Time for financial reports to look to the future

Is the emphasis on historical financial performance in annual reports overdone? And is there a need to develop a new vision for corporate and financial reporting? writes Ian Gomes.

An electronic board displays trading activity and the Dow Jones Industrial Average. Jin Lee / Bloomberg

If you asked a member of the public or many investment professionals why companies should prepare an annual report, they will tell you about the importance of having a reliable earnings number as a basis for assessing business value and how it has been managed.

Ask an accountant and you will get a different answer. They are more likely to focus on the essential role that the annual report plays in helping shareholders assess management’s stewardship of business assets by summarising the results of huge volumes of transactions.

Society needs business reporting to address both these perspectives. This means acknowledging the role that financial reports play in investors’ decision making, alongside the essential role they play in shareholder assessment.

Financial statements too have traditionally been a key element in the corporate reporting chain. But will that still be the case in 10 to 20 years?

I believe that it is unlikely, as pressures build for a new vision for corporate and financial reporting, as well as for the related assurance the auditing profession provides. The scope of corporate reporting should be extended to better support investors’ own assessment of business value and performance prospects, and to enable investors to make judgments about the sensitivity of their assessments to key risks and opportunities.

Providing future-orientated information on the basis of clearly stated assumptions is an important part of this, while at the same time recognising the legitimate concerns that companies may have in doing this.

There is an increasing sense among stakeholders – boards, audit committees, investors and auditors alike – that traditional financial reporting, which for most large and listed companies in Europe (and elsewhere) is based on reporting historical earnings performance under International Financial Reporting Standards, is becoming increasingly less fit for purpose.

The extent of shareholder value creation is rarely sufficiently visible in today’s annual reports so that, while shareholders can see how much profit the business has generated, they have little sense of how those results have arisen and very little knowledge of whether the current year’s earnings are sustainable.

There are various reasons why people criticise the relevance of today’s financial statements.

Some feel that they have become overly complex, others that they are focused too much on technical issues and detail, rather than on the big picture. Others say they are too voluminous in disclosure, and that the notes covering sensitive areas are too often expressed opaquely. Moreover, they are not linked sufficiently with the overall strategy and business model of the entity as set out in the director’s report or management commentary.

This complexity has many causes. It is not only the growing volume of disclosure that leads to more complexity in financial statements. Obviously, the world of business and finance itself is more complex than it was a few decades ago, and this growing complexity is also reflected in financial reporting. However, financial reporting itself may at times also contribute to complexity, for example, where requirements in standards become overly anti-abuse driven, overly prescriptive, or no longer reflective of the business model that the reporting set out to portray.

The result of increased complexity and volume in detail is that financial statements are increasingly seen as a compliance document – to satisfy some companies law requirement, an exercise for the accounting experts only. A broader discussion is required as to whether the current reporting package is adequate or aligned to the needs of investors, those of the capital market and the wider stakeholder community.

The focus of traditional reporting on past performance creates a gap between the information reported and the information needed to assess business values. Where are the assumptions about the ability of business to generate returns over the medium to long term? What expectations do managements hold regarding changes in the business environment and what are their potential responses to enable value addition? Risk disclosures, too, focus on mitigation as “business as usual”, not on future risks, and rarely enhance the reader’s understanding of business prospects.

To heed that call, now is the time to start thinking afresh, in new and bolder ways than we have done before.

Ian Gomes is head of advisory – KPMG Lower Gulf