Speech by Richard Fleck at "Meet the Experts" Conference November 2012

News types: Speeches

Published: 12 November 2012

Find below the plain text version of Richard Fleck's speech at the Meet the Experts Conference on 12th November 2012.

It is a great privilege to be invited to speak on this occasion. I have reflected on what I should cover this afternoon. As a lawyer, I don't want to provide you with opportunities to ask technical questions about accounting standards! So I propose to say a few words about the activities of the Financial Reporting Review Panel (FRRP), before turning to the importance of confidence in financial reporting.

And as a lawyer, I should make the usual disclaimer – namely that the views that I express are my own views – and not those of the Financial Reporting Council – and that is particularly true, if they are views you disagree with!

The Financial Reporting Review Panel

As not all delegates are familiar with the activities of the FRRP, I will just say a few words about its remit and activities. I think I am right in saying that the UK was the first European country to introduce independent review of company's financial statements – which occurred in 1991. Initially reactive to referrals such as complaints, it adopted a proactive approach in 2004.

Now, each year, it aims to review around 300 sets of reports and accounts for compliance with the law, which includes accounting standards, and with related obligations arising under the UK Listing Regime. This brings into scope half year reports and certain third country issuers (who use IFRS or UK GAAP). A secondary, but no less important objective of the FRRP, is to enhance the quality of future corporate reporting of UK listed entities.

The FRRP is authorised to review the financial statements prepared by public limited companies – including all listed and UK AIM quoted companies – and large private companies.

Because the FTSE 20 currently accounts for 52% % and the FTSE 250 accounts for 95% of all monies invested in equities, it is obviously important to public confidence that we review companies in the FTSE 350 on a regular basis. In practice, we aim to review the FTSE 100 companies at least once every three years – and the remainder of the FTSE 350 every four years or so. That means we review annually the reports and accounts of some 200 companies outside the FTSE 350.

We continue to investigate complaints by third parties and referrals from other regulators. We also review the accounts of companies whose reports and accounts are considered, or are reported – perhaps in the press - as posing a threat to public confidence in financial reporting.

Each year, we identify priority industries as a key focus of our selection of accounts for review. We will shortly be announcing our sectors for 2013/2014. Our current thinking is that these will include:

Retail
Construction companies
Mining and extractive industries
Support services

Our aim in selecting priority sectors is to identify those facing more risks in the year under review – perhaps due to economic factors – or, perhaps because management attention is likely to be drawn away from financial reporting because of regulatory or other pressures.

In addition we will carry out our reviews, Stephen Maijoor will be pleased to hear, with an eye to the areas of accounting that ESMA will shortly be announcing as common enforcement priorities in the reviews of accounts of EU listed entities. Where they are significant in the accounts we have selected, we will report our findings and take action both to address aspects of non-compliance but also to improve the quality and transparency of future corporate reporting.

Our approach has always been to operate in a way that encourages constructive dialogue with boards – through correspondence in which we ask questions, raise issues and seek clarification on matters of substance where non-compliance could have a material impact on the company’s reporting. In the vast majority of issues raised s, resolution is reached through correspondence - the provision of explanations and documentation and the occasional informal meeting – with companies either clarifying the position or agreeing to address our concerns in their next set of accounts.

Where a matter of substance is not resolved at that level, we escalate the issue to an FRRP Review Group of 5 people drawn from a Panel of independent directors, audit committee members, accountants, lawyers. FRRP members are all people operating at the very highest level of their profession and, with the exception of the FRRP Deputy Chairs and myself, they are all unpaid volunteers.

If the Review Group advises that the FRRP should pursue an issue, then, following further correspondence and meetings as set out in our procedures, the FRRP can advise the company that it is minded to apply to the Court for an order that the company revise its accounts for the matter at issue.

The power to apply to court is the one and only formal enforcement power available to the FRRP. In fact, it has never had to take that step – companies have – to date - always accepted our view when the FRRP has made it clear that it proposes to apply to the court.

In fact, the FRRP has reached the door of the court on a number of occasions – the case prepared, the evidence ready – but on each occasion, the company has concluded that discretion is the better part of valour and has settled.

Some have likened this power to the equivalent of the iron fist in the velvet glove. We do not bluff – nor do we threaten anything we are not prepared to carry out.

For obvious reasons, the fact that the FRRP is considering a company’s accounts is confidential unless or until the resolution necessitates a public announcement – whether that is from the company, ourselves as regulator or through a statement in a company's next report and accounts.

Many of you will know that the FRRP is part of the UK’s Financial Reporting Council – and that the FRC has recently undergone a major reform and re-structuring. That reform has not affected the modus operandi of the FRRP – which, in substance, continues unchanged. The main consequence to the FRRP and the Corporate Reporting Team is that it will now work more closely with the Audit Quality Review team (formally the Audit Inspection Unit). Where the AQR through its work comes across an accounting issue indicating potential and substantive non-compliance in a company’s accounts it raises the matter with the corporate reporting review team who will consider the matter in accordance with our usual procedures.

