Comments from ACCA to the Financial Reporting Council (FRC), March 2011.
ACCA is pleased to comment on the FRC’s consultation on Effective Company Stewardship.
ACCA agrees that the disclosure by limited companies of financial and non-financial information reinforces directors’ legal duty of stewardship and provides stakeholders with information which may be useful to them. Effective communication in corporate reporting is also desirable in the context of the FRC’s goal of achieving more active involvement in corporate affairs on the part of investors, a goal which we strongly support.
The annual report is one means by which effective communication with shareholders and other stakeholders can be achieved, although it is not the only one. While it makes sense to consider how the potential of the annual report as a communication mechanism can be exploited further, the report - however it is structured and presented - will never be seen as the only channel through which key stakeholders acquire the information they seek about listed companies. The annual report should not, therefore, be seen as the key to achieving high levels of shareholder engagement.
We agree that directors should be responsible for ensuring that the information their company publishes in annual reports is fair and balanced. The main problem with applying any new requirements in this respect is that there are currently no set parameters for the annual report. One way of resolving this would be to re-brand the annual report as a wholly regulatory document containing only specified material (including any new disclosures which may result from the current paper). This would help to add much-needed brevity, coherence and meaning to the report, and greatly assist auditors and regulators in relation to their own proposed new functions.
We support the proposed enhancement of the role of the audit committee and the new disclosures it is suggested be made by it. We believe the committee has an especially important function in respect of auditor independence. That said, expectations about what the audit committee is capable of achieving should remain realistic, and any new responsibilities should not overshadow those of the board as a whole. The proposals in this area would appear to raise the bar as regards the level of skill and care that is to be expected of committee members – this is likely to have significant implications for the preparedness of individuals to serve on audit committees.
While we support the migration to on-line publication of annual reports, we do not think that it would be reasonable to disenfranchise those shareholders who wish to continue to receive reports in hard copy form.
We welcome the FRC’s concern to avoid over-prescription in any reforms it puts forward in this area. The repeated references to ‘boilerplate reporting’ in the report underline the point that if companies feel too constrained in the way they have to report they will do so in a way which lacks conviction and value. We suggest in particular that any new proposals in respect of narrative reporting need to incorporate an appropriate element of flexibility so as to allow companies to frame their reports in the way that they think most effectively enables them to communicate the messages they want to convey. This concern for flexibility was one of the major conclusions of the ACCA-Deloitte investigation of stakeholder views on narrative reporting Hitting the notes: but what's the tune (2010).
A wider governance-related point which the FRC should address in the context of this initiative is the increasing tendency for shares to be held by nominees. Tax legislation and institutional investors both encourage individuals to hold investments through pooled funds. In this situation, individual investors are effectively disenfranchised and have no contact with companies. This is a serious problem and becoming more serious as occupational pension schemes move from DB to DC.
One other issue which is not explored in the paper is the more fundamental one of whether the annual report should even be retained in the way we currently know it. This is partly a question of whether there is likely to be any new value to readers in companies disclosing the additional information being proposed, and partly a question of whether a one-off report remains a useful vehicle for communicating important corporate information. Major companies argue that, if their key stakeholders need information, they will provide that information directly to them either pro-actively or in response to requests. If information is in practice communicated in this way, the question is whether other stakeholders want or need to have it provided to them in a formal statement. On the second question, it could be argued that the interests of flexible communication, supported by FRC in the paper, could be better met not by the publication of a once-a-year document but by the provision of information in real time. We suggest therefore that these wider questions relating to the basic purpose of the annual report be addressed in the review process.
Comments on the specific recommendations
1. Directors should take full responsibility for ensuring that the annual report, viewed as a whole, provides a fair and balanced report on their stewardship of the business.
We support the basic proposition that directors should take responsibility for the information the company publishes.
It is not entirely clear from the paper, though, whether the FRC is proposing that any new provision on this matter should apply to what we commonly know to be the full annual report document or merely to the ‘regulated’ elements of it. The key point is that companies are under no legal or regulatory obligation to produce an annual report per se – only to publish the statements and information required by the Companies Act, accounting and standards and the Listing Rules. For the FRC to apply the proposed new provision to the whole of the annual report document would therefore go beyond the scope of documents which are currently subject to regulation, and would be based on an assumption (one which is admittedly already made in the UK Corporate Governance Code) that companies will in practice always produce an annual report.
