As CFOs I believe you are in a unique position in your organisations given you have the opportunity to engage with every element of your business. A few years ago I heard the CFO role described as "the single source of truth" and thought it fit well. Organisations and stakeholders need relevant, reliable, comparable and understandable information and you are in the best position to get it. Your financial report is at the heart of financial reporting.
While numbers are expected to be your core competency the increasing need for you to contribute to and tell the story of your business means you would also be expected to be developing soft skills such as communication to ensure effective financial reporting.
The increased need for you to tell your organisation's story to the market aligns with new developments in financial reporting which mean it is seen more broadly than the financial report. My talk is designed for CFO's at organisations that wish to tell their story effectively, not those, and I believe there are still some, that don't believe in transparency, and are very defensive about giving information to the market.
We all know the world is changing quickly and we have to recognize important trends in our areas of responsibility. A very important trend in our area is the increasing emphasis on transparency, including in financial reporting.
I will cover this trend in my talk as well as its connection with other trends in financial reporting.
Firstly I'll explain the Financial Reporting Council's role. The Financial Reporting Council (FRC), which I chair, is responsible for overseeing the effectiveness of the financial reporting framework in Australia. Its key functions include the oversight of the accounting and auditing standards setting processes for the public and private sectors, providing strategic advice in relation to the quality of audits conducted by Australian auditors, and advising the Minister on these and related matters to the extent that they affect the financial reporting framework in Australia.
The FRC monitors the development of international accounting and auditing standards, works to further the development of a single set of accounting and auditing standards for world-wide use and promotes the adoption of these standards. It is a statutory body under Part 12 of the Australian Securities and Investments Commission (ASIC) Act 2001.
In short, the FRC is the key external advisor to the Australian Government on the financial reporting system.
To meet its objectives the FRC seeks views from a broad range of stakeholders, including users, preparers and auditors of financial reports. Among the stakeholders are the Commonwealth, State and Territory governments, standard setters and industry regulators, as well as professional accounting, business and investor bodies. Key stakeholder bodies are represented on the FRC as Members. There are currently 16 Members including myself. I am interested in your views as preparers of financial reports, hence I am attending this Summit and giving this presentation.
The case for transparency
I am sure that CFO's who attend this Summit would be outward-looking hence would already understand the case for transparency however I will repeat it to confirm your views.
In general, organisations that lack transparency in their operations, that is those with overly complex financials and structures, are riskier investments. The reason is simple: less information on relevant issues means less certainty for investors. When financial statements are not transparent, investors can never be sure about an organisation's real fundamentals and true risk.
High-profile cases such as Enron showed everyone that managers that employ opaque financials and complex business structures tend to hide unpleasant news -which can mean nasty surprises to come.
Transparency pays, according to Robert Eccles, author of "The Value Reporting Revolution" (2001). Eccles showed that companies with fuller disclosure win more trust from investors. Relevant and reliable information means less risk to investors and thus a lower cost of capital.
A related experiment was conducted in 2002 with reports of a Danish company called Coloplast. An edited version of Coloplast's 2002 annual report was prepared that omitted all of the contextual information and non-financial data. This modified, pared-down version of the report complied with accounting standards and included the sort of narrative that companies typically provide in annual reports, but nothing more. Different teams of analysts were then given either the full original or the edited version of the report, but not both, and asked to:
- Develop a forecast of revenue and earnings
- Provide a "buy" or "sell" recommendation for the stock
- Provide an assessment of the relative riskiness of the company and
- Provide a supporting rationale for their recommendations
The teams had two hours to complete their task - without consulting others or referencing external information sources. The outcomes of the teams' efforts proved quite interesting.
The analysts given the original, information-rich report actually forecast lower revenues and earnings than did the analysts who used the financially-based, regulatory-compliant version, which at first sight seemed to disprove the hypothesis that companies are rewarded by providing the information that investors are seeking. Despite the lower forecasts however, 60 % of the analysts with more complete information recommended buying the stock. By contrast, nearly 80 % of the analysts with less complete information recommended selling the stock.
With more contextual information to support the financial data, it appeared that the analysts had more confidence in their forecasts and were much more likely to issue a "buy" recommendation. Conversely, the analysts who used financial information alone showed less certainty in their economic projections, questioned the value of the company, and came up with an overwhelming "sell" recommendation.
The message to companies is that, although analytical investment models may be financially driven, confidence in their use increases when there is greater access to more contextual and non-financial information.
