Speech by Sir Winfried Bischoff at PWC Meet the Experts Conference - 10 November 2014
News types: Speeches
Published: 13 November 2014
On 10 November, Sir Winfried Bischoff spoke at
PWCs Meet the Experts Conference.
Sir Winfried Bischoff
Chairman, Financial Reporting Council
PWC Meet the Experts Conference
10 November 2014
The Lancaster London, Lancaster Terrace
The FRC’s mission statement is to promote high quality financial reporting and governance to foster investment. The key part of this mission statement, for me, is the aim to “foster investment” - we believe that trustworthy information engenders trustworthy behaviour, which in turn encourages investors to continue providing long term capital in UK markets.
Our starting point is that the delivery of long-term, sustainable returns to investors is a powerful demonstration that governance is working as it should. The financial crisis, as for many others, was a prompt for us to tackle a number of issues within our sector. One of the first things people asked during the crisis was ‘how could companies go bust (or be in danger of doing so absent government support) when they had only recently been given a clean bill of health by their auditors?’ We realised that not only did we need to look at the quality of audits – was there sufficient scepticism and challenge of management - we also needed to consider whether boards were looking far enough ahead at the health of the business, and reporting sufficiently around any risks. The crisis made it imperative that accounting standards resulted in accounts that gave rise to the right analysis by shareholders, and that presented an accurate picture of the condition of the company.
Ultimately, we need to ensure that the UK remains a high quality market in which to list. We want investors and companies to use London because it matches a deep pool of international capital with a hard-earned reputation for high quality corporate governance and reporting.
So this is where we come from, but I’d like to take you through the three areas that are driving our work at the moment and how we are responding to key concerns in the reporting and governance spheres.
Firstly then, one of the main drivers for our work at the moment is the move towards transparency in reporting, and a clearer focus on reporting strategic business risks more transparently.
Clear and concise/strategic report
You might wonder how in a world where reports and accounts are becoming so full of information can companies filter down their reporting to the most salient and useful information?
The FRC believes that reports should be ‘clear and concise’. Yes, we ourselves have potentially added to the length by expanding some requirements for reporting. But that does not mean that companies cannot be innovative and sensible in the way they report. There is no need to use boilerplate text or disclose immaterial or duplicated information. We addressed this in June when we issued guidance on the new strategic report that was introduced as an update to the Companies Act a few months earlier.
The guidance encourages companies to be innovative in the drafting of their annual reports, presenting narrative information in a way that allows them to ‘tell their story’ to investors concisely; linking related information; and in a fair, balanced and understandable way.
We hope that our proposed guidance will act as a catalyst for companies to publish more relevant narrative reports, facilitating communication and engagement. Investors tell us that they want information to be forward-looking and focussed on strategy and the business model; highlighting relationships and interdependencies between information presented in different parts of the annual report; and with an emphasis on materiality and conciseness. We need to be mindful that the strategic report is not just useful for existing investors. It should also assist those looking at the company anew to decide whether it is the kind of business they think is deserving of their funds, and their time.
The strategic report guidance is just one item in a number of initiatives that will make up the Clear & Concise agenda that includes three areas: work by our Accounting and Reporting Policy team, reports from our Financial Reporting Lab and our work on influencing those who set disclosure requirements in Europe and internationally.
So, what happens with all these measures in practice? It is my belief that if companies respond to these drivers for high quality reporting, audit and governance they will produce reports that will indeed be more meaningful.
Corporate Reporting Review
Our Corporate Reporting Review team found this year that corporate reporting by large public companies is generally of a high standard, particularly among FTSE 350 companies. However, we have continued to see a higher proportion of poorer quality accounts produced by smaller listed and AIM quoted companies. In response to similar findings over several years, we established a project in April to help improve the quality of reporting by smaller companies within the next three years.
We believe that trustworthy information engenders trustworthy behaviour, which in turn encourages investors to continue providing long term finance in capital markets.
The CRR’s Annual Review identifies the areas likely to pose future areas of challenge for preparers and where Finance Directors and Audit Committee members should have particular focus when planning their next report and accounts.
The Review, based on a review of 271 sets of reports and accounts in the year to 31 March 2014, supports the wider Clear & Concise initiative by providing examples of where it has challenged companies on whether their reports contained immaterial or unnecessary disclosures.
