Financial reporting debate: ‘utopia isn’t achievable’

Transcript

Joined-up financial reporting is something that leaders internationally are keen to achieve, with the European parliament plugging seven and a half million pounds into reporting standards groups. But is regulatory harmonisation realistic? World Finance speaks to a panel of experts – including Nick Jeffrey (Director of Public Policy at Grant Thornton), Marian Williams (Codes and Standards Director at the Financial Reporting Council) and Raj Thamotheram (Visiting Fellow at the Smith School of Enterprise and the Environment at the University of Oxford) – to find out if the EU’s vision is really just that.

World Finance: Now the move towards greater regulatory harmonisation has been shared by most, but do you think this is even a feasible plan?

Nick Jeffrey: Ideally we would like to see regulation harmonised across the world. Ideally. But that’s a little bit of a nirvana that we’re never really going to get. There’s too many barriers in the way of that. You’re never going to get international rules across the board.

We would like to see regulators continue to talk with each other, exchanging their views on the problems that they’re facing, that investors want them to address, and to have consistency as far as possible across the world.

But that’s a little bit of a nirvana that we’re never really going to get

World Finance: Marian?

Marian Williams: I would completely agree with Nick: utopia isn’t achievable, at least in our lifetime. I think what we do at the Financial Reporting Council, we work alongside the PRA, the FCA, obviously our counterparts both in the European Union and across the world, in terms of getting a better regulation.

As the regulator responsible for reporting and auditing in the UK, clearly our remit is quite wide. And also at the same time we set the codes and standards for our reporting in the UK. So trying to get cross-working, across all of those areas, is challenging. But it’s something we seek to do.

World Finance: Okay. Raj?

Raj Thamotheram: With the best will in the world, regulators and indeed all of us, are a little bit like the generals fighting the last war. Back in the 70s something like 80 percent of a company’s assets were due to the finances and the physical assets. Today that’s probably down to 20 percent. The stuff that matters are the non-financial assets, and that’s the key game in town. It’s the human capital, it’s the corporate culture, it’s the governance, it’s the behavioural governance, it’s the R&D, it’s the innovation.

The really big challenge today is how to get harmonisation of that kind of reporting. Because that’s how we can look forward.

World Finance: Now looking at harmonisation, first let’s talk about what needs to be disclosed in financial reports.

Let’s consider the repatriation of funds. Do you think that information needs to be included in financial reports, when it’s involving European companies? Marian.

Marian Williams: So essentially, in our Strategic Report – which was introduced at the beginning of this year – you would expect such challenges, or such information, to be part of what a company should disclose to its investors. Because clearly that is a part of what will help investors decide if they want to invest, or if they want to take their money from that company.

So I think if something is clearly material, then that should be disclosed in the financial statements.

World Finance: Okay, now let’s talk about The Takeover Panel. For instance, you are tasked with looking out for the public’s interest. Do you think that if there is a multinational takeover bid, that your organisation in any way should be involved in that process? Perhaps your remit might be too narrow in focus right now.

Marian Williams: At the moment the FRC does not have a role in takeovers as such, but we are responsible for the issuance of the Stewardship Code, which was issued two years ago, and we review it every two years. And that was really about promotion of the long-term interests of companies via the investors.

And so in a takeover situation, you’ve got a very delicate balance between who’s investing for the long term, and who’s investing for the short-term. And that’s quite a challenge to understand how the Stewardship Code should apply.

World Finance: Nick, what do you think of the Stewardship Code?

Nick Jeffrey: I think the Stewardship Code came around as a reflection that companies and their owners were not talking together. In some ways they were talking past each other.

That in itself was a reflection that periodically a company would produce five or six hundred pages, as you were referring to. There’d be this whole raft of information appear, and investors were saying, ‘What am I supposed to do with this?’

The Strategic Report that Marian was referring to, I’m a strong supporter of that. What that’s intended to do is to kind of stratify the information, to give everybody the same amount of information if they want it, but to direct different users of financial reports and annual reports as Raj was referring to, to a different degree of granularity. Depending on what they want and what they need.