As you know in Australia the Corporations Act 2001 requires a "financial report" and stipulates its contents as including financial statements, the notes and the directors' declaration (S295 (1)). Broadly, financial reporting can be said to be the periodic process of providing information in financial statements (including the notes) about the financial position and performance of a reporting entity to users to assist them in making informed decisions about allocating scarce resources.
Financial reporting has always been helpful in reviewing the performance and financial position of an organisation at a point of time in the past. An increasing trend connected with the need for transparency, probably resulting from the GFC, is for users to seek more forward-looking information. This trend has led to more importance being attributed to the management discussion and analysis (MD&A) in the annual report, as signaled by the Coloplast experiment.
Last year ASIC introduced Regulatory Guide 247 to assist preparers to better complete this section of annual reports known in Australia as the Operating and Financial Review or OFR.
This guide shows you how to tell your story effectively. It describes how to provide shareholders with a narrative and analysis to supplement the financial report and assist shareholders in understanding the operations, financial position, business strategies and prospects of an entity. If you haven't already read it closely I encourage you to do so.
An associated trend that is becoming more topical is integrated reporting. Based on a strategic plan agreed by FRC Members in 2011, the FRC set up a Task Force to review developments in integrated reporting.
Last year, the FRC, amongst many other organisations, sent a submission to the International Integrated Reporting Committee (IIRC) in relation to their proposed framework for integrated reporting which has now been released. One of our concerns was that it would add to reporting burdens when financial reporting is already seen as too complex. The IIRC answered each concern we raised in our submission in writing because we represent multiple stakeholders. They clarified that the integrated report should be identifiable, but this does not mean it needs to be additional where existing reporting requirements are consistent with the proposed integrated reporting framework.
For example, an integrated report can be prepared in response to existing compliance requirements such as a requirement to prepare a management commentary that provides context for its financial statements – e.g. the OFR in Australia. Furthermore, they have confirmed that the OFR could be the vehicle used for the integrated report in the Australian context.
I hope you are focussing more on telling your story through the OFR if your company is listed with ASIC, as well as users of financial reports, will be watching this development in financial reporting. I also encourage you to read the integrated reporting framework, whatever your organisation type, as it could give you some good ideas for more effective reporting. Involvement in better reporting should also help people within your organisation better understand how it adds value over time hence improve their performance.
I should be completely clear here that the view of the FRC and the Government is that adoption of integrated reporting in Australia will be completely a matter for the reporting entity, and is most appropriate as an issue for consideration for listed entities.
As mentioned, one of the major concerns currently in financial reporting is increasing complexity. The FRC also established a Task Force called the "Reducing Complexity Task Force" in 2011 to address this major issue. After a couple of meetings the members realised they could not reduce complexity as it was mainly due to fundamental forces such as increasingly complex business operations and complexities in the regulatory framework. They changed their name to the "Managing Complexity Task Force" and, after submissions from stakeholders, released a report with recommendations that are now being followed up.
Three major recommendations were to:
1. Examine how the current financial reporting regime for the various types of reporting entities in Australia can be best explained and understood, and if needed, seek rationalisation of the regime (for example, through further deregulation of who needs to report).
A new FRC Task Force has now been established to progress this recommendation to review Australia's financial reporting system and offer advice, as appropriate. This Task Force is currently in the information gathering stage.
2. Encourage a more coordinated approach between different agencies of government when considering accounting disclosure requirements
The Australian Accounting Standards Board (AASB), the Auditing and Assurance Standards Board (AUASB) and ASIC have agreed to work together to encourage simplification of reporting practices in Australia. As a result the AASB recently released a staff paper on their website "To Disclose or Not to Disclose: Materiality is the Question". The paper is designed to prompt you to rethink your criteria for determining which disclosures to include in your financial statements. The AASB is also contributing to the IASB's efforts to achieve simplified disclosure requirements in the future. ASIC has already confirmed that its financial reporting surveillance program focuses on the importance of material disclosures and issued a media release on this topic (27 November 2012) emphasising that directors and auditors should focus on disclosures of useful and meaningful information for investors and other users. The AUASB similarly plans to issue guidance to auditors on the same topic. It is well recognized that too much irrelevant information is a distraction to understanding the financial report.
3. Encourage preparers to make better use of developments in information technology in the delivery of financial reports.
The Task Force advised, for example, that while the current trend is for company reports to be provided to users on company websites only in a PDF format (which does not allow users to effectively navigate through particular sections of interest), companies should provide the information contained in Annual Reports to users in an interactive online format which allows users to not only be able to filter the specific information they require, but also be able to access the level of detail suited to their needs.