Despite the fact that there is currently no authoritative understanding of what the annual report is intended to achieve, it is in the interests of their readers that annual reports, where they are published, communicate a credible account of where the company stands and, where appropriate, of its competitive position: the board of directors should indeed assume ultimate responsibility for ensuring this happens. There is currently a widespread sense that companies use their annual report documents as vehicles for self-promotion, and this can serve to detract, for some, from the credibility of the main financial and narrative statements. A different issue, though one which also serves to impact adversely on the information value of the annual report for many readers, is the sheer amount of data and information which is included in modern annual reports.
Both these factors contribute to undermining the information value of the annual report as we currently know it. We would therefore welcome any initiative which might help to bring about more coherent and focused corporate communication.
One potential advantage of applying the proposed provision to the annual report as a whole would be to encourage companies to focus on those statements that they are obliged to publish, and to reduce the amount of additional, discretionary material included in the report. If directors were to be expected to assume full regulatory responsibility for all the material included in a report, they may be less inclined to include discretionary and speculative content. On the other hand, since the annual report currently has no definitive aim, it is not clear that the report as it currently exists is exclusively about communicating matters relating to the board’s stewardship of the company.
We consider that, if the FRC’s proposed provision is to be adopted, the parameters of the annual report need to be defined unambiguously. The simplest way of doing this would be to re-brand the annual report into a regulatory document which contained (only) the various reports and disclosures required by company law, the Listing Rules and other official guidance. By virtue of doing this, there would be clarity about directors’ responsibilities in relation to it as well as clarity in respect of the proposed additional functions of auditors, the FRRP and the AIU. Any other promotional material a company might wish to publish could be issued separately.
In terms of guidance, we do not think that a reporting standard would be appropriate for the purpose of offering advice in this area. This is because of the need to avoid narrative reporting of the ‘boilerplate’ variety: companies should be encouraged to express themselves, in their narrative reporting, in the way they consider is most likely to achieve effective communication. It would be more appropriate, in our view, for ASB to issue a document of the status of a reporting statement. This could be added to by a provision in the Code on Corporate Governance to the effect that fair and balanced reporting in the annual report should be an integral part of the board’s responsibility of accountability.
In the context of encouraging fair and balanced reporting, we think it is also appropriate to point out here that the rules governing the preparation of financial statements by listed companies are very complex. Many directors do find them difficult to understand and difficult to relate to the way that the company is managed. Further, it will be remembered that fair and balanced presentation of information is not necessarily the same thing as fair and balanced reporting. If compliance with applicable accounting and audit standards is not required to be subject to some overriding criterion of prudence or similar, then the outcome of strict compliance with those standards may be reporting which is neither fair nor balanced. In this respect, we note the recent reported comments by Peter Wyman about the banks being able to pay dividends and bonuses out of unrealised profits because that practice was permissible under the applicable standards.
We would also mention here that, during the interviews we conducted for our report Hitting the Notes: But What’s the Tune?, the most discussed topic was the external assurance of narrative information. There was a widespread feeling that the credibility of non-financial information would benefit from some kind of opinion/verification from an independent third party. For audit or some other form of assurance to be feasible, the information disclosed needs to be in a form which is capable of being audited or otherwise verified.
2. Directors should describe in more detail the steps they take to ensure:
the reliability of the information on which the management of a company, and therefore directors’ stewardship of the company, is based; and
transparency about the activities of the business and any associated risks.
We agree with the comment made in the paper to the effect that directors cannot be expected to have personal knowledge of all the activities of their business and the risks arising from those activities. It is inevitable that delegation of responsibility will have to take place and equally inevitable that directors will have to make their decisions on the strength of the information provided to them by management. ACCA has recommended on previous occasions that the board should be given an undertaking by the company’s risk manager or director that it can rely on the information on risk being provided to it, and we continue to believe that directors would benefit from such an undertaking.
Part of directors’ responsibility of stewardship must though be to ensure that they take effective steps to ensure that the information on the basis of which they are called upon to make strategic decisions is reliable.
We consider that the sort of matters outlined on page 11 will already be being addressed by any responsible board, and so a new reporting obligation in relation to such matters should necessitate no new actual work on their part. We would also agree that information on such matters is likely to be of interest to readers. The one item of detail that we do not see a need to include is the last item – ‘the effectiveness of external assurance arrangements’: this matter should be dealt with in the proposed report of the audit committee.
