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FRC publishes findings on the quality of corporate reporting in 2018/2019

  • FRC Image

30 Oct 2019

The Financial Reporting Council (FRC) has published its Annual Review of Corporate Reporting 2018/2019, which provides the FRC's assessment of corporate reporting in the UK based on evidence from a variety of sources, including the work of the FRC's own Corporate Reporting Review (CRR) team.

In announcing the publication, the FRC commented:

The FRC expects companies to improve the quality reporting of forward-looking information, the potential impact of emerging risks on future business strategy, the carrying value of assets and the recognition of liabilities. Failure to report on these crucial areas undermines trust in business and can lead to the conclusion that management is either unaware of their potential impact, is being opaque, or is not managing them effectively. 

In times of uncertainty, investors and other stakeholders expect greater transparency of the risks to which companies are exposed and the actions they are taking to mitigate the impact of those uncertainties. The FRC expects companies to think beyond the period covered by their viability statement and identify those keys risks that challenge their business models in the medium to longer term and have a particular focus on environmental issues.

The report is structured around the FRC’s overall assessment of corporate reporting and in particular focuses on those areas which fall within the remit of the FRC’s reviews: the financial statements and the strategic report. It provides findings for the year, highlights where the FRC see room for improvement and sets out the FRC’s expectations for the coming reporting season.

Alongside the Annual Review the FRC has also published a letter to Audit Committee Chairs and Finance Directors in advance of the 2019/20 reporting season on key areas that need to be considered in the preparation of forthcoming annual reports and accounts. Those key areas are drawn from, and are consistent with, the findings included in the FRC’s Annual Review of Corporate Governance and Reporting.

Financial Statements

The FRC observes that the frequently raised issues this year were very similar to those raised last year; in particular questions continued to be raised with respect to the adequacy of key accounting judgements and estimates disclosures, aspects of the strategic report, alternative performance measures and cash flow reporting. Whilst the FRC highlights that “…generally reporting has improved” and that “more companies appear to be getting more of the basics right” it does suggest that there is still “scope for improvement”. The most significant findings of the FRC relating to financial statements include:

  • Judgements and estimates companies make in the preparation of their accounts.   The FRC indicates that this is “still the most frequent area of questioning”. Most companies are now clearly distinguishing between judgements and estimates and there were fewer instances of boilerplate disclosure. The FRC also found that there were fewer cases where matters were not disclosed as key judgements or areas of significant estimation uncertainty in the financial statements despite indicators to the contrary elsewhere in the annual report.

However, similar to last year, the area of most frequent challenge was in relation to lack of, or inadequate, sensitivity analysis or information about the range of possible outcomes for areas of estimation uncertainty. Specific areas of estimation uncertainty where there was a lack of sensitivity analysis included impairment reviews, pension assets and liabilities, uncertain tax positions and onerous contracts.

The FRC also questioned estimation uncertainties “which did not appear to give rise to a significant risk of material adjustment to the related balances within the next year”. The FRC encourages “companies to be mindful that the judgements and estimates disclosed are those with the greatest potential effect on the financial statements”.  

  • Consolidation adjustments. The FRC questioned consolidation judgements, specifically the question of control over another entity. Questions focused around:
    • The control of trusts;
    • the determination of joint control in a situation where one party holds a majority of voting rights;
    • de facto control, in a situation where a company and its associate have several directors in common; and
    • the point at which control passed with a “locked box” arrangement.

The FRC indicates that “companies need to have a full understanding of the rights and obligations – both contractual and constructive – arising from their arrangements, in order to assess the criteria for control of another entity and determine correctly whether or not it should be consolidated. This may be particularly relevant in situations such as a joint arrangement where the rights arise from contractual, rather than voting, rights”. The FRC encourages companies to disclose the nature of these judgements made in accordance with IAS1:122 where material.

