Speech by Stephen Haddrill at Ernst & Young's Financial Reporting Outlook Conference - 10 November 2014
News types: Speeches
Published: 24 November 2014
On 10 November, Stephen Haddrill spoke at Ernst & Young's Financial Reporting Outlook Conference.
CEO, Financial Reporting Council
EY Financial Reporting Outlook Conference
10 November 2014
Park Plaza Westminster Bridge, London
The FRC’s mission is to promote high quality financial reporting and governance to foster investment. The key part of this mission, for me, is to “foster investment” – we believe that trustworthy information engenders trustworthy behaviours, which in turn encourages investors to continue providing long term capital in UK markets.
The financial crisis was a call to action for many. For the banks and their regulators. For Boards. For shareholders. For audit and accounting. And for the FRC.
People asked us ‘how could companies go bust when they had only recently declared themselves a going concern and been given a clean bill of health by their auditors?’ We realised that we needed to consider whether boards were looking far enough ahead at the health of the business, and reporting sufficiently about the risks they faced; whether auditors were sufficiently skeptical and aware of risks themselves; and whether investors were both getting the information they needed and exerting sufficient influence on the companies they owned.
As many of you will know both we and the Department for Business have introduced a number of reforms directly to address these concerns.
We have empowered shareholders by introducing the annual election of directors of FTSE 350 companies into the Corporate Governance Code and we have introduced the Stewardship Code to encourage fund managers and others to engage with companies on all matters of concern. We also strongly welcome the creation of the Investor Forum to facilitate and stimulate such engagement. We believe engaged shareholders are a key ingredient of a healthy capital market. We will now be monitoring closely whether fund managers are implementing the approach to engagement they committed to in signing up to the Code.
We have also sought to enhance reporting and reinvigorate audit and the value it provides to investors. We introduced the requirement for reports to be fair, balanced and understandable and have seen real progress in the response to this. Good progress has been made, especially in companies’ commitment to balance.
On audit we introduced audit retendering every ten years and that has certainly shaken up the moribund audit market. However, for that reform to be successful we needed to ensure that increased competition drives up audit quality rather than driving down price. The initial signs on this in the largest companies are good, not least because audit committees have taken control of retendering. I also believe that the changes we introduced on audit committee reporting and auditor reporting have also helped. Investors have welcomed the greater understanding they now have of the work of the Committees and of the auditor. That has encouraged Committees to focus even harder on securing audit quality and has encouraged auditors to innovate in their reporting.
The third area of concern was the weakness of longer term thinking and risk assessment. We introduced best practice guidance on this two years ago, but more significantly this year we have changed the Corporate Governance Code in line with Lord Sharman’s recommendations on going concern. We have clarified that in making the going concern judgement Boards should look at least a year ahead. More radically, we have introduced the longer term viability statement through which Boards should state that they have a reasonable expectation that the company will remain solvent and able to meet its liabilities over a longer period. Crucially this period, consistent with a principles-based approach, is to be chosen by the directors, not set by us. We have issued guidance that it should reflect the nature of the business and investment plans but not specified a set period.
This is a significant step designed to promote longer term thinking but not the only one. We have also changed the Code on executive pay. It now links remuneration to the sustained success of the business rather than linking pay only to recruitment and retention. This is reinforced by a clawback provision.
So the last three years has been a journey towards better reporting and governance driven by a threefold focus on better long term thinking; enhanced audit quality; and the encouragement of investor stewardship.
So what now?
First we must resist the temptation to introduce new initiatives and make sure instead that the recent changes bed in successfully. To that end we are working with companies both through the Financial Reporting Lab and in other ways to highlight best practice. We will, for example, shortly produce guidance for audit committees on how best to assess audit quality. We also have a project underway to help smaller listed companies to enhance the quality of their reporting. We recognize that the many changes in reporting requirements are harder for such companies to assimilate.
I cannot promise there will be no further change. There are European requirements in the pipeline and other proposals, for example, the Competition Commission recommendation that our audit inspection findings be reported by companies. But we will be mindful of the burdens on business. We have decided for example, that we will not change the Code again until 2016 in relation to inspection findings and only then after careful reflection and consultation.
So first we need to bed in recent change. Second is the old chestnut of over-cluttered and over-lengthy accounts. I recognize our own requirements have added to the length of corporate reports but only account for a part of the increase. Whatever the cause nobody wants the current trend to continue and we are working hard to encourage clear and concise reporting.