As regards any new requirement to report specifically on risks, it would make sense for companies to highlight any risks which would destroy their business model. The case of Northern Rock would be a useful example on which to base such a disclosure.
Whatever reforms are made as a result of this consultation, suitable provision needs to be made for future developments in the framework of reporting. The project to develop a new framework of integrated reporting is on-going and may lead to a provisional framework being put forward for official approval later this year. That project is motivated, fundamentally, by a concern that the existing modes of reporting, whether financial or non-financial, do not adequately satisfy the information needs of readers of annual reports. Although the integrated reporting project has a long way to go before it can come up with a new template for reporting which can supersede or exists side-by-side with the existing structure, the long-term aim is to fuse financial information with much of what is currently found in narrative reports
3. The growing strength of audit committees in holding management and auditors to account should be reinforced by greater transparency through:
fuller reports by Audit Committees explaining, in particular, how they discharged their responsibilities for the integrity of the annual report and other aspects of their remit (such as their oversight of the external audit process and appointment of external auditors) and
an expanded audit that
– includes a separate new section on the completeness and reasonableness of the audit committee report and
– identifies any matters in the annual report that the auditors believe are incorrect or inconsistent with the information contained in the financial statements or obtained in the course of their audit
Fuller reports by audit committees
We agree with the FRC that the audit committee has an important and pivotal role to play in enhancing stakeholders’ confidence that the audit process is effective and demonstrably independent. The committee already has extensive functions in this regard under the Code of Corporate Governance and APB’s Practice Note 136. While we support the further strengthening of the role of the audit committee, we would caution against investing too much reliance on committees being able to secure complete effectiveness in the accounting and audit processes. It must be remembered that legal responsibility for the company’s accounting statements will and should remain with the full board and responsibility for the audit will and should remain with the auditor.
On the specific issue of reporting, successive amendments to the guidance on corporate governance has already resulted in fuller reporting being made by audit committees. Whether or not it is necessary or desirable for these disclosures to be added to must depend fundamentally on whether shareholders actually want to see more information. We believe that there is evidence that they indeed do want to see more information, or at least more assurance, on the specific issue of risk. We suggest that the contents of the committee’s report should however remain based on the statement of responsibilities that is already set out in the Code on Corporate Governance: there is no need to specify any new greatly expanded schedule of contents. With regard to the individual proposals made in the paper, we consider it would be especially problematic to require the committee to comment on how it has assessed the ‘effectiveness’ of the audit.
Increasing the audit committee’s responsibilities on the lines proposed would have at least two consequences. Firstly, we consider it will be increasingly difficult to justify the current criterion which says that only one member of the committee should have competence in accounting and/or auditing: for the body to operate effectively in future, it will need at least half of its membership to satisfy that test. Secondly, the enhanced role of the committee is likely to mean that it will become more difficult to locate suitable individuals to sit on audit committees: the fees commanded by members can accordingly be expected to rise.
An expanded audit
With regard to the proposals regarding the expansion of the responsibility of the auditor, ACCA supports the idea that the standard audit model needs to be expanded in order to address the evolving information needs of shareholders and other stakeholders. We have previously expressed the view that the scope of the audit should develop so as to encompass issues such as the company’s risk management, corporate governance arrangements and the financial assumptions which underlie the company’s business model (Reshaping the Audit for the New Global Economy) in all these areas we consider that the audit can add further value to stakeholders’ understanding of the entity’s position and performance. We also believe that the very concise wording of the standard audit report does not help in terms of communicating to readers what the auditor has done and the major factors which have been considered during the audit process.
The specific proposals under these heading are addressed separately below.
(i) Reporting to audit committees
The first proposal put forward in the paper under this heading concerns information which the auditor should provide systematically to members of audit committees. This is an area that is already covered by ISA 260, which requires quite extensive disclosures to those charged with governance (which may or may not mean audit committees depending on the circumstances). The FRC appears to be proposing additional reporting responsibilities to those that are currently addressed by the standard and, as ACCA has consistently warned, divergence from accepted international standards may adversely affect the competitiveness of a jurisdiction. The proposals could be interpreted as necessitating additional work by the auditors to support the increased reporting. This is particularly the case for reporting on the effectiveness of the company’s controls (including in relation to business model risks). Such work would need to be clearly distinguished from the type of engagement (known as an ‘integrated audit’) that takes place in the US and which results in public reporting.