World Finance: In its current form then, do you think it’s taking in all of those financial and non-financial factors that you’ve written about extensively, Raj?

Raj Thamotheram: The intent is absolutely right, and the encouragement from the FRC and government to greater stewardship is absolutely the way to go, but I think there’s a little bit more box-ticking than substance at the moment, today. So if you look just at the issue of mergers and acquisitions, what we see is very low transparency on the part of investors on the reporting of how they actually deal with it.

I looked at four investors who are at the top of the field, and actually to get the data of how they were voting took my researcher the better part of one whole day to be able to compare just those four investors.

What we found was that actually, the vote against mergers and acquisitions went from 0.5 percent to 50 percent. There is some reason for this huge difference. And I think that actually part of it is that the system isn’t working in terms of shining light on the key factors that investors should consider.

World Finance: Marian, will the system work better now that we have the ISB as well as the FASB working towards convergence in standards?

Marian Williams: The recent revenue recognition and standard that was issued by FASB and IASB was around getting one standard that could be implemented globally, which looks at reporting of how revenue should be reported.

I think that’s a very positive move, and we feel there’s something that we’ve worked closely with the IASB on all their projects, this one included.

So getting a standard that can allow consistency, comparability across the world, is very positive. However this has only really just been introduced, so you know, it’s probably too early to tell whether we can raise the flag of success, if you like.

World Finance: But the sheer fact that we have these convergent standards demonstrates that at the international level there is coordination that’s happening. Do we even need the government to be involved in financial regulation?

Nick Jeffrey: We definitely need the likes of the FRC! We definitely need audit regulators. And that was brought around at a time in the history of financial and corporate reporting when investor confidence had taken a knock.

Since the FRC and others have been cooperating at the international level, that has reinforced investor confidence in financial information. We’re very close, in the next maybe five years, to approaching the point of diminishing returns.

The point that Raj is making about wider information about a business is not just the numbers, but wider information about intangibles. Think about Grant Thornton’s business: our two main assets are our brand and our people.

World Finance: Raj? Do you think that we can trust companies to self-regulate?

Raj Thamotheram: You know, the thing is you can trust most people to do the right thing, but you can’t trust the people who can’t be trusted! And that’s where the role of the regulator is important, to make sure that there is a policing mechanism.

I think that Ronald Reagan said “Trust but verify”. We need that backstop in order for the voluntary system to work well. The bit that it’s not working well on – and this is the challenge looking forward – is that the things that are really important to assess a company going forward – the Capex, the return on invested capital, the human capital, the staff engagement – these things are currently very badly reported. This is why we need government intervention, to just turn up the dial and make sure that we start to deliver on what we need to be delivering.

World Finance: Okay, speaking – oh, did you want to add a point?

Marian Williams: Yes, if I can just disagree on that point. I agree on the point about giving more information where it’s relevant. I think the word relevance is really important to emphasise.

Human capital for instance, at the Financial Reporting Council, really wouldn’t make very interesting reading, but it may do at another organisation. So I think it’s really for… in my view and our view, it would be very difficult to police non-financial reporting.

However, I think what companies should be doing is liaising with their investors as to what is relevant. If it’s British Airways and its carbon emissions, or hotels and its occupancy, then that’s probably – it will stick more if investors really want it.

World Finance: Nick.

Nick Jeffrey: The Strategic Report. What that does really well, what the UK government’s done really well, is it’s given a framework or high level, minimum requirements, that allow companies that want or need to do this sort of reporting, in reacting to what their stakeholders want.

I think you’ve got to be very careful when you’re talking about governments stepping in to start setting reporting requirements in the non-financial area. Because I think what we really need here is innovation. And to my mind, we haven’t heard enough from investors and other stakeholders about why human capital is so important to them.

Marian Williams: Well we liaise with NGOs on what is important to them. And I think we have listened to them, and the value us listening to them. But I agree with Nick in terms of, it needs to be relevant. It should sit possibly in the Strategic Report, but if companies want to give more information because their investors want it, it should probably sit on their website.

