if there were less prescription in the format of the business review or the OFR, companies would disclose less information. Also, by removing elements of standardisation, different companies may disclose different things and some companies may choose not to report matters which they are currently required to do. But this takes us back to the one of the main sources of confusion reported in our study, which was who the narrative report was aimed at? Given that the overriding purpose of the business review is to help shareholders of each company to assess how directors have complied with their stewardship obligations, it would seem illogical to insist on standardised disclosures in every case.   

We agree that, if companies are to be encouraged to communicate with their audience in a meaningful and informative way in their business reviews, they should be encouraged to adopt their own approaches and to elaborate on the basic disclosure rules. With more experience of producing these reports, and more encouragement by shareholder and pressure groups, we expect improvements in quality to occur. We do not believe that there is any excess of prescription in the current rules for the business review, but suggest the following could be eliminated:

i. the requirement to disclose information about persons with whom the company has contractual or other arrangements essential to the business of the company. 

ii. the statement about any items covered by s417(5)(b) which have not been discussed in the review. 

With respect to i) above, we would expect any company which has business-crucial relationships with other entities to discuss them under its obligation to discuss principal risks and uncertainties. If there were any doubt about whether specific relationships should be disclosed, non-statutory guidance could deal with this matter. 

On ii) above, the disclosure of environmental, staff, social and community information is already subject to the test of the information being necessary for an understanding of the development, performance or position of the company's business. It should be clear that, if no information is disclosed on any of these matters, then the company believes the disclosure test is not satisfied. It will still be up to the company's shareholders to argue otherwise. 

Q9    Is there value in re-stating elements of the OFR? Would a statutory reporting standard help to improve the quality of reporting?

The business review incorporates the great majority of the provisions which were initially included in the statutory OFR, as well as reflecting the disclosure items which are mandatory under the Fourth Directive. The differences between the Review and what would have been the statutory OFR are thus not great: listed companies are already required to disclose future-orientated information and information on their policies and practices on environmental, social and community issues. The Business Review is therefore cross-referenced adequately to s172 of the Act and the ASB reporting statement is able to guide companies on how to approach compliance.

There is though one aspect of the OFR that would be very valuable to re-adopt. This concerns the statement of the objectives and strategies of the company. While the review requires companies to discuss the principal risks and uncertainties facing the company, and factors likely to affect the development, performance and position of the company's business [in the future] and the company's policies in relation to those factors, there is no requirement for companies to set out their objectives and forward-looking strategies on a pro-active basis. Without a discussion of the goals of the company, and its plans for achieving them, it can be argued that the narrative report as currently framed lacks an overall context, within which users can assess the policies and practices of then company and the performance of the company and its directors (the latter in relation to their own statutory duty under s172).   

Q10 (iii)  Are there key disclosure issues missing from what is currently contained in the business review?

As stated above, we consider that coverage of the company's strategic plans would enhance the information available to shareholders. 

Q12  Should there be an advisory vote on the business review?

We very much support the active engagement of shareholders in company affairs and agree that their monitoring of and feedback on company reports can be very useful in terms of positively influencing the on-going quality of reporting, as well as the underlying behaviour. We also recognise that the business review has an overriding statutory purpose of communicating information to shareholders which will help them in assessing the performance of their company's directors. 

We do not think, however, that having an advisory vote for the business review on its own would be likely to enhance the level of shareholder engagement with the company's reporting processes for the following reasons:  

