Corporate Reporting - Future Directions John Collier, Secretary General, Institute of Chartered Accountants in England and Wales

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1 Corporate Reporting - Future Directions John Collier, Secretary General, Institute of Chartered Accountants in England and Wales Introduction Corporate reporting is currently going through a period of radical change. It has traditionally been regulation-led with innovations arising from new accounting standards and changes in legislation. Increasingly, however, the voice of the market-place is becoming far more influential. It is now clear that the annual report of the 21 st Century will not be annual and it will not be a report: it will be an up to date, informative, permanent dialogue. Table 1 below shows reporting changes are now being driven by globalisation, new technology and increased notions of accountability by corporations, professions and others. If we are to develop a successful new reporting model to meet the needs of the 21 st Century we will need to look at issues such as the provision of information on shareholder value, how we report on risk, web-based reporting and last, but far from least, international harmonisation in a European and global context. Table 1 Reporting in a Period of Change Old Shareholder focus Paper based Standardised information -t New -t Stakeholder focus -t Web based -t Customised information Company controlled information -t Information available from a variety of sources Periodic reporting -t Continuous reporting Distribution of information -t Dialogue Financial statements -t Broader range of performance measures Past performance -t Greater emphasis on future prospects Historical cost -t Substantial value-based information Audit of accounts -t Assurance of underlying system Nationally oriented -t Globally based Essentially static system -t Continuously changing model Preparer-led regulations -t Satisfying market-place demands 133

2 CORPORATE REPORTING - FUTUR DIRECTIONS Reporting on shareholder value Investors today want information about a company's potential for creating shareholder value. From their perspective, value created is the growth in the company's share price over a period together with dividends received from it, that is the total shareholder return. This is essentially a forward-looking measure since share prices reflect the market's expectations of future cash flows. If a stock market prices shares efficiently, this will reflect the value created by management in a period. Value is created by enhancing a company's prospects which stem from a company's competitive advantage and the ability of management to choose and implement a strategy which exploits that advantage. Annual reports have traditionally been prepared from an historical cost perspective and provide limited information on these issues. The UK Accounting Standards Board statement on the "Operating and Financial Review" recommends the inclusion of a discussion of the main factors that may influence future results, including the principal risks and uncertainties, but the reporting offorward-looking information by most companies is currently very sparse. Many managers believe that a gap exists between the internal perception of a company's potential and that of the stock market. One of the roles of effective management is to act as a bridge between the external world and the company, ensuring that the external perception of a business reflects the way in which the company operates. Management will have its own business model and will have chosen strategies expected to optimise future performance. It will have developed value-related measures of performance and lead indicators that reflect progress towards achieving the chosen strategy. The measures and lead indicators used at board level are equally important to the stock market in ensuring a fair judgement of the business and reliable forecasts of future returns. A challenge for management is to link the internal and external perspectives of the business, making key aspects of a company's capabilities more transparent to investors. The future is uncertain and cannot be reported as a matter of fact, but reporting on the past is no longer enough. The annual report should be designed with the aim of encouraging managers to report both why their strategies are expected to lead to the creation of value over the long-term and their view of performance. Together these will enable investors to make their own assessments of the future prospects of a business and take better-informed decisions. A recent report by a study group of my Institute, "Inside Out: Reporting on Shareholder Value ", (ICAEW, 1999) has developed proposals for a more forwardlooking perspective in annual reports (Table 2). They are not intended to be a theoretical "wish list" but are incremental, building upon and giving a structure to practices which are already emerging around the world. If implemented, these 134

3 CORPORATE REPORTING - FUTURE DIRECTIONS proposals should enable companies to present a sharper image of their businesses and differentiate them from competitors in increasingly demanding capital markets. Table 2 Recommendations for improved reporting on shareholder value For the company as a whole: its ambitions; its strategic direction, together with targets or milestones towards achieving its objectives; a description of the decision-making process; the preferred measures used internally to monitor economic performance; In addition to the above, for each significant business activity as identified for management purposes: a description of the key drivers of value in the business, derived from, inter alia: - a description of the market in which the business operates, using both qualitative terms and quantitative data; - why management believes it the right market to be in; - the business's competitive position within the market; - future trends anticipated in the market; - how management intends to maintain or alter the business's position within the market; measures of performance appropriate to the business, including non-financial measures, and/or lead indicators derived from the key drivers of value that are used internally to monitor potential in that business. Risk reporting Research carried out by my Institute and published in a paper on "No Surprises: The Case for Better Risk Reporting" (ICAEW, 1999) shows that many listed companies already report significant information about the nature and extent of risk being carried in their business. So the key question for directors to consider is not "Do you want to report risk?" but "Do you want to do a better job of reporting risk?" There is a compelling case for saying "Yes". Listed companies should want to obtain capital at the lowest possible cost. Knowing how the directors of a business see its risks and how they manage them effectively helps outside investors assess the likely volatility of its returns. The more they know, the more accurately investors will be able to determine a company's cost of capital. The best approach a board of directors can adopt for minimising its cost of capital and maximising 135