What I think is really exciting is the Sustainable Stock Exchange Initiative, which potentially allows many stock exchanges to move in the right direction

So there is opportunity for companies to give more, but it may not sit on the annual report.

World Finance: I had a chance to speak with a small firm that was fined for falling under national accounting standards. Here’s what they had to say about the current state of financial regulation in the UK.

“The number of high profile cases coming to light is not resulting in the level of sanction that the public might expect. This is partly because big firms have deep pockets, and audit work requires judgement to be exercised by human beings.”

FRC, let me first pose a question to you. How do you expect these various groups to be able to keep up with the ever-changing nature of financial regulation?

Marian Williams: I think it is more challenging clearly for the smaller firms to keep up with financial regulation. But if you’re in the business of giving accounting, or being an audit firm, there are some requirements that you must comply with in order to meet those standards. And the FRC’s role is to make sure that they are behaving appropriately.

Just in terms of the cases, and I suppose specifically the larger firms, at the moment we’re looking at about 20 investigations. Of those 20, about half of them are in reference to larger firms. You’ve probably heard most recently of the Rover case, which, although it’s subject to appeal, the tribunal came up with the figure of £14m against Deloitte.

So the land has probably changed here. I think we’re looking through our processes to make them more efficient, post-reform.

World Finance: Nick.

Nick Jeffrey: I think the complexity issue, I’m afraid I’m not terribly impressed by that argument. If that’s the field we’re playing in, you’ve got to deal with that issue. And you’ve got to be prepared, if you want to work for large corporates, you’ve got to be prepared to deal with it.

World Finance: Now there are other means of policing of course. The European Parliament voted to force companies to hire new auditors at 10-24 year intervals to reduce the excessive familiarity between statutory auditors. What do you make of that, Nick? Do you think that is actually going to be achieved through this rotation process?

Nick Jeffrey: I think the environment that we’re now living in, audit is no longer a job for life. And by the same token you don’t give loads of other services to a big company’s auditor.

The idea of changing your auditor every two or three years would be harmful to quality. But changing them periodically, I think really as a market we ought to be able to cope with that. And I think it’s a good development. The package of measures that’s come out of Europe is well balanced. It’s not focused on one particular issue. And it reflects the investor sentiment that’s been happening in the market.

They don’t like lots of non-audit services going to the auditor. They don’t like audit being a job for life. They want periodic challenge.

World Finance: Okay, Raj?

Raj Thamotheram: The connection which Nick made I think is terribly important. The purpose of the audit is primarily for the investors. It is a mechanism to reassure the investors that the financial accounts and the other statements are true and fair. A due process of renewal of that contract allows for the prevention of capture of interest by personal relationships and other factors. And so it’s the connection with the trust that we spoke about.

We know we need to reestablish why that’s so important today, I think.

World Finance: What does that do to the monopoly that maybe the big four currently have in the industry? Nick, what does that do when you have audit rotation? Does this level out the playing field?

Nick Jeffrey: There are things that the FRC and other audit regulators can do to make sure that there is a level playing field. They can make sure that where appropriate they’re comparing audit firms that do similar sorts of work: they’re not comparing apples with oranges.

They can publish named reports on individual firms, which the FRC has done for a while now, and that’s extremely helpful for investor confidence.

When they publish those reports they can publish them at the same time. So we’re not comparing one firm’s recent report with another firm’s old report.

There’s a bit that the regulators can do. I have to say that the FRC is probably one of the better in the world at doing these sorts of things. I think the FRC can still be better though.

Marian Williams: So just on that point, I think Nick’s point is fair around… we publish the audit quality reports for each of the big four on an annual basis. In fact it was released last week. And on Grant Thornton’s BDO we publish those every two years. Now we’d look to publish that annually. So I think the point is well made.

World Finance: Raj, do you think that’s enough?

