30 January 2018 by Phil Fitz-Gerald
The Financial Reporting Lab asks what is required from company disclosures
In November, the Financial Reporting Lab released a report called ‘Risk and viability reporting’. The report summarised views of more than 200 retail and institutional investors, gathered by the Lab from a series of roundtables, interviews and surveys.
The Lab began the project by seeking to understand if investors wanted risk disclosures and if so, what they did with them.
The answer to the first question is emphatically yes. There was a clear indication from investors that understanding the risks faced by a company is essential when making investment decisions, both before investing and during the holding of that investment.
The interaction between a company’s risk profile, an investor’s risk appetite and views on the overall reward from those investments is a complex and constantly-changing assessment that investors make. To do this they need regular and detailed information.
“There was a clear indication from investors that understanding the risks faced by a company is essential when making investment decisions”
Investors see the annual report as a regular and reliable source of information from the company for their assessment of risk. Other sources of company-specific risk information used included investor presentations, prospectuses and meetings with management.
This is important context: the annual report disclosure is only part of what investors look at, and as such, it needs to be a consistent and integrated part of the whole suite of risk information.
Investors in the project felt that since the financial crisis their interactions with companies and directors suggested an increased focus on risk management. Overall they also felt that companies had improved their risk disclosures in the annual report.
Based on the feedback, all companies are encouraged to consider the following:
The Lab’s analysis of risk disclosures from the past five years showed that they have become more comprehensive, but they are still not delivering fully for investors. The Lab worked through some example disclosures with investors and identified areas of good practice.
The full Lab report provides a detailed explanation of what investors liked about each example. However, they shared the following characteristics:
Overall, investors want risk disclosures to be useful information and not an exercise in management liability avoidance. Companies that focus on communicating their perspective on the risks and challenges that they face will be of far greater value to investors.
Although companies have had some years to try and perfect risk reporting, viability reporting is in its infancy.
It is fair to say that investors participating in the Lab’s project were underwhelmed with current reporting, principally because they did not feel it was providing them with sufficient information to assess the long-term sustainability of a company’s business model.
The Sharman Inquiry was initiated in 2011, after the financial crisis and amidst concerns that companies were not adequately considering their long-term viability. Leading on from the outcome of the inquiry, the viability statement was introduced in 2014 to the UK Corporate Governance Code as a means of requiring directors to report annually on viability.
“Investors participating in the Lab’s project were underwhelmed with current viability reporting”
Both companies and investors acknowledge that viability is integral to the decisions that each of them makes. For companies, their continuing existence and growth is dependent on the sustainability of their business model and strategy – and therefore critical considerations for boards.
For investors, investment decisions are determined, at least in part, by the confidence they have in the sustainability of the company and its stated business model and strategy.
For companies that participated in the Lab’s project, there was a view that long-term thinking had been a key consideration of management and boards for some years.
However, the formalisation of the review as result of the viability statement had been useful, particularly the requirement to carry out quantitative and qualitative analysis.
Although investors encourage this focus from companies, they do not think that the current viability disclosures often deliver useful information.
Investors are looking for companies to explain their long-term prospects more clearly. The current practice is often that viability statements are prepared as a form of longer-term going concern statement with a focus on liquidity, rather than as a means to communicate how the company will remain relevant and sustainable in the longer-term.
Details of the stress, or scenario analyses, that have been performed are particularly useful in providing information on the company’s resilience to risk, especially where they include details of the extent and likelihood of mitigating activities.
The Lab project considered how to move practice forward in viability reporting. Companies have real concerns that focusing on relevance and sustainability of long-term business model is not in line with the requirements and might leave them exposed.
However, the Lab’s work highlights a potential way of balancing the different views of companies and investors.
The UK Corporate Governance Code envisages a two-stage approach to the viability statement. It recommends that the directors firstly consider and report on the prospects of the company, taking into account its current position and principal risks.
Secondly, they then can state whether they have a reasonable expectation that the company will be able to continue in operation and meet its liabilities as they fall due (over the period of their assessment), drawing attention to any qualifications or assumptions as necessary.
Investors are not necessarily looking for viability statements that cover very long periods, but they are encouraging companies to consider their prospects over a longer term, relative to their specific business. They understand that the directors must have a reasonable expectation that covers the period over which they state viability.
The code links the period for the assessment of prospects and the statement over viability in a way that suggests they should match.
However, many investors would like more information about the risks and prospects of a company over a more extended period, consistent with the company’s investment and planning process (the first stage), even if the statement (the second stage) is limited to a shorter period.
The full Lab report provides detailed examples of good practice for both risk and viability reporting as well as providing more on the views of the companies and investors that took part in the project. It is available for free from the FRC’s website.