In an IFAC report, investment experts say financial accounts have become so complex it has become difficult to trace the financial performance of a business.
The complexity of some modern business activities risks undermining shareholder confidence, a leading institutional investor warns in a new IFAC report. Responding to a debate on how to develop better business reporting methods, Michael McKersie, assistant director of capital markets at the Association of British Insurers, says more informative financial accounts are needed.
For the third part of its series on improving business reporting, the International Federation of Accountants (IFAC) interviewed six specialists with close ties to the investment community. The key themes of the debate were the opaqueness of activities such as off-balance sheet accounting, warehousing of financial instruments and mark-to-market valuation.
Tanya Branwhite, executive director of strategy research at Macquarie Securities in Australia, says the complexity of financial accounts has increased to the point where it has become difficult for many investors to trace the financial performance of a business.
‘If financial accounts are not prepared with the users in mind, then we risk a whole area of unaudited “shadow reporting” being provided directly to investors that doesn’t go through the rigorous financial accounting process,’ she warns.
In response, McKersie, who represents the largest single group of investors in the UK, states: ‘If complexity is masking real issues, however, that is a real concern because that might result in less confidence. Therefore companies should genuinely try to produce financial accounts that are informative. In our opinion, this is a better way forward than introducing new regulations.’
The six interviewees provide insights into a number of other significant business reporting issues. These include information overload, fair value accounting, operational performance, convergence of accounting standards, real time reporting, management commentary and sustainability reporting.
According to Branwhite, all these reporting issues indicate that there is an urgent need for investors to become more involved in discussions about the presentation of financial accounts. ‘We can’t be critical of the accounting standard setting process unless we get involved and try to put forward solutions to some of the issues,’ she says.
Fair value
Another hot topic during the debate was fair value. David Webb, a Hong Kong-based investor and shareholder activist, says fair value accounting is important for comparability. ‘We need comparability between companies in a sector, between companies in a market and between companies in different markets,’ he says.
Supporting this stance, Matthew Waldron, director of the financial reporting policy group at the CFA institute, the global association of investment professionals, says fair value was ‘the most decision-useful measurement basis for investors.’
McKersie says he is concerned about the reliability of fair value measurements. But Waldron adds that investors feel that relevance had ‘primacy over reliability’ and thus ‘combining high quality disclosures with the fair values presented in the financial statements presents more decision-useful information.’
Direct cash flow method
According to the interviewees, the direct cash flow method might help retail investors better understand the performance of a company. Carlos Madrazo, head of investor relations at Grupo Televisa in Mexico, recommends that standard setters and regulators make more effort to distinguish between the impact on earnings that results from changes in fair value and those from the day-to-day running of the business.
Branwhite was also supportive. ‘There is merit in the use of a direct cash flow statement because the wider investor community will be able to see more clearly the operating performance of the business; the investing decisions being made by the business; how the business is being financed; and any changes in the value of the assets and liabilities,’ she says.
International convergence of accounting standards
Another topic high on the agenda was international convergence. Waldron says a single set of reporting standards will further improve comparability and analysis of investment opportunities globally. However it is agreed that convergence should not compromise quality.
Branwhite points out that the priority of both the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) should be to make the information in the accounts more relevant, reliable, transparent and consistent. ‘If convergence is not the outcome yet, we have not lost too much as long as those other quality criteria are met,’ she adds.
Management commentary
When it came to discussing management commentary, shareholder activist Webb suggests that an independent election system for independent directors would give them more authority. ‘In that case, I would favour giving them their own section of the annual report - and an obligation to report any issues that they are concerned about and any issues on which they have disagreed with the rest of the board,’ he adds.
Looking at the subject in general, Waldron raised the issue of quantity versus quality. ‘When companies include models, estimates, assumptions, principles applied, sensitivity analysis, and aggregated disclosures, they need to make sure that all of the qualitative factors - such as understandability, completeness, relevance and comparability - are considered,’ he says.
In response, Branwhite recommends the use of key performance indicators (KPIs). ‘Knowing what management has set as its KPIs is critical. It provides an insight as to how aligned the company’s long term performance objectives are with those of its shareholders,’ she adds.
Sustainability reporting
The interviewees had mixed views on the usefulness of sustainability reporting. According to Grupo Televisa’s Madrazo, investors are increasingly seeking information on a company’s environmental, social and governance performance because they see these as indicators of good overall corporate management - and often superior performance.
However, Webb argues that sustainability reporting is of no real value to investors. ‘We shouldn’t expect companies to try to make the world a better place at the expense of their shareholders,’ he says. Instead, he sees a role for governments: ‘If everybody is required to clean up their waste, companies will economically price it into their products.’
Branwhite concludes that: ‘As there are going to be very clear financial implications on social and environmental aspects, they should become integrated into mainstream financial reporting.’
The interviews above are from the third of a series of five articles on business reporting. The articles are based on interviews with 25 key business leaders from around the world and focus on their practical recommendations to improve corporate governance, business reporting and auditing in the aftermath of the financial crisis. The article and the full interviews are posted on the IFAC website, where readers are encouraged to comment on the recommendations. Based on the recommendations and reader input, IFAC plans to develop an overall concluding article; a follow-up action plan; and principles-based international good practice guidance.
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