Having taken the above into account, we believe, nevertheless, that the auditor is in a good position to add value to the company’s management of its internal controls and risk, and an enhanced responsibility in this area would be of benefit to shareholders and other stakeholders. Such increased responsibilities could involve an increase in auditor risk and would need to be facilitated by a corresponding initiative on the issue of auditors’ liability.
Ensuring auditor independence
We agree that the elements of objectivity, integrity and independence are crucial to the performance of a credible audit, and by extension to the credibility of a set of financial statements. We support the action being taken by the FRC to reinforce the application of these elements via the audit committee.
(iii) Reporting on the audit committee report
There is an obvious potential risk in the auditor reporting on how the audit committee oversees the auditor’s work. To address the potential problem of self-review, careful consideration would need to be paid to the precise requirements of both the auditor’s report on the committee’s report, and the auditor’s reporting duty to the committee. At this stage, we would query the use of the term ‘completeness’ in respect of the auditor’s duty, and suggest that, if it is adopted, it needs to be clarified that that term implies only that the committee has disclosed the matters that are required to be disclosed.
(iv) Reporting of other matters contained in the annual report
We believe this matter is already largely covered by ISA 720. Under that standard, auditors are obliged to read any financial and non-financial information which is included in a document containing audited financial statements, and to take appropriate action if they come across any information which is materially inconsistent with those financial statements. This will include the annual report. Appropriate action under ISA 720 may mean modification of the audit report or the inclusion of an emphasis of matter paragraph. Where material inconsistencies are identified subsequently, and management is not prepared to take action, the auditor is obliged to notify those charged with governance. If there is a ground for additional regulatory action to be taken in this area, we suggest that the audit committee, or the board of directors as a whole, should be required to inform the shareholders at the general meeting at which the accounts are laid that the auditor has made a report of material inconsistencies. The FRC will be aware of the IAASB project to update ISA 720 and indeed its project on auditors’ reports. It is through influencing such international developments that the FRC is best able to promote the adoption of its thinking more widely and avoid detriment to the competitive position of the UK and Ireland that would follow as a result of divergence from international standards.
4. Companies should take advantage of technological developments to increase the accessibility of the annual report and its components
All UK listed companies are now required by law to post their annual accounts on their web sites and all companies are spared the need to send out hard copies unless individual shareholders request them. The paper proposes that companies, presumably listed companies only, should no longer be required to comply with that latter requirement.
We are aware that developments in technology offer the opportunity for companies to issue their annual reports not only on-line but in other non-paper formats and, in the process, save themselves material amounts of money. We would not however support the abolition of the requirement to send out hard copies if individual shareholders still want to read the report in paper form. In time, it may well be that more and more shareholders will be content to inspect the report on line or in some other electronic form and will opt to receive it in that format. But for the time being, it would not be reasonable to assume that all shareholders will be in that position.
As regards the reference to the printing of hard copies being a drain on companies’ resources, listed companies do of course continue to produce many hard copies, on a voluntary basis, for their own marketing purposes.
We do though very much support the idea of requiring listed companies to make their reports searchable on the internet via the adoption of a suitable reporting language.
5. There should be greater investor involvement in the process by which auditors are appointed
We believe that the body of shareholders, as the addressee of the audit report, should remain directly responsible for appointing the company’s auditors. It would not be appropriate for this to be done by any third party. We have no objection to the idea of the audit committee assuming an enhanced responsibility in making the recommendation to the shareholders, and we would support any meaningful new involvement in the process on the part of shareholders. Any new process should not, however, be prescriptive, in our view. Rather, the committee should be required only to take steps to consult with shareholders and to report to shareholders at the annual general meeting at which the appointment is to be made on how they have gone about this.
6. The FRC’s responsibilities should be developed to enable it to support and oversee the effective implementation of its proposals
We have no objection in principle to the extension of the remit of the FRRP to cover the whole of the narrative content in annual reports and accounts, and that of the AIU to cover the auditor’s consideration of narrative content. As already stated, however, it would be helpful for their purposes, if the parameters of these documents were more precisely defined.
7. The FRC should establish a market participants group to advise it on market developments and international initiatives in the area of corporate reporting and the role of assurance and on promoting best practice
The widest possible consultation on the implications of new developments and the merits of new proposals must surely be good for preparers and auditors.