Raj Thamotheram: The ecosystem of players is I think the critical issue. And I think it’s not just auditors who can keep companies on the true path. It’s also investors.

This is where the regulatory bodies, not just the FRC, could perhaps step up. For example, let’s go back to the mergers and acquisitions example again. We know that all the data suggest that something like only 13 percent or 17 percent of mergers and acquisitions deliver the value that they’re stated to deliver.

Today there is no requirement for investors to report on why they voted in the way they did. Now the FRC could in fact ask investors to explain how they’re tracking that reporting, what they’re learning from it. This wouldn’t be micro-managing, it would just be asking another aspect of the value-adding function.

Now that then creates space for the auditors to do their job better. Because there’s another player in the game, having some insight. It’s very hard for auditors to challenge their sort of fee-paying client on some very sensitive issues. So I think it’s an ecosystem.

World Finance: Do you think that we have seen a maturation of the financial reporting community in terms of… I mean even if we look back to the 1970s where we had the Nestle babymilk scandal, which everyone is aware of. In the aftermath of that scandal, we saw many indices that came to birth, including the FTSE4Good Index, reporting on what people wanted to know in terms of those investors who were looking for that additional information as you mentioned. But how does an organisation such as the FSC, or another one, then say, ‘let’s look at this index versus another’? How do you measure the merits? Raj?

Raj Thamotheram: I fully agree that regulators can’t micro-manage companies and tell companies what to report. But I think there are some areas where the gaps have been so consistent and so long-lasting. I can go back to human capital, for example.

Say for example we’re invested in two retail companies, and a retail company changes its management and starts to lose the engagement of its staff, and starts to have a staff turnover. We know that that’s a lead indicator of risk. But currently there’s no requirement to report on that.

So unless investors have consistent reporting on some standards, the system won’t take it into account. It’s not possible for passive investors to take a little bit of data here, but if there’s no data here, kind of compare it.

So I think there’s a levelling that regulators need to do around material issues. And it’s happening, but it’s happening a little bit too slowly.

World Finance: Nick, you have an intimate understanding of course, being on the front lines of auditing accounting standards, and where your clients are willing to apply them. Corporate governance: how important really is it to them?

Nick Jeffrey: It’s part of the mosaic that helps to bring the whole thing together. Just to go back on something that Raj was saying, I think we’re arguing about shades of grey. I think Raj seems to be towards the end of the spectrum where he wants more impetus, because companies aren’t doing what investors need now. I’m slightly the other way; I would say that it’s for investors to drive their informational needs, and not to rely on governments too much.

For me, it’s for investors to be more vocal about what they want to know about sales per square metre, or staff turnover. It’s for them to be more vocal about the things that drive their investment decisions.

World Finance: What do you make of this criticism? Do you think that the FRC and other regulatory bodies have shouldered enough of a burden, and taken action as a result?

Marian Williams: I think the Strategic Report is a good example where companies have to give details of their principle risks, and therefore in this situation companies should be providing the information that is important for shareholders, that is relevant.

We just need to watch the amount of information. A project that launched this morning actually was our Clear and Concise project, where we’re looking at what is relevant to stakeholders and investors.

I think we’re all saying the same thing, I think really, is what is really relevant to investors? And two retailers, for instance, clearly if one starts giving profit per square foot, then that might make the other provide that information too. So I think if you see some leadership in that particular topic, or in that area, then you might find others follow. But I don’t think really it is for the regulator in this instance, for non-financial reporting, because as I said it’s a very deep ocean. I think we’d be drowning.

World Finance: I think you would get a faster reaction if you leave regulation to one side and let the market innovate. And if you let the market react to what investors are asking, or to what competitors are giving.

Raj Thamotheram: That actually is happening, which is great. In the European context, the European Federation of Analytical Societies (EFFAS) is encouraging standardised disclosure on ESG issues. And in America, Michael Bloomberg and Mary Schapiro have just joined the Sustainability Accounting Standards Board, which is doing the same.

The challenge there is we’re going to fall back again into that FASB, IASB divergence. And then we’re going to have to knit this thing together.