As well as summarising the FRC’s findings, this year the report gave areas of reporting focus for Boards in the next reporting season. These include the need to:
Assess the accounting effect of any changes in the structure of pension arrangements;
Analyse the effect of new accounting standards that will apply in the next few years, in important areas such as consolidation and revenue;
Make a step change in the quality of disclosure of critical judgements and estimates around accounting policies;
Identify all the relevant intangible assets arising in recently acquired businesses.
Secondly, let me turn to transparency of audit
We hope that boards will make their reports more relevant and useful to current and potential shareholders. They can do this is by responding to the new enhanced auditor and audit committee reports. Innovation in audit is a second key driver for our work. We promote high quality audit and confidence in the value of audit. We aim to set high quality standards for auditors, and audit committees, to ensure investors get the most helpful and pertinent information on the audit possible. We maintain these standards through our conduct work, monitoring the quality of audits and reporting on our findings.
Audit Committee Reporting
Last year we made changes that have encouraged Audit and Risk Committees to explain in more detail the work they do and their interactions with the auditor. The idea is to make the work of the audit committee a more open book, explaining the interaction between audit committee and auditor and giving investors better awareness of the audit process.
Auditor reporting
We also introduced a step change to the auditor’s report. These revisions together aim to improve the transparency of the audit, complete the circle with the new audit committee report and respond to the increasing interest of investors in the audit. To us, the audit report should always be worth reading, even studying with care.
The changes mean that auditors are required to explain in more detail the scope of the audit, how they assess risks of material misstatement and how they apply concepts of materiality. They should pick up on any risks or transactions they have raised during the year that have not been adequately highlighted by the audit committee, and bring them to the attention of the shareholders in their own report. They are also now expected to affirm whether they agree with the board’s assessment that the report and accounts are ‘fair, balanced and understandable’.
In practice we do not expect the auditor to have to report a disagreement with the company, but it is a key part of risk management and mitigation that the auditors have the opportunity to flag concerns directly to investors reading the annual report.
Audit Quality Review
We have seen examples of the new auditor reports in this year’s round of annual reports and have broadly been impressed with the way that auditors and audit committees have embraced the opportunity to enhance their disclosure of the work they do. But we also monitor the quality of audit procedures on an annual basis as part of our audit quality inspections regime. The FRC’s Audit Quality Review team looks at around 100 audits of public interest entities a year and recently reported on its findings for the year preceding the introduction of the enhanced auditor reports.
This year’s results show an improvement on last year’s, but improvements in bank and building society audits have been generally slower than of other Public Interest Entities. For this reason we will be issuing a thematic report at the end of the year identifying where and why progress has been slow and what needs to be done to achieve necessary improvements. Specific issues highlighted in previous reports were the adequacy of the testing of loan loss provisions and general IT controls. The report will assess the extent to which the firms’ actions to address the FRC’s concerns are having an impact and if not, identifying what further action is required.
The ultimate goal of audit inspections is to ensure that audits, and audit processes, are of the highest quality possible.
Audit competition
In 2012 we introduced the requirement that companies put their audit out to tender every ten years in order to avoid the perception of the possibility of auditors becoming so familiar with a business that they lose their objectivity, and, importantly, to promote competition in a concentrated audit market. Supported recently in the EU Audit Directive, the measure has seen a large amount of tendering activity in the market this year. This change will hopefully allow companies to appoint the best auditor for their business at that particular time. Please note that the requirement is on a ‘comply or explain’ basis which avoids forced rotation that could reduce choice and exclude the most appropriate auditor from continuing. The measures were designed to help audit committee chairs, to focus on the reason for their choice of auditor, and to communicate the reasons for their decision to investors. In turn, we have seen that investors have become more engaged with the process of auditor appointment.
AQR Findings
In 2013 the Competition and Markets Authority recommended that the FRC should require audit committees to publish the grade given to the audits inspected by our Audit Quality Review team. We announced earlier in the year that we intend to undertake a full formal consultation on this recommendation in time for any update to the UK Corporate Governance Code in 2016.
Some audit committees have indicated that they may wish to implement aspects of the Commission’s recommendation in advance of any changes to the Code. The FRC is supportive of investors having additional and better information about the quality of an audit. We encourage companies to report in their own words their consideration of the AQR’s findings. It is important that investors understand what the company itself believes to be important and how it has applied its judgement. We will issue more detail on this process later in the year.
