Telling a story

If you want to find out how well a company is performing, you could look at its published financial statements. But the spectacular collapse of Enron was a reminder that the numbers companies put in their accounts tell only half the story, if they tell anything at all.

To get a better picture of what’s going on, you’d have to read the narrative sections of the statements, the parts where the senior executives offer their take on how the year has gone, and what the future holds in store. The problem here is that as these sections are usually unaudite, the report writers can say almost whatever they like. Small successes are made to sound like major triumphs; uncomfortable facts are glossed over. Spin is rife.

Common markets
Further difficulties are created by the so-called disclosure paradigm. This is the regulatory approach – common in market economies – whereby companies are required to disclose vast amounts of information, which investors then have to try to make sense of. Experience shows they tend to fail, and end up making educated guesses about important aspects of a business, or just overlook the significance of details buried in the small print. But if they get the wrong take on the published stats, ‘that’s their fault, not the companies’, according to this model.

The problem is, that helps nobody. A lack of clarity about how an individual company is performing is bad for its share price. When applied across a whole raft of companies, it’s bad for stock markets, which require quality information if they are to function effectively.

To add another layer of difficulty to the problem, those companies that do want to tell investors more about what’s going on, often fear litigation. For example, they might want to give an update on how the Russian pipeline project is going; they report that all seems to be going well, and the project should complete on time, but to be honest there are so many uncertainties that it’s hard to be sure. Taking comfort from this, the shares rise. But the following year, the project runs into a major setback. The shares plummet. Investors are up in arms: the company said it was going well, they complain. Were the board’s comments negligent, or was it just telling investors what it knew at the time?

Encouragement
In an effort to resolve some of these problems, regulators around the world are producing standards and guidelines aimed at encouraging companies to improve their narrative reporting, and sometimes offering them legal protection to speak more freely about their uncertainties and concerns, without the risk of being attacked later. The UK has led the way here, or at least tried to. The country’s Accounting Standards Board (ASB) did pioneering work when, in 1993, it published an official statement on the Operating and Financial Review (OFR), the part of UK company accounts that includes narrative reporting. The statement built on the foundations of existing best practice by providing a framework within which directors could discuss the main factors underlying the company’s performance and its financial position. This was updated in 2003.

The OFR remained voluntary and a lot of companies simply ignored its recommendations. So, after a long review exercise, the government decided in 2002 to make publication of an OFR compulsory for listed companies. Two years later it came out with detailed rules and guidance explaining how this would work.

Initially, many in the business community complained about the extra compliance burden, but over time they came to appreciate two things. First, open, narrative communication with investors and the wider world was a good idea. Second, it was useful to have a framework within which this communication could take place: most people agreed that the OFR provided such a framework.

Inevitable
And, in any case, there were legal changes underway at a European Union level that made a stricter narrative reporting regime inevitable. The EU Accounts Modernisation Directive was going to require an enhanced review of a company’s business (the Business Review) in the directors’ report. Under this Directive, for company financial years starting on or after January 1, 2005, large and medium-sized (but not small) companies are required to provide “a balanced and comprehensive analysis of the development and performance of the company’s business…[which] shall include both financial and, where appropriate, non-financial key performance indicators … including information relating to environmental and employee matters.”

Eventually, the government’s rules became law and company boards started getting ready to write their OFRs. But then, bizarrely, the Chancellor of the Exchequer, Gordon Brown, announced an eleventh hour decision to scrap the OFR, or at least to remove the legal requirement for one. Nobody really knows why he did this. The best guess is that it was intended as a sop to the business community, which, Brown mistakenly believed, did not want the OFR.

However, by that time, most companies were so close to finishing their first OFRs that there was an outcry. They had invested huge amounts of money in preparing the information systems needed to provide the base data for the review and, having got stuck into the project, many had decided it was a good idea after all. They didn’t appreciate it being cancelled. Brown’s move left a basic legal requirement for companies to provide a business review in the directors’ report. This is much more limited in scope than the OFR. It has to include a “fair review of the business of the company” and a description of the principal risks and uncertainties it faces. There also has to be a “balanced and comprehensive” analysis of the development and performance of the business during the financial year and the position of the company at the end of that year.