To that end, in June we issued guidance on the new strategic report introduced under the Companies Act. This is an important development. In effect it encourages Boards to show how the key elements of their report (governance, financial, etc.) contribute to its longer term strategy. As such it largely delivers an integrated report as called for by the IIRC, whose work we strongly support.
Our guidance encourages companies to experiment and 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 focused 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.
Third we will maintain our close focus on audit quality through our inspection work. Following recommendations from the Competition Commission the number of inspections is set to increase so that we inspect the audit of all FTSE 350 companies at least once every five years. We are also conducting broader thematic reviews and have recently concluded our work on the auditing of banks’ loan loss provisions. The results of this will be published shortly. Other reports have looked at materiality levels – a key issue – and at compliance with laws and regulation. Thematic reviews enable us to highlight issues across a sector and we will be conducting more of them in future.
Finally we will continue to focus strongly on influencing the work of the International Accounting Standards Board, both through direct engagement with it and through the EU. We are delighted that one of the FRC’s board members, Roger Marshall, sits both on the IASB’s advisory forum and is currently acting President of the Board of EFRAG, the European Advisory Group on Financial Reporting.
We have sought to act as a critical friend to the IASB as it works on new standards and, in particular, to influence its Conceptual Framework. In particular, and in response to investor concerns we have worked to ensure prudence is an underlying principle in the new Framework. We are pleased that it seems the IASB is itself now minded to agree.
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 are in the best interests of investors and in a global market allow them a better picture of which companies most deserve their funds. We welcome the recent commitment by the SEC’s chief accountant to revisit the matter. 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 implemented well.
Of course, sometimes major issues emerge that focus attention on particular aspects of accounting standards. We are pleased that the new IFRS9 on financial instruments is ready for EU adoption as an important response to the financial crisis. In another area, the problems at Tesco have thrown a strong spotlight on revenue recognition. The new standard 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 recognize revenue, and we will do all we can to encourage EU adoption by the IASB’s implementation date of 1 January 2017. It is a tighter, more specific standard than its predecessor and whilst it is not and will not be in force for some time companies may well benefit from considering if they can make use of some of its provisions earlier to get a better grip on revenue recognition without being inconsistent with current requirements.
CEO, Financial Reporting Council
EY Financial Reporting Outlook Conference
10 November 2014
Park Plaza Westminster Bridge, London
The FRC’s mission is to promote high quality financial reporting and governance to foster investment. The key part of this mission, for me, is to “foster investment” – we believe that trustworthy information engenders trustworthy behaviours, which in turn encourages investors to continue providing long term capital in UK markets.
The financial crisis was a call to action for many. For the banks and their regulators. For Boards. For shareholders. For audit and accounting. And for the FRC.
People asked us ‘how could companies go bust when they had only recently declared themselves a going concern and been given a clean bill of health by their auditors?’ We realised that we needed to consider whether boards were looking far enough ahead at the health of the business, and reporting sufficiently about the risks they faced; whether auditors were sufficiently skeptical and aware of risks themselves; and whether investors were both getting the information they needed and exerting sufficient influence on the companies they owned.
As many of you will know both we and the Department for Business have introduced a number of reforms directly to address these concerns.
We have empowered shareholders by introducing the annual election of directors of FTSE 350 companies into the Corporate Governance Code and we have introduced the Stewardship Code to encourage fund managers and others to engage with companies on all matters of concern. We also strongly welcome the creation of the Investor Forum to facilitate and stimulate such engagement. We believe engaged shareholders are a key ingredient of a healthy capital market. We will now be monitoring closely whether fund managers are implementing the approach to engagement they committed to in signing up to the Code.
We have also sought to enhance reporting and reinvigorate audit and the value it provides to investors. We introduced the requirement for reports to be fair, balanced and understandable and have seen real progress in the response to this. Good progress has been made, especially in companies’ commitment to balance.
On audit we introduced audit retendering every ten years and that has certainly shaken up the moribund audit market. However, for that reform to be successful we needed to ensure that increased competition drives up audit quality rather than driving down price. The initial signs on this in the largest companies are good, not least because audit committees have taken control of retendering. I also believe that the changes we introduced on audit committee reporting and auditor reporting have also helped. Investors have welcomed the greater understanding they now have of the work of the Committees and of the auditor. That has encouraged Committees to focus even harder on securing audit quality and has encouraged auditors to innovate in their reporting.
