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Enhanced disclosure

30 January 2017 by Thomas Toomse-Smith

Reporting: Enhanced disclosure - read more

The Financial Reporting Lab shares its insights from investors and companies on business model reporting

The Financial Reporting Lab has recently been focusing on what good disclosure looks like for the reporting of business models and dividends. Here is some insight into the findings and some top tips for the reporting season.

Business model reporting

In October, the Lab published its project on business model reporting. During the project, the Lab interviewed 38 members of the investment community and their message for companies is clear: business model information is fundamental to their analysis and understanding of a company and its performance, position and prospects, both at the initial investment stage and for their ongoing monitoring and stewardship responsibilities. Too often current business model reporting does not meet investors’ needs.

Questions for companies to ask about their business model disclosure:

  • Is your business model disclosure comprehensive, covering all relevant elements?
  • Does your disclosure cover all your significant businesses?
  • Are the key drivers of your business model clear?
  • Does your disclosure link well with other areas of the strategic report and is it consistent?
  • Does the business model graphic improve the understandability of the model for those outside the organisation?

Importance of good disclosure

Investors consider that all listed companies should provide good business model disclosure. It is particularly important for companies not well covered by analysts (often smaller listed or those quoted on the Alternative Investment Market) as it provides context to all other information in the annual report. According to investors, the benefits of providing comprehensive business model disclosure include:

  • Avoiding the risk that others less close to the business develop their own definition of the business model
  • Enhancing investor trust by demonstrating the board’s clear understanding of their business and its key drivers
  • Enhancing internal alignment of understanding of the purpose and strategy of the company.
Current practice

Although investors believe the case for good disclosure is clear, they think companies need to do a better job. Practice by companies is varied, with business model disclosures ranging from very high level to quite detailed and covering different information sets. This variation is partially a reflection of some companies not understanding the importance of their business model disclosure to investors. In particular, investors find current disclosures are often lacking information that answers questions such as:

  • What are the key revenue and profit drivers and how do profits convert to cash? 
  • Are there any key asset and liability items that support the business model?
  • What is the competitive advantage?

During the project, some companies expressed concern that disclosure of their competitive advantage is commercially sensitive and could impact the company’s prospects. However, investors believe companies can balance commercial sensitivity with providing sufficient disclosure to enable them to understand what differentiates the company. They are not looking for the detailed ‘secret recipe’ to be published; rather they want to understand that the ‘recipe’ is a competitive advantage and therefore how its value is maintained and enhanced.

Investors also note improvement is needed in linkage and consistency between the business model and other information in the annual report. Investors believe that natural linkage can be achieved if the key drivers of the business are clearly articulated in the business model disclosure.

Presenting the business model

Nearly all investors believe the business model should be presented near the front of the annual report, with many wanting it presented as the first section, as it provides context to the remainder of the information.

Investors want the business model description to be written in plain, clear, concise and factual language. They indicate that promotional and aspirational language obscures their ability to understand the business model and it is not conducive to fair and balanced reporting, so it should be avoided – some investors say such language discourages them from reading further.

Most investors believe business models are best communicated through a combination of infographics and detailed narrative. However, some investors prefer good quality narrative only, and view many of the existing graphics as unhelpful at best. Consideration should be given to whether the addition of a graphic depiction achieves greater impact and understandability than narrative alone (for instance, in depicting relationships or relative importance of elements).

Where there is more than one significant business, investors expect companies to present each business model together with the group business model for holding the different businesses.

Once the business model disclosure has been clearly defined and meets investor needs, investors expect that companies will only modify the disclosure to reflect substantive changes. Changes in the year and forthcoming changes should be clearly identified, including their rationale. Companies should consider how best to communicate significant business model changes – a small number of investors believe the inclusion of both pre and post-change business models in the year of change can be helpful.

Dividend disclosure

In November 2015, the Financial Reporting Lab published a report ‘Disclosure of dividends – policy and practice’. Based on input from 19 companies and 31 investment organisations, the report suggested ways to enhance disclosure of dividend policy and practice.

From an investor’s perspective, a company’s strategy for determining and funding dividends is often key to their own investment decision. Dividend policy disclosures are an important way that companies can communicate their intentions to investors, however it is an area in which disclosure could be improved.

Dividend decisions are taken in the context of a range of factors and circumstances, including the company’s approach to capital management and its business model and strategy – for example, how it is pursuing reinvestment in the business, acquisitions, capital requirements in regulated businesses, etc. Although a company’s business model disclosure is about how it generates financial value, dividend policy disclosure communicates the extent to which the company will distribute this to shareholders.

Good dividend disclosure should answer the following questions:

  • Why this policy?
  • What will the policy mean in practice?
  • What are the risks and constraints associated with this policy?
  • What was done in practice under the policy?

What makes a good disclosure?

Providing an understanding of this wider context is important. The Lab’s report on dividend disclosure stressed the importance of developing a coherent and consistent narrative on dividends, through both the disclosure of policy and practice.

Dividend policy disclosure

Good disclosure provides an understanding of the board’s considerations in setting the policy, including the rationale for the approach selected, and sufficient detail on what is intended:

  • Progressive: clarity on the level and period of progression, i.e. maintaining the dividend; or a minimum, range, target or specific level of increase, or 
  • Payout ratio: the defined basis for the ratio (e.g. IFRS or adjusted measure), its rationale and whether a minimum, range, target or specified ratio is adopted.
Dividend practice disclosure

Lab project participants suggested that good disclosure includes the key judgements and constraints in applying the policy, including the availability of sufficient cash and distributable profits/reserves to pay dividends and makes clear linkage between the policy and specifics on how it has been applied.

Bringing together various elements of disclosure to provide a focused narrative on decision making by the board in relation to dividends is important to investors and helps them assess the likely approach the board will take in the future.

How is practice changing?

A recent review by the Lab of FTSE 350 dividend disclosures noted encouraging improvement by 28 companies. Key areas where companies enhanced disclosure include examples that:

  • Explained the details of the dividend policy and how it is intended to operate (11 companies)
  • Added context on factors considered in adopting the dividend policy with some including the approach to capital management (four companies)
  • Explained the relevance of dividend resources (16 companies) by providing a distributable profits figure for the parent company, or confirming the sufficiency of distributable profits (and for some cash) for dividends, or providing insight on the availability of distributable profits at the level of significant operations below the parent
  • Brought together disclosure related to dividends (one company).

Room for improvement

Further improvement is expected over this year’s reporting season as companies have had more opportunity to consider how best to enhance their disclosure in light of the report and their own circumstances. Investors would particularly welcome more detailed disclosure of how dividend policies operate in practice, from policy to declaration.

They would also welcome disclosure of risks and constraints, which may impact dividend policy and declaration decisions (especially pertinent to continued concerns around pension deficits, the potential impact of Brexit and other factors that may have a bearing on capital management decisions).

More details can be found in the summary of findings from the Lab’s review available on the
FRC’s website.

Thomas Toomse-Smith is Project Director at the FRC Financial Reporting Lab

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