The Task Force also suggested that consideration be given to allowing companies to present their governance policies and procedures on their websites to help minimise the current boilerplate descriptions that are found in Annual Reports.
As a result the ASX, through the new Corporate Governance Guidelines, is offering greater flexibility to listed companies to make their governance disclosures on their websites rather than in their annual report.
More financially literate directors
A topic highly related to complexity in financial reporting is the financial literacy of Directors. The FRC set up a Financial Literacy Task Force before the Centro case hit the headlines because the FRC strategic plan identified this as a significant issue.
A survey was conducted with both directors, and financial professionals who deal with directors, being asked to rate the financial literacy of directors in Australia. They were also asked to suggest ways that the financial literacy of directors could be improved.
Some of the observations from the survey included:
- There were challenges for directors in acquiring and maintaining the level of financial literacy they needed
- The financial professionals who deal with directors rated director financial literacy at notably lower levels than the directors themselves
- Financial professionals who regularly deal with directors, on average, rated the general financial literacy of the directors of the top 200 ASX listed entities (good to very good) higher than that of other ASX listed entities (fair to good) and substantially higher than non-listed entities (poor to fair).
- Both directors and financial professionals rated the knowledge of directors of basic accounting principles (fundamental accounting concepts, the purpose of financial statements, the role of accounting policies and the role of notes in financial statements) as higher than their knowledge of specific, more technical accounting issues.
- Directors conceded that on average their knowledge of more technical accounting issues was fair. The financial professionals who regularly deal with them, on average, rated it as poor to fair.
- A number of respondents expressed concern that the increasing complexity of accounting standards is making it more difficult for directors to acquire and maintain the level of financial knowledge needed to sign off on financial statements.
Three follow up actions taken as a result of the survey, as well as suggestions from participants are:
- ASIC has developed a webpage on financial literacy for directors with links to appropriate courses on financial literacy for directors provided by ICAA, CPA Australia, IPA Australia and the AICD.
- A free directors' financial literacy app is being developed by a working group of the same organisations so that directors will be able to self test their financial literacy and undertake appropriate education if warranted.
- The AICD is developing a publication called "Financial Fundamentals for Directors". This follows introduction by the AICD of compulsory continuous professional development requirements for all directors, requiring them to keep up to date with developments affecting directors, including changes in financial reporting laws, accounting standards and regulatory expectations, as suggested by survey participants.
Increased pressure on auditors internationally
Another important financial reporting trend is increased pressure on auditors.
The latest audit reforms in Australia were introduced in 2012. These reforms were under the Audit Enhancement Bill and arose from a strategic review undertaken by Treasury of audit quality in 2010 which considered how Australia's audit quality framework compared internationally. The general consensus of this review was that Australia's audit environment was stable and no major changes were needed.
The main reforms that were introduced were:
- A change in the role of the FRC giving it a strategic policy role of advising the Minister and professional accounting bodies on audit quality in Australia.
- The flexibility to extend the five-year auditor rotation period by up to two years, provided the audit committee or directors are satisfied that auditor independence and audit quality can be maintained.
- The publication of a transparency report by audit firms that audit more than ten significant entities in a year, thereby ensuring that factual information is publicly available about firms who audit listed and other publicly important entities such as banks and insurance companies.
- Allowing ASIC to publish audit deficiency reports where ASIC believes an audit firm has not taken appropriate remedial action to remedy a failure to comply with relevant auditing standards, codes of conduct, or requirements under the Corporations Act 2001, and also allowing ASIC to communicate directly with an audited body.
By contrast audit reforms being considered in Europe are more detailed and intrusive, largely as a result of bank failures there during the GFC.
Michel Barnier, the current EU Commissioner for Internal Markets, has led the debate. In 2011, the legislative process began when some major reforms were proposed to become part of EU law.
Late last year, the Lithuanian Presidency of the EU managed to achieve political agreement on proposed audit reforms. The next step is a formal vote in the plenary of the European Parliament. This "European Union Compromise Package" would then become legislation however, although the Regulation could come into force quite quickly, the Directive has to be translated into law and implemented by each member state. This is generally required to take place within two years. As they are mutually dependent, immediate effect is unlikely.
The headline messages are that the reforms would introduce a 10 year mandatory audit firm rotation regime for the audits of EU public interest entities (with a member state option to allow another 10 years if a competitive tender or joint audit is held), and substantial new restrictions on the provision of non-audit services.
It is not likely that the US will introduce similar audit reforms. If and when they are introduced in Europe the FRC will consider the implications for Australia.