The third area of concern was the weakness of longer term thinking and risk assessment. We introduced best practice guidance on this two years ago, but more significantly this year we have changed the Corporate Governance Code in line with Lord Sharman’s recommendations on going concern. We have clarified that in making the going concern judgement Boards should look at least a year ahead. More radically, we have introduced the longer term viability statement through which Boards should state that they have a reasonable expectation that the company will remain solvent and able to meet its liabilities over a longer period. Crucially this period, consistent with a principles-based approach, is to be chosen by the directors, not set by us. We have issued guidance that it should reflect the nature of the business and investment plans but not specified a set period.
This is a significant step designed to promote longer term thinking but not the only one. We have also changed the Code on executive pay. It now links remuneration to the sustained success of the business rather than linking pay only to recruitment and retention. This is reinforced by a clawback provision.
So the last three years has been a journey towards better reporting and governance driven by a threefold focus on better long term thinking; enhanced audit quality; and the encouragement of investor stewardship.
So what now?
First we must resist the temptation to introduce new initiatives and make sure instead that the recent changes bed in successfully. To that end we are working with companies both through the Financial Reporting Lab and in other ways to highlight best practice. We will, for example, shortly produce guidance for audit committees on how best to assess audit quality. We also have a project underway to help smaller listed companies to enhance the quality of their reporting. We recognize that the many changes in reporting requirements are harder for such companies to assimilate.
I cannot promise there will be no further change. There are European requirements in the pipeline and other proposals, for example, the Competition Commission recommendation that our audit inspection findings be reported by companies. But we will be mindful of the burdens on business. We have decided for example, that we will not change the Code again until 2016 in relation to inspection findings and only then after careful reflection and consultation.
So first we need to bed in recent change. Second is the old chestnut of over-cluttered and over-lengthy accounts. I recognize our own requirements have added to the length of corporate reports but only account for a part of the increase. Whatever the cause nobody wants the current trend to continue and we are working hard to encourage clear and concise reporting.
To that end, in June we issued guidance on the new strategic report introduced under the Companies Act. This is an important development. In effect it encourages Boards to show how the key elements of their report (governance, financial, etc.) contribute to its longer term strategy. As such it largely delivers an integrated report as called for by the IIRC, whose work we strongly support.
Our guidance encourages companies to experiment and 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 focused 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.
Third we will maintain our close focus on audit quality through our inspection work. Following recommendations from the Competition Commission the number of inspections is set to increase so that we inspect the audit of all FTSE 350 companies at least once every five years. We are also conducting broader thematic reviews and have recently concluded our work on the auditing of banks’ loan loss provisions. The results of this will be published shortly. Other reports have looked at materiality levels – a key issue – and at compliance with laws and regulation. Thematic reviews enable us to highlight issues across a sector and we will be conducting more of them in future.
Finally we will continue to focus strongly on influencing the work of the International Accounting Standards Board, both through direct engagement with it and through the EU. We are delighted that one of the FRC’s board members, Roger Marshall, sits both on the IASB’s advisory forum and is currently acting President of the Board of EFRAG, the European Advisory Group on Financial Reporting.
We have sought to act as a critical friend to the IASB as it works on new standards and, in particular, to influence its Conceptual Framework. In particular, and in response to investor concerns we have worked to ensure prudence is an underlying principle in the new Framework. We are pleased that it seems the IASB is itself now minded to agree.
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 are in the best interests of investors and in a global market allow them a better picture of which companies most deserve their funds. We welcome the recent commitment by the SEC’s chief accountant to revisit the matter. 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 implemented well.
Of course, sometimes major issues emerge that focus attention on particular aspects of accounting standards. We are pleased that the new IFRS9 on financial instruments is ready for EU adoption as an important response to the financial crisis. In another area, the problems at Tesco have thrown a strong spotlight on revenue recognition. The new standard 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 recognize revenue, and we will do all we can to encourage EU adoption by the IASB’s implementation date of 1 January 2017. It is a tighter, more specific standard than its predecessor and whilst it is not and will not be in force for some time companies may well benefit from considering if they can make use of some of its provisions earlier to get a better grip on revenue recognition without being inconsistent with current requirements.
Conclusion
Investors are entitled to expect that auditors, board and regulators work together more effectively to identify, mitigate and report on risk. Ultimately, we need to ensure that the UK remains a high quality market in which to list. London matches a deep pool of international capital with a hard-earned reputation for high quality corporate governance and reporting.
The further progress we can expect in these areas should give investors even 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 probably the most powerful way in which markets can win back the support of the public.