So the trick I think is to do the learning from the last experience ahead of time, and try and create a convergence standard.

What I think is really exciting is the Sustainable Stock Exchange Initiative, which potentially allows many stock exchanges to move in the right direction.

We are definitely arguing about gradations, but for me it’s not an either/or situation. Everyone needs to be in the game.

World Finance: In terms of financial reporting, where would you say you would add more information relating to how to enhance investor relationships, or pull back?

Marian Williams: I suppose I would look at the characteristics really. So I think materiality, clearly. If it’s material to a user of a financial statement, that must be in. It must be relevant. But at the same time it must be concise. So you’re trying to balance the two, which is really challenging.

World Finance: But when we’re looking at 400, 500 pages of reporting, while the intention might be right. Do you think that the European shareholder is going to sit and read through every single page of that report? Or only focus on what’s key? And should the rules and regulations as to what’s being reported in the basic report, should that be changed faster?

Marian Williams: You know, your challenge is fair. And I think there’s probably something to think about in innovation that Nick mentioned earlier, around how can companies get smarter with where they put their information. There may be something to think about there.

For instance we’re looking at a new project on reporting in a digital world. So maybe there’s something there, around how companies – not what their report is, but where they report it and how they report it.

Raj Thamotheram: I think that’s where the potential of, kind of, collaborative action between regulators and investors could be really potent.

Because the great thing about investors is, by consensus, they can define a set of standards and criteria with companies on what’s most material. And that being not regulated can evolve every two or three years as understanding evolves. And I think there’s a real potential here, between what regulators can do, and what investors can do.

I just want to challenge this though. We keep… we used your phrase, ‘non-financial’. But you know, when you look at Lehman’s, or BP, or Rentokill, or Parmalat, or Avendi, or WorldCom. To call these things non-financial misses the strategic importance of them. And I think that’s what we’re continuing to do sometimes, to miss the strategic importance of these superfinancial, or extrafinancial – whatever we call these things!

Because the great thing about investors is, by consensus, they can define a set of standards and criteria with companies on what’s most material

Now how to capture that I think is the challenge for both regulators and investors, supported by auditors. So I think you’ve framed the discussion extremely well.

World Finance: But I think what we also need to consider is that there are people, companies rather, that are doing this well. You work with some of them. Can you tell me who is doing this well, who is incorporating this kind of information, if you want to use a term other than non-financial?

Raj Thamotheram: You know, a company like Unilever is well experienced – and not just for PR reasons, but over a long period of time – at integrating into all aspects of its strategic planning and its remuneration design, long-term incentives to take into account these sustainability factors.

So the current CEO came in with a desire to double his financial targets and halve his carbon footprint.

Not a trade-off either, a win-win.

That’s not yet the norm, and I think that’s our challenge. Because that’s what society needs us to do, we need to rapidly move to greater resources efficiency, better organisational governance, behavioural governance cultures, and a more empowered and engaged workforce.

Now that examples exist, we need to move it into the norm of practice.

World Finance: Grant Thornton must work with some big names out there; is there an appetite for change similar to what Raj has been discussing?

Nick Jeffrey: We react to the pressures that are in that environment. And I think we as a profession could be smarter and stronger in advising the companies that we work with, and the investors that we work for, to help them understand what is really material to the users of their information, if I can put it like that: the information that goes out there.

Not to just put everything out there in reaction to what they think a regulator might react to. We’ve got to be stronger in saying to the companies that we audit, ‘You don’t need that bit of information, it’s not material to users.’ And we need to be stronger in saying to regulators when they come in and rightly challenge us on that, ‘It’s not material’.

World Finance: Well it sounds like the innovations really have to take place at various levels, not just at the regulatory level, but even in the way that companies perceive their role in this world and their long-term interests.

Well Nick, Marian, Raj, thank you so much for joining us today, now, have financial regulators and governments done enough in policing this industry? Tweet us your thoughts @worldfinance and remember to include #FinancialReporting.