An audit development that is more likely to affect more Australian companies is the auditor reporting project. This project has resulted from pressures from users for better information about audits. The project was instigated by the International Auditing and Assurance Standards Board (IAASB) to encourage auditors to provide meaningful commentary with their audit opinions.
The FRC sent a submission to the IAASB last year, developed by our Audit Quality Committee, noting that the proposed reporting by auditors on key audit matters provides useful information to users. However it is possible to confuse key audit matters with key business risks hence it needs to be clear that key audit risks are not necessarily key business risks, and vice versa. We were also concerned about the auditor potentially providing "original information" about the entity, which should be the province of management and those charged with governance.
There is an additional concern about expanding the auditor commentary on "going concern" given different users of financial reports have widely divergent understandings of this concept. The FRC based this concern on a survey conducted by the FRC on perceptions of the usefulness of audit reports for retail shareholders conducted in 2012. We believe that the concept of a "going concern" and its application is a matter better addressed by accounting standards, not audit standards, and we continue to encourage the IAASB to liaise with the IASB to clarify the relationship between accounts that are prepared on a "going concern" basis and whether or not the entity is likely to be viable in the medium to long term.
Continued progress to one set of global accounting standards
The final trend I will discuss is progress to one set of global accounting standards. This has been planned for many years and has been a G20 agenda item since the Washington G20 Leaders' meeting of November 2008. I am very interested to know if this is an issue for you, as preparers, given Australia is hosting the G20 this year.
As you would know, Australia was one of the early adopters of International Financial Reporting Standards (IFRS) in 2005 - and this is because we recognised early on, that with the current pace of globalisation, the movement to a global set of accounting standards is a logical transition. In today's world where businesses and investments operate on a global level - companies, investors and other stakeholders all gain from the use of one set of accounting standards. Companies can prepare reports for subsidiaries located in different countries on the same basis; a lower cost of capital can be accessed by companies because investors can easily understand and compare financial information across jurisdictions; and the problem of regulatory arbitrage can be minimised. In economic terms, having one set of accounting standards allows the market to operate efficiently - and everyone benefits from an efficient market. IFRS are particularly important to Australia given we are a capital importing country.
IFRS are now being used by over 120 countries around the world and they are a major contributor to transparency in financial reporting. Global investors are no longer as hampered, as they once were, by accounting rules that differ country by country.
Furthermore convergence projects between IFRS and US GAAP have significantly reduced the differences between them. While the GFC has delayed a positive decision by the US on adopting IFRS, it was agreed in 2007 that foreign registrants in the US could lodge their financial reports in IFRS, without reconciliation to US GAAP.
Large multinational companies in the US are now being encouraged to consider using IFRS more as part of a cost cutting effort. Last year a senior manager from Ford, for example, was reported as saying that they are adopting IFRS to save time and money-that they found it more cost effective to convert from IFRS to US GAAP in the corporate office than to convert from US GAAP to IFRS in 60 different subsidiaries.
US GAAP takes a rules based approach to accounting while IFRS exemplify the principles based approach. While a principle based approach can be criticised for offering flexibility, a rules based approach, by specifying what companies can do, means they can follow the letter of the law while avoiding the spirit of the law.
It is now generally recognised that IFRS is the appropriate set of global accounting standards that will achieve a global language for financial reporting.
In preparation for the future the IFRS Conceptual Framework is currently being reviewed. Comment was requested by early this year in the first stage of the process. The FRC submitted that, given Australia has adopted a transaction-neutral framework, with IFRS used as the basis of accounting standards in the for-profit, not-for-profit and public sectors, it is important that the conceptual framework continues to allow for this integration of accounting standards across each economy as well as across all economies.
Therefore we encouraged the IASB to use sector-neutral expression in the conceptual framework wherever possible, and to maximise its liaison with the International Public Sector Accounting Standards Board (IPSASB) regarding the Boards' respective conceptual framework projects. We also suggested that the framework could be enhanced with a clear and simple introduction, designed to be read by key financial report stakeholders such as directors, so they can better understand the principles underpinning IFRS. While the FRC submission provides a high level strategic oversight of the issues involved the AASB has provided a much more detailed analysis in its submission.
I hope you now better understand some of the trends in financial reporting that the FRC is considering, that you are even more supportive of transparency, and that this talk is useful to you in some way in telling your story through financial reporting.
My final message is please contribute to the debates about financial reporting. Standard setters regularly seek advice on developments and views are appreciated – especially regarding the practical implications for reporting entities. With your input we can continue to improve financial reporting in Australia.