The detail of this analysis depends on the size and complexity of the business, but should include key performance indicators (KPIs), relating to both financial and non-financial performance, such as environmental and employee issues. There should also be a forward-looking indication of how the business is likely to develop in future. The Chancellor, it seems, stopped the UK’s great narrative reporting revolution in its tracks. However, several large companies said they would comply with the OFR guidance regardless of whether they had to or not, simply because it was a good idea.

Narrative reporting
To determine how well they have done, and how closely companies are complying with their more limited statutory requirements, the ASB recently published a review of narrative reporting. It was also a way, it said, of encouraging improvements and keeping the issues in the spotlight. Its review was based on an analysis of annual reports from several listed companies, and also included findings from other similar research exercises. It found that most companies were good at describing their strategy and current performance, but were weaker on providing forward looking information and identifying their principal risks and how they are managed.

The ASB report identified several areas where, in its view, companies were doing a good job. They were good at providing descriptions of their business and markets, together with their strategies and objectives, although some improvements could be made in providing information on their external environment. They were also good at describing the current development and performance of their business. More companies were covering environmental, employee and social issues, although very few of them discussed their contractual arrangements and relationships in any depth.

All well and good, but the ASB also identified several areas for improvement. The greatest difficulty companies had related to their disclosure of forward-looking information. The standard-setter said the companies should make more information available. They should also, it said, think carefully about how they describe the resources available to the business, in particular on those intangible items not reflected in the balance sheet.

Managing risk
Another problem area is that companies need to think more carefully about what their principal risks and uncertainties are, and focus on reporting those, rather than listing off reams of risks. With that, they should tell readers what they are doing to manage and mitigate those big risks. The ASB found that the number of risks and uncertainties reported by the companies it looked at ranged from four to 33. “We question whether a company can really have 33 principal risks and uncertainties,” it said.

The ASB review found that companies were, in general, complying with the legal requirements for the Business Review. However, many companies are finding the disclosure of key performance indicators (KPIs), both financial and non-financial, challenging. It noted that what to include was a matter of judgment for directors, but issued a reminder that companies that skip KPIs in future risk being investigated by the Financial Reporting Review Panel, an ASB sister-body that polices company reporting.

The overall conclusion of the review, it said, was that companies should think carefully about the structure and placement of their narrative reporting to ensure that cross-referencing is kept as simple as possible and does not adversely affect the flow of the narrative. Also, there is a legal requirement for a “balanced” analysis and in considering balance companies need to assess what the prominence should be of reporting bad news: the implication is that some have been trying to bury it.

“Narrative reporting is an increasingly important feature of corporate reports, providing an opportunity for directors to set out a clear and balanced analysis of the strategic position and direction of their business,” said ASB chairman Ian Mackintosh. “It is pleasing to see that many companies are reporting beyond simple compliance with the law and moving towards best practice.”

Improvement
Mr Mackintosh said the ASB would try to support this trend. “We hope that more and more companies will regard good narrative reporting as a means by which they can achieve transparent and open communication with their shareholders.” But he added that there was “room for improvement.”

Would the quality of company reporting be any better if the government had stuck to its guns and legally obliged them to produce an OFR? It is impossible to say, but one thing is certain: to make narrative reporting work, investors and other stakeholders will have to pay close attention to the stories that companies tell, and hold them to account if they turn out to be pure fiction.

The ASB analysed the annual reports of 23 listed companies, with a year-end of March 2006 or later – and so required to comply with the current legal provisions to prepare a Business Review. It also drew on surveys by a number of other organisations and the work of other parties with an interest in narrative reporting. Together, these reviews of annual reports cover a significant number of the FTSE 350 leading quoted companies.

For more information, please visit www.frc.org.uk/asb/press/pub1228.html