i. A listed company is already required to hold a question and answer session at its AGM, a process which should invite comment on any issues relevant to the business of the meeting. There is nothing to prevent companies from inviting particular attention to be paid during this session to the business review, the financial statements or any other statement, and nothing to prevent shareholders from raising questions on the content of the review. We consider in fact that it would be helpful if companies did devote dedicated time in this session for special focus on both the financial statements and the business review (as well as the remuneration report which is subject to special arrangements already). But making the review subject to special mandatory rules which did not apply to other annual statements would focus attention unhelpfully on one statement at the expense of others. 
ii. The business review will always deal with a range of matters. Some of these will be within the company's power to control and some of which will not. In these respects it is different in character from the more focused remuneration report, on which there is already an advisory vote. A vote on the business review would thus involve a single vote on a report which covered diverse contents. It is conceivable also that a formal vote, on such a wide-ranging report, could invite some shareholders to vote against it not because they were dissatisfied with the quality of the report or particular strategies adopted by the board but because they were dissatisfied with the board generally. If shareholders are dissatisfied with the board then they already have the opportunity to air their grievances, to influence their peers and to vote against the re-appointment of all or any of the serving board. Substantial investors can (and we believe should) exert particular influence on these matters.    
iii. It should remain the responsibility of the directors to compile and approve the various statutory reports. The defeat of a business review would mean that the board suffered embarrassment but the defeat would not and should not affect the status of the document. It would in fact be unrealistic to expect the company's directors to revise it on the strength of an adverse advisory vote at the AGM. In such circumstances the vote of the shareholders would be seen to count for nothing and their sense of grievance would doubtless increase. 

We agree that boards should be encouraged to keep under on-going review the quality of their narrative reports, as well as the policies and strategies which are discussed in them. They should be prepared to be receptive to any feedback which they receive from shareholders on these matters, whether this comes at the AGM or via other means. But companies should not be constrained on this point and should be free to determine for themselves what they think is the most effective and representative way of obtaining this sort of feedback.     

Q13  Are there non-regulatory solutions to increasing quality through better guidance or publicising excellence in business reports?

We favour non-regulatory solutions on this point. We would encourage, for example, the major investor groups to take an active interest in the company's approach to narrative reporting in their interaction with each investee company. 

Companies themselves may consider inviting feedback on their reporting via their web sites or through direct mailing exercises. As regards the Department's suggestion of some form of awards or ranking system, such initiatives already exist of course and we agree they can be constructive, at least in relation to those companies that value their position in the published ranking. Another alternative would be to encourage companies to benchmark their narrative report against a set of guidelines relevant for the particular sector they operate in (over and above the ASB's reporting statement). Most business sectors have a forum or some kind of an authority that meets periodically to discuss sector/industry matters eg The Futures and Options Authority in the financial services sector. These authorities might be persuaded to set guidelines for narrative reporting in their sector and to monitor their adherence. 


Our concluding thoughts on this consultation are as follows:

  • There remains much scope for narrative reporting to add value to the information contained in the financial statements. But the evidence suggests that the quality and scope of reporting is improving and that this process is being influenced not just by regulatory demands but by entities' assessment of the concerns and information needs of their stakeholders. 
  • The particular role of narrative reporting in the wider reporting process needs to be clearly understood. Many stakeholders will continue to see the information contained in the financial statements as being more useful for their particular needs. This is understandable, and should not detract from the distinct contribution that narrative reports can make. But the disclosures made in the narrative report should still aim to be as relevant as possible to the needs of the different classes of users.  
  • Any changes to the content of the business review (or any OFR which may replace it) will need to take into account the current work being undertaken by IASB on the management commentary standard. Reporting entities will need to see consistency between the requirements of legislation and technical requirements. In particular, they will need to see an agreement between the two as regards the intended primary audience for the business review and the purpose of the statement. These are crucial elements since they dictate the way the whole statement should be prepared and affect the way it will be viewed by users.     
  • In the light of the general concern to reduce the complexity and length of corporate reporting, we would caution against using the business review or its replacement as a repository of individual, ad hoc regulatory disclosure requirements. Where specific disclosures are appropriate, they could be disclosed separately from the narrative report and entities should be entitled to cross-refer in the narrative report to where those disclosures are made. Many preparers consider that too much prescription in disclosure tends to detract from the coherence of narrative reporting and may inhibit the adoption of distinctive and innovative approaches. This concern notwithstanding we consider that the current disclosure requirements for the business review would be enhanced by more emphasis on the disclosure of corporate strategies.
  • Where possible we would favour the adoption of non-regulatory solutions to the encouragement of better reporting practice. Initiatives to benchmark and reward good practice on different aspects of narrative disclosures can, in our view, be very constructive in this respect.