The nature of the issue can be very varied, for example:

a change in a significant accounting policy that is not properly explained;
an accounting treatment which has been the subject of considerable debate and where there may be question about the judgement exercised by management in determining their final choice of treatment, which gives them a highly favourable economic outcome;
omission of key disclosures supporting a highly material item in the accounts

The AQR Team can, as appropriate, share their reports of what was recorded on the audit files; their concerns and the audit firms’ responses to those concerns with the FRRP to inform our approach and line of questioning.

The benefits of closer co-operation work both ways. The correspondence from FRRP enquiries started after 1 April this year can now be shared with the AQR team to inform their consideration of specific audits. The increased transparency has contributed to the efficiency of the two teams, neither of which now have to work with, effectively, with one hand tied behind its back when we are dealing with similar issues around the same set of accounts.

Key issues

I want to take this opportunity to mention one or two areas that the Panel attaches particular importance to.

1. Cutting clutter

The Panel is very aware that many companies and users of company financial statements are concerned at the length, complexity and impenetrability of modern day financial statements.

This was, and remains, a concern of the Financial Reporting Council which, in 2011, published 'Cluttering Clutter'.

The FRRP is only too aware that this policy objective – to ensure that important messages, policies and transactions are appropriately highlighted and not obscured by irrelevant detail – might be seen to conflict with its duty to enforce the disclosure requirements of both legislation and accounting standards. 4

To reconcile this apparent conflict, our policy is to respect a board’s judgement as to the materiality of, and therefore the need for a disclosure PROVIDED that the company can demonstrate that it reached a considered position at the time the accounts were prepared and that the item is neither material nor relevant to its financial reporting. . Provided that they are not material or relevant, we expressly discourage boards from including additional disclosures required by IFRS in their accounts. And we say that in our letters.

2. Principal Risks and Uncertainties

I think we are all aware of the increasing importance being attached by legislators and regulators to the narrative part of a company's annual report – and we are no different.

One of the recurring criticisms following the financial crisis has been that banks and other financial sector companies did not make any reference, for example, to the stability of the credit markets in their 2007/8 annual reports.

The Panel attaches considerable importance to the requirement that a company’s business review includes a clear description of the principal risks and uncertainties it faces. Boilerplate disclosures referring to every obvious risk are neither appropriate nor helpful to the reader.

The disclosure of principal risks should be sufficiently specific to the company so that the reader can understand why they are important to that company.
The disclosure should focus on the principal risks – which are those risks that the company pays most attention to when assessing and implementing its strategy.
It should explain the mitigating actions taken by the Board to manage the impact of those principal risks and uncertainties.

3. Timeliness

Obviously, the FRRP cannot review the accounts of all UK issuers as soon as they are published and so, if we are to complete our reviews and any discussions with companies before the next annual accounts are is due, we need to have an efficient turn-around.

We do not set time limits for responses (as occurs in the US). We are therefore dependent on timely – and comprehensive - responses by companies.

From our perspective, that shouldn't be an issue. The issues we raise are, generally, apparent on the face of the financial statements and the annual reports – and, as such, they should have been carefully considered by the company and/or its advisers.

If that wasn't the case in the past, it certainly should be following the introduction of the amendments to the Code to give effect to 'Effective Company Stewardship' and the emphasis on the auditors' report to the Audit Committee.

So there should be – readily available – an explanation for the position taken in respect of significant accounting choices. And our approach to the reasonableness of the time taken to respond and of the company's approach, in having discussed this issue with their auditors and their audit committee, will be influenced by that explanation.

In order to ensure we can discharge our responsibilities in a timely way, and where companies do not do cooperate by providing their response to us within a reasonable time frame, we will consider making use of our powers to require responses or call the company to a meeting to explain their position.

Lessons from past years

So – after all this work – what have we learned?

I think I can summarise our experience in the following way:

Financial reporting in the FTSE 100 and 250 is generally good and we encounter few occasions where companies fail to comply, substantively, with legal or accounting requirements.
Most of the points we raise relate to the adequacy or clarity of disclosures – whether descriptions of accounting policies or detailed disclosures requirements supporting or explaining management’s judgements
Our impression is that the quality of financial reporting by companies in areas requiring judgement is improving. We base this assessment on the fact that companies are able to demonstrate an increasingly sophisticated approach to such issues as impairment calculations.
However, as companies become smaller and their financial resources (whether internally or externally) are less sophisticated, we encounter increased non-compliance with legal or accounting requirements. More importantly, the issues we raise are potentially more substantive and it takes longer to resolve them.

The Financial Reporting Laboratory

I often hear complaints about the financial statements and annual reports.

Preparers express frustration at the "complexity and overlapping requirements of the current regime" and call for improvements to the reporting framework in order to achieve a "significant step change in disclosure practice".

Investors describe a reporting model that leaves them struggling to understand the underlying performance of an entity. They talk of the need for better linkage between the financial and non-financial data presented, and are keen to explore the potential to leverage technology to offer a more time and cost-effective mechanism for assimilating the data reported.

These are not issues that the FRRP can address – as our remit is to uphold existing standards.