  • Cash flow statements. A “significant number of questions” were raised in this area. The FRC notes that many of the errors identified were basic commenting that “it remains a concern that companies’ own quality control procedures and those of their auditors are failing to spot such matters”.  The most common errors were in relation to misclassification of cash flows between operating, investing and financing activities:
    • Examples of cash flows incorrectly included within investing included:
      • Fees received from associates and joint ventures
      • Restructuring and post-acquisition integration costs
      • Purchase and sale of rental fleet assets
    • Examples of cash flows incorrectly included within operating included:
      • Disposal of investments in joint ventures
      • Non-trading advances to joint ventures
    • Examples of cash flows incorrectly included within financing included:
      • Repayments of loans to joint ventures
  • Additionally the FRC challenged companies where:
    • additions and disposals of assets held under finance leases were presented as cash flows;
    • dividends from associates and joint ventures were not presented separately;
    • there were unclear captions providing insufficient explanation of cash flows presented;
    • basis for inclusion or exclusion of amounts such as overdrafts and current asset investments within cash and cash equivalents was not clear; and
    • there was difficulty in reconciling movements in working capital balances to the amounts shown in the reconciliation of cash flows from operating activities.

The FRC draws attention to its recent Lab report Disclosures on the Sources and Uses of Cash which companies should use to help them improve disclosures as to how cash is generated and used linking to strategy and priorities for that cash.

  • Supplier financing arrangements. The FRC continues to raise concerns about the adequacy of disclosures provided to explain supplier financing arrangements although it does indicate that there has been “an increase in both the number and quality of disclosures”.   The FRC expects disclosures in this area to contain:
    • An explicit statement to confirm reverse debt factoring is not used;
    • The accounting policy applied;
    • Whether the liability to suppliers is derecognised;
    • Whether the liability is included within KPIs such as net debt;
    • The cash flows generated by such arrangements; and
    • The existence of any concentrations of liquidity risk which could arise from losing access to the facility.
  • Income taxes. There were fewer cases where the FRC challenged whether there should have been a tax effect reported in the financial statements for matters such as provisions and share-based payments. There were also fewer instances where companies were challenged on the allocation of tax effects between profit or loss and equity. However, the FRC did challenge companies whose descriptions of adjusting items in the tax reconciliation were not specific enough to enable a reader to understand their nature.
  • Provisions and contingencies. The FRC challenged companies’ disclosures relating to provisions – either they were missing or unclear or were not consistent with information disclosed elsewhere in the annual report. There were a number of instances of “inadequate disclosure” including:
    • Releases of provisions netted against increases in provisions;
    • Movement due to change in discount rate inconsistent with discount rates disclosed; and
    • Lack of disclosure of the uncertainties about the amount and timing of cash flows.
  • Fair value measurement. The FRC raised concerns about the application of IFRS 13 especially regarding the disclosure of the valuation techniques and inputs used for fair value measurements categorised within levels 2 and 3 of the fair value hierarchy, including quantitative information about the significant unobservable inputs used. Companies were also challenged where fair value hierarchy disclosures were not provided for all fair values disclosed or, where they were provided, companies were challenged if they were inconsistent with disclosure elsewhere. These challenges were predominantly in relation to the fair value measurement of financial instruments including derivatives.
  • Thematic reviews. The FRC published the results of three thematic reviews in relation to IFRS 9 Financial Instruments, IFRS 15 Revenue from Contracts with Customers and the impairment of non-financial assets on 10 October 2019. The FRC draws attention to the messages from these reviews. A thematic review looking at the initial application of IFRS 16 Leases will also be published shortly. The report, published today, includes preliminary findings of the areas of common weaknesses identified from that review.

Strategic reports

The FRC’s specific challenges to companies in this area were principally on:

  • the identification, description and mitigating actions taken to manage principal risks and uncertainties;
  • the comprehensiveness of business reviews; and
  • disclosures relating to alternative performance measures (APMs).

