Venturing into A New Frontier

What do you want to know about the company you invest in? What about the company you work for and depend on for your pension? Or the company with a large production facility near to your house? Or a supplier who has located most of its manufacturing or product sourcing in low wage economies?

The more you extend this list of questions, the more unlikely it is that the conventional financial reporting package is going to be sufficient to satisfy the competing information demands of an increasingly aware and articulate universe of stakeholders. So, has financial reporting finally reached the crossroads? Is it time to junk our historically focussed, financially biased experiment with financial reporting? What the stock market would ideally like from companies are annual profits and cash flow projections which they could then test against their own in-house forecasts. Wisely perhaps, the accounting profession has resisted the temptation to enter into this exercise in crystal-ball gazing, opting instead for the Operating and Financial Review (OFR) statement. The OFR seek to provide an interpretation of current operating results and current financial position as seen “through the eyes of management”, without going the additional step of trying to forecast future trends.

The OFR exercise is gaining increased international support though there is a tendency towards so-called “boilerplate” reporting. Recent developments in the UK , however, are now pointing towards a more rigorous OFR regime, based around management’s evaluation of what is actually material information from an investor perspective. Corporate governance disclosures take us further into the non-financial reporting field. The “comply or explain” approach to disclosure is now well established. Research from well-established consultancies such as McKinsey have pointed to the financial advantages to be gained from falling in line with international governance norms and there is burgeoning market for corporate governance ratings. Nevertheless, there remain significant regional differences in governance practice and disclosure, normally deriving from legal or cultural business approaches. Research conducted by ACCA in 2002 indicated that Asian business models are not well equipped to deal with the full frontal transparency requirements of western governance codes. Similarly, the European Union is cursed (or blessed, depending on how you want to look at it) with a patchwork quilt of governance regimes. 

Reporting on risk is a relatively new area of corporate disclosure.  Admittedly, financial statements are now benefiting from recent advances in classifying debt and equity. But such risk related disclosures only deal with the current effect of past financial transactions, and do not embrace any discussion of risk arising from  general operational factors — such impaired reputation. The OFR regime is partly intended to counter this shortcoming in core GAAP, as are the risk management aspects of some corporate governance disclosure regimes (for example, the UK’s 1999 Turnbull Report on internal control). Intangibles pose another problem for accountants. As business increasingly becomes service and IT focused, so the ratio of intangible to tangible assets grows. For financial accountants this represents a major area of concern. Issues like innovation continue to be dealt with in narrative form if at all. We rarely capitalise internally generated intangible assets such as brands, and we cannot, as yet, value human capital from a balance sheet perspective. As a result, balance sheets significantly fail to explain - or support - the valuations placed on a company by the market.

Recent developments in narrative reporting via the OFR are, however, partly designed to close this intelligence gap and provide investors with a much clearer picture of how wealth is both created and sustained. Disclosures in respect of product innovation, patents applied for, research and development trends and brand support are all part of the move towards filling in the gap between the balance sheet and the market valuation. As the scale of environmental degradation and third world poverty becomes clearer to us, it is also becoming clear that business has a role to play in reducing such externalities. The volume of investment in socially responsible or ethically managed funds has quadrupled in the last ten years and  companies are increasingly recognising this sector of their investor base by providing increased disclosure of social, environmental and economic (as opposed to purely financial) performance. Currently some 85% of the FTSE 100 either issue stand alone reports dealing with aspects of corporate social responsibility or make limited disclosures through the annual report and accounts. Being virtuous, however, is insufficient for stock markets. The most respected companies are those which communicate most successfully the marriage between innovative market strategies and socially responsible behaviour. As investors become more concerned with corporate attitudes to child and forced labour, contracts with despotic regimes, fraud and corruption and third world poverty, reporting on these issues is becoming more common. With respect to human capital, the starting point any discussion is usually a statement in the Chairman’s report to the effect that “our most important asset is our employees”. It then transpires that all employee related costs are expensed immediately and never appear in the balance sheet at all.

But of course, employees are valuable. As well as wages and salaries, companies also incur significant training expenditures. In the case of directors, companies make huge commitments in terms of share options (usually ignored for accounting purposes but soon to be expensed along with all other employee related costs). Companies take out “key man” insurance policies and place restrictions on the ability of disaffected employees to move to competitor organisations. It seems unlikely that the traditional approach to dealing with employee related costs is going to change any time soon. What is more likely to happen is that companies will begin to disclose more pertinent information relating to employees so that better informed analysis and bench-marking can take place. These disclosures will either be in the OFR or in a separate section of the annual report, perhaps called an “Intellectual /human capital” report, which will bring together information relating to both costs and innovation. It is clear then that the traditional finance function is facing some stiff challenges.  In conjunction with the Board, it may be equipped to deal with measurable accounting issues and with much of the corporate governance disclosure. But expanding the annual report to accommodate risk, human and intellectual capital and socially responsible behaviour implies a breaking down of internal barriers and a far greater sharing of knowledge and understanding of the inter-relationship of risk, innovation, stakeholders and return than is usually the case.

Accountants of the future will need to be aware of a much broader range of reporting issues than earlier generations. ACCA itself is introducing a range of education and training initiatives designed to equip tomorrow’s accountant for this new role. Social and environmental issues are now part of our core syllabus and we have developed separate diploma schemes - in international financial reporting and corporate governance - which will enable our existing members to add to the their core competences. Our programmes of continuing professional development also reflect this changing agenda. Yes, there is a new frontier, but it is one which accountants and the accounting profession should not shy about venturing across.
The Association of Chartered Certified Accountants
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