4 CORPORATE REPORTING - FUTUR DIRECTIONS shareholder value over time is to be open in reporting information about the way they manage risk. If this approach is adopted, listed company annual reports would contain information about risks, actions to manage them and relevant measures. Risk should be thought of in terms of uncertainty and volatility, not just in terms of the potential down side impact. All risks are relevant. There is no point in trying to define some as being beyond the directors' responsibilities because they are ultimately responsible for total shareholder value. In the United Kingdom, companies do make extensive disclosures about a wide range of risks and related actions and measures. In-depth research into companies that floated on the London Stock Exchange in 1998 showed that companies make such disclosures in their prospectuses. But they provide rather less complete information in their annual reports. I believe that listed companies should aim, at a minimum, to maintain prospectus standards of risk disclosure in their annual reports too. Even though risk is high on management's agenda, companies' readiness to improve their risk reporting is hindered by acceptance of current market practices and misgivings about commercial sensitivities and directors' legal liability. Changes are taking place, however, which are likely to increase discussion of risk related issues in corporate reports. An example would be the guidance in "Internal Control: Guidance for Directors on the Combined Code (The Turnbull Report)" (ICAEW, 1999) on risk management and internal control, applicable to all listed companies incorporated in the United Kingdom. This guidance does not require disclosure of actual risks but calls on companies to indicate that there is an ongoing process for identifying, evaluating and managing the significant risks that has been in place for the year under review and that is regularly reviewed by the Board of Directors. The Directors are also called on to summarise the process they have applied in reviewing the effectiveness of the company's system of internal control, thereby publicly committing them to effective risk management. Web-based reporting Technology affects not only the physical medium of the report but also its traditional boundaries. More and more companies around the world have websites. Increasingly these websites contain not only sales and customer service details but also corporate reporting information, including financial data. Research published by both the Financial Accounting Standards Board in the US as part of their broad study on the Business Reporting Research Project and by the International Accounting Standards Committee shows that there is a very 136

5 CORPORATE REPORTING - FUTURE DIRECTIONS wide diversity in terms of content and presentation of information on the internet. Content ranges from entire annual reports, quarterly statements and press releases to only summary information. Presentation styles are equally diverse ranging from static information at one extreme to sites that are enlivened with sound, video and interactive features at the other. But web-based reports have great potential to be more than simply an electronic version of traditional paper reports. The Web represents a totally new reporting environment with many implications for the content, form and ownership of corporate reports. It expands the amount of information available to nonspecialist investors and allows it to be delivered cheaply and quickly. Anyone with a modem and computer can now obtain information that was previously the preserve of, for example, professional investment analysts and the financial press. Internet access, coupled with political changes which see individuals taking more responsibility for their own welfare, is also increasing the number of individuals who are actively involved in trading shares. These investors are able to conduct all of their trading and research via the Web without any form of personal guidance from brokers or other investment professionals. This development has important implications for the demand for the quantity and types of company information available online. It is less clear who will own and provide the corporate information available on the internet. Companies have an obvious interest in ensuring that their version of events is available to their stakeholders. This interest is currently supported by legal requirements to provide certain information in specified formats. Databases such as the SEC's EDGAR in the US and the private sector CAROL based in the UK, however, also collate information about a variety of companies and support comparisons and analysis. The need to develop a common language and standardised formats and content is clearly growing. Technological developments include computer programmes based on artificial intelligence that can complement human analyses and provide further support for the decision-making processes of data users. Advances in the computer language used to put financial information on the internet will also make it easier for information from different sources to be collated and compared, whether by a human intermediary or by an intelligent computer agent. Eventually, corporate information will be found in many different places on the web with far-reaching implications for those providing assurance on the data as well as for investors and the companies themselves. The internet does not respect country borders so information exchange and trading takes place across national frontiers. National and international accounting standard-setters will have to make sure that they are not left behind with regard to online reporting developments and, in particular, that their current focus on international harmonisation does not lead them to focus too much on current 137

6 CORPORATE REPORTING - FUTUR DIRECTIONS differences rather than looking forward to the very different reporting environment that is starting to emerge. International harmonisation The free flow of capital around the world has made the use of national accounting standards both inconvenient and economically damaging. The main capital providers operate on a global basis and if financial information is to be clear to them it must be prepared using international standards applied throughout the world. Companies failing to do this risk confusing the markets and pushing up the cost of capital. In addition, a lack of confidence in reported results leads to lower share prices and lower volumes of shares traded. This results in higher hurdle rates for new projects, lower investment in innovation and poorer job prospects. Against this background, my Institute welcomes the financial strategy for Europe developed by the Federation des Experts-Comptables Europeens (FEE). The paper offers clear support for international standards as the basis for preparing accounts throughout Europe. It does not support the suggestion that the European Union should establish its own standard-setter or issue interpretations of international standards for use by EU companies. I believe that developing a Eurocentric rather than a global approach to accounting would reduce the competitiveness of European companies and risk distancing them from international capital markets. The reforms favoured by the FEE paper reflect the practical problems of shifting from a myriad of standards to a uniform approach. FEE recommends that use of international standards in consolidated financial statements should be optional for listed companies and that companies that do not use international standards for their main financial statements should be required to publish a reconciliation from the practices they have employed. The FEE paper goes on to outline methods for enforcing compliance advocating a body to review financial statements and reconciliations with the power to refer any instances of non-compliance to enforcement bodies in individual countries. It would be up to the European Commission to make national governments establish such bodies where they do not exist. The proposed new European body, the Financial Reporting Co-ordination and Advisory Council, would also have a wider role in promoting the use and understanding of international standards. But FEE's proposals will only be effective if supported by continuing improvements in international standards. The International Accounting Standards Committee needs to build on its achievement of providing core standards that command widespread support. It must continue to combine high professional standards with sensitivity to cultural variations. To achieve this goal, standards should be issued only after comprehensive exposure and, to ensure fairness, minority views on the Board should be published. 138

7 CORPORATE REPORTING - FUTURE DIRECTIONS I believe that if adopted, these proposals will help to build confidence in international accounting standards and in the markets that use them. If this can be achieved, both the cost of corporate reporting and of capital will be reduced, helping to create a sound platform on which to build further world economic growth. 139

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