In relation to business reviews the FRC “frequently identified instances where significant balances or transactions had not been discussed or adequately explained in the strategic report”. The report includes a number of examples of areas that the FRC would expect to see discussion in the business review such as significant impairment charges or bad debts, performance of businesses acquired in the year, significant changes in working capital balances including trade receivables, trade payables and accruals, movements in provisions. Significantly, the FRC expects to see significant cash flows or changes in cash flows discussed.

In relation to APMs the FRC encourages all companies to comply with the European Securities and Markets Authority’s (ESMA’s) Guidelines on Alternative Performance Measures. The FRC notes improvements in:

  • the labelling of APMs with fewer adjusted measures given potentially misleading titles
  • fewer instances of undue prominence of APMs compared with IFRS compliant performance measures; and
  • explanations as to why APMs are used.

However, notwithstanding the improvements, the FRC continues to see:

  • Absent or unclear definitions of APMs and/or reconciliations to the closest equivalent IFRS line item;
  • Unclear reasons as to why certain amounts are excluded from adjusted measures that seemed to be part of normal business;
  • Instances of companies describing activities as non-recurring which had been reported for a number of years.

The FRC also commented that an “apparent reluctance to identify and highlight the audited IFRS numbers from which APMs are derived is a cause for concern.”

Other key areas of FRC focus include

  • Climate change – The FRC draws attention to its recently issued statement setting out its expectations of companies in relation to reporting on climate change and also the Lab report in this area. Companies should, where relevant, report on the effects of climate change on their business (both direct and indirect). Challenges were made of companies where the business model appeared to give rise to significant climate risk but no disclosures were made to that effect in the annual report. The FRC highlight that boilerplate disclosure should be avoided, commenting that companies who make such disclosures can expect “cursory or boilerplate disclosures to be challenged”.
  • Brexit – in previous years the FRC had reported that development of focused disclosures in this area has been “patchy”. The FRC is encouraged that companies now appear to be providing specific risks related to Brexit in the their annual reports along with mitigating actions that they have been able to take to address them. Almost all companies reviewed by the FRC with UK or EU operations referred to the risks of Brexit in their viability statements.
  • Non-financial information statement – the FRC found that whilst most companies reviewed made references to non-financial reporting matters in their annual report, the disclosures were “sometimes generic”. The FRC will continue to challenge companies where it feels that disclosures “fall short of the requirements” including the requirement to present the information in a separately identifiable non-financial information statement (although cross-referencing to the strategic report is acceptable). The FRC letter to Audit Committee Chairs and Finance Directors indicates that the statement should contain:
    • A clear description of the company’s policies.
    • Any due diligence processes implemented in pursuance of those policies and their outcomes in respect of environmental, social, anti-corruption and anti-bribery matters, employees and respect for human rights.
  • Section 172 reporting – the FRC encourages Board to disclose:
    • the issues, factors and stakeholders that they consider relevant in complying with s172(1) and the basis on which they came to that view;
    • the main methods they have used to engage with stakeholders and to understand the issues to which they must have regard; and
    • information about the effect of that regard on the company’s decisions and strategies during the financial year.
  • Dividends and distributable reserves – the FRC challenged companies that had paid interim dividends in excess of the distributable profits shown in their latest published financial statements. It reminds public companies of the need to file interim financial statements prior to a distribution being made if the most recent annual accounts do not show sufficient profits.

A slide deck of technical findings (see link below) from the CRR during the year has also been published, which gives more detail on the areas challenged by the Panel. The Annual Review of Corporate Reporting does not cover an assessment of corporate governance. Later this year, a separate report will be published which will assess early adoption of the new UK Corporate Governance Code, reporting on the 2016 Code and expectations for reporting in 2020.

The press release, full report, Technical findings 2017/18 and the letter to Audit Committee Chairs and Finance Directors can be obtained from the FRC website.  Our related Governance in brief publication is available here.

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