But the FRC is not standing idly by – a year ago it launched the Financial Reporting Laboratory with the aim of improving the effectiveness of corporate reporting and audit committee reports.

It provides an environment where corporates and investors can come together to develop pragmatic solutions to today’s reporting needs. This is not another talking shop. Instead the Lab encourages management and investors to experiment with new reporting formats that offer a tangible step forward in effective communication.

In just a year, it has produced reports on the following four projects –

Debt terms and maturity tables;
Operating and investing cash flows;
Net debt reconciliation; and
A single figure for remuneration.

And our hope is that learning from these projects will influence actual reporting and, in the future, the development of accounting standards.

Europe

So far I have focussed on the national, the parochial, aspects of our operations.

As I am speaking between Steven Maijoor (i.e. Europe) on the one side and the US (Wayne Carnall) on the other, it is appropriate that I refer to the international side of the FRRP’s operations.

The UK is sometimes accused of adopting a semi-detached approach to international affairs, particularly Europe. One area where this is certainly not the case, and where the FRRP is truly engaged, is European Securities and Markets Authority (ESMA).

Even before the creation of EECS (European Enforcers Co-ordination Sessions), we were active at ESMA (then CESR) as advisor to the FSA, the UK securities regulator. We have been on the agenda committee of EECS since its inception and have a policy of participating in all EECS Working Groups where we have expertise, joining with our EU equivalents to foster consistent application of IFRS in the accounts of EU.

Consistency, of course, does not necessarily mean the same in all circumstances. IFRS is built on a set of principles, it relies on the exercise of management judgement; it has options; it allows for variations in circumstances, providing flexibility to deliver appropriate treatments to changing facts and circumstances.

Applied consistently and with integrity, IFRS delivers quality reporting and accounting.

Confidence in the Integrity of Financial Reporting

I want, now, to turn to an area that I attach considerable importance to – confidence in the integrity of financial reporting.

I cannot recall a time when society has had such a lack of trust in business. Whichever way you look, business comes in for criticism. Anyone who watches Question Time on BBC, which is itself facing a crisis of public confidence, cannot fail to note the unhesitating criticism of business:

the bankers who have become the whipping boys of the media and politicians,
utility companies who make too much profit,
petrol companies that don't pass on reductions in oil prices,
transport companies that put up prices to fund infrastructure investment,
pharmaceutical companies that fail to identify damaging side effects of new products.

The list goes on and on.

And sadly, financial reporting has become another area where trust has been eroded.

That occurred, particularly, after the financial crisis in 2007/2008. Commentators queued up to complain that banks and other companies in the financial sector produced accounts that failed to correctly reflect their financial position, were prepared on a going concern basis when the companies concerned faced real difficulties and uncertainties and, perhaps most serious of all, raised funds through rights issues that were shown to be based on unsound data only a few months later.

Now, let me hasten to say that I do, of course, understand the counter-arguments. But it's not whether those arguments and counter-arguments are right or wrong that concerns me. That is in the past and we must look to the future as we rebuild confidence in financial reporting – and, in particular, the integrity of financial reporting. My emphasis is on the word 'integrity'.

As I have said, most major companies comply with the legal requirements and accounting standards relating to financial reporting. But that is not enough. The financial statements must inspire confidence – and that won't be achieved if users and commentators believe that financial statements are capable of manipulation to suit the preparer.

This is important because if society does not have confidence in the integrity of financial statements, capital markets will not thrive - and they make a vital contribution to the economy, to the UK's ability to compete internationally and globally, to growth, to employment, to pensions – indeed throughout our society.

And we do no service to the many people dependent on the success of our economy if we undermine confidence in financial reporting.

I must emphasise that this is not a meant to imply a criticism of accounting standards. I am sure that everyone will agree that no suite of standards can be beyond criticism – but that is not the point I want to make.

Accounting standards do not and should not be expected to address the specific facts and circumstances of every situation or every transaction. Our experience has been that issues arise when

Commercial situations arise which standards do not address at all – or where the commercial situation is unusual or complex and so involves two or more standards and their effect is not easily reconciled
Attempts are made to achieve an accounting treatment by introducing terms and arrangements that have no commercial substance other than to facilitate an accounting outcome that is favourable to the company – rather than that which is most appropriate.

Some, perhaps many, will say 'So be it'. But if the result is that the accounting treatment is regarded by analysts and informed commentators as being illogical – so that they disregard that effect when assessing the financial statements – it undermines the integrity of financial reporting and adds grist to the argument that financial reports have little or no relationship with the way business is run and how business performs. 8

Against that background, I am left asking:

whether such accounts give a 'true and fair' - the legal test in the Companies Act 2006; and
whether they are 'fair, balanced and understandable' – and so meet the test in the UK Corporate Governance Code that applies to the report and accounts taken as a whole.

So, in conclusion, I would encourage companies and their advisers to be wary of ingenious accounting that enhances a company's financial results and recognise that confidence is based on trust. That trust is earned – by candour, by meeting expectations and by acting with integrity.