Long-termism and prudence
So – to the third and final concern that has driven much of our work. We support the idea that long-termism is a driver for sustained growth in UK capital markets. We approach this in two ways: through our work setting standards for corporate reporting and in recent changes to guidance for corporate governance.
IFRS/UKGAAP
We have a wide remit for corporate reporting: we set UK GAAP for SMES, influence international financial reporting standards internationally, and are responsible for monitoring the quality of annual reports and accounts.
We have sought to act as a critical friend to the International Accounting Standards Board as it works on new standards and have sought to influence the Conceptual Framework that went out for consultation earlier this year. We have already built prudence into the new UK GAAP – accounting standards for small and medium sized companies – and have worked to ensure prudence is an underlying principle in the new Framework. We have been largely successful in this and we expect prudence to be included when the final Framework is issued.
We also hope that the current pause on convergence between international and US standards remains just that, a pause and not a cessation. Fully international accounting standards would be in the best interests of global investors and allow them a better picture of companies and those most deserving of their funds. At the same time, we believe that quality standards remain the priority and that quality should not be overlooked in the drive for convergence. Ultimately, we need to make sure we get accounting standards right and then implemented well.
Of course, occasionally issues emerge that focus attention on aspects of accounting that we and others need particularly to address. One such current topical issue is that of revenue recognition. There is obviously a need to ensure that existing standards are adhered to and that any improvements are carefully considered. But we should not make knee-jerk reactions.
The new IFRS 15 – Revenue from Contracts with Customers - was issued in May 2014 by the International Accounting Standards Board. It explains in detail how and when an entity should recognise revenue. It is useful for any company trading goods. The FRC is working with the EU – European Financial Reporting Advisory Group and the Commission – on the adoption process for IFRS 15 (on revenue recognition), and we hope that it will be adopted Europe-wide in time for the IASB’s implementation date of 1 January 2017. We will issue an impact assessment in due course and engage with our stakeholders on the significance of the changes.
Corporate Governance
As well as high quality corporate reporting that is fair, balanced and understandable the FRC believes corporate governance and stewardship can foster trust in the way companies are run. Within the UK Corporate Governance Code is the underlying theme that boards should have a focus on the long term. In particular, it is essential that boards look forward at strategic risks that could affect the company as well as its long term viability. For investors, as providers of risk capital, knowing how the board is managing and mitigating risks is an important indicator when judging whether the company will be able to deliver the value that providers of capital seek.
For this reason, in 2011, we commissioned a report on the quality of information that companies provide on their financial health and their ability to withstand stresses in the short to medium-term. Undertaken by Lord Sharman, the report made recommendations on how we can raise the bar for risk management by boards and for communication to shareholders, or potential shareholders, about the risks faced by the companies and how they are managed or mitigated.
On 17 September this year we issued guidance for a robust assessment of whether risks give rise to material uncertainties that should be taken into account and reported on in relation to the companies’ going concern basis of accounting. We have introduced a new type of viability assessment - one that is focussed not only on the narrow meaning of assessing going concern, but that also gives a broader integrated assessment and description of solvency and liquidity, specifying the period covered and why directors consider that period appropriate.
Companies will be asked to state the period they believe they will be able to continue in operation and meet their liabilities taking account of their current position and principal risks. That period is expected to be significantly longer than 12 months.
Under the new Code, boards of listed companies will also now need to ensure that executive remuneration is designed to promote the long-term success of the company and demonstrate more clearly to shareholders how this is being achieved. Performance-related elements should be stretching and rigorous, and companies should have claw-back arrangements in place. Companies must demonstrate a clear link between performance and pay. These changes focus companies on aligning reward with the creation of value in the long term. The provision in the code that remuneration should “recruit retain and motivate” has been removed as it had become boilerplate language used to quantify or explain all kinds of remuneration policies and practices.
Conclusion
Let me conclude by observing that investors are entitled to expect that auditors, boards and regulators work together more effectively to identify, mitigate and report on risk.
If progress is made in these areas, investors will have greater confidence in listed companies, attracting more capital to UK markets. This virtuous circle of long-term, sustainable returns attracting capital that creates demonstrable value for the real economy through increased employment and innovation is one powerful way in which markets can win back the support of the public.
Thank you for listening.