The perfect annual report

The annual report is the most important document in any equity investor's arsenal. A thorough reading should deliver insights into how a business is performing, and how financially healthy it is. Via its three most important components - the balance sheet, cash flow statement and income statement - almost any financial ratio needed to determine a company's strength can be calculated and, in concert with the latest share price, highlight whether its shares offer good value.

Remarkably, many investors simply don't spend enough time doing this. Sure, companies may be cutting back the distribution of paper annual results, but every one of them is required to publish these important documents online, too. There is no excuse for not reading them.

However, there is a groundswell of opinion that the annual report isn't always as useful as it should be. Accounting firm BDO LLP is one of the format's biggest critics, and is pushing hard to bring about substantial improvement to the standard of this most crucial facet of corporate reporting.

Confusion reigns

Any step that generates greater clarity in corporate reporting has to be welcomed, but in the wake of the financial crash, many companies seem to have lost the plot, hoping that providing a plethora of financial data will serve the purpose of presenting better levels of transparency. This isn't working because instead of presenting a clear picture designed to show what a company is doing with its (shareholders') money, reports and accounts have degenerated into a litany of small print and legalise designed more to provide a barrier against potential litigation and to tick all the regulatory boxes.

This has progressed to such an extent that many corporate reports are less useful, less transparent and more complex than before the financial crash. Indeed, financial accounting is under threat as a useful activity, auditors are becoming less meaningful and financial accounting has left the board room, and now resides with lawyers and accountants, which could lead to wrong investment decisions. In some cases, chief executives would be hard pressed to fully understand their own accounts.

Of course, risks will always remain, and even the clearest picture of how a company is operating is little guard against unforeseen events like natural disasters, economic collapse or plain fraud. But providing a better picture of how a company is operating will not only be beneficial to shareholders, but it will also help companies too, because investors will be more inclined to put their money with a company they understand.

A new standard

There are signs that governments, standard setters and regulatory bodies are beginning to appreciate the need for change as regards to form and disclosure at least, and some modifications are in the pipeline. But part of the problem is finding a clear and defined template that companies can adhere to. And that is not going to be easy because company results can vary from around 20 pages when published as part of the Regulatory News Service for a housebuilder, for example, to well in excess of 100 pages for a life insurance company.

In an attempt to give some idea of the improvements that could be made, BDO LLP, a partnership of chartered accountants in the UK, has put together some guidance on the changes that could improve corporate reporting without recourse to legislation, and has presented a set of accounts showing its key proposals. This isn't easy because different business sectors have different characteristics that investors will find of interest, but emphasis has been placed on highlighting the key performance indicators.

Dealing with the uncontrolled growth in accounting policy notes that even the most ardent student would not tackle in one sitting, BDO has suggested that the relevant notes can be set down next to the analysis of the numbers to which they directly relate. In its simplest form, this would negate the need to flip from the balance sheet to the note buried in the back of the accounts and then back again. Much of what is currently disclosed can be removed altogether on the grounds of materiality. In other words, removing financial information that becomes irrelevant to the decision-making needs of the user.

Within the proposed annual report format, BDO has retained a brief chairman's statement, but has dispensed with separate reports from the chief executive and chief financial officer. In fact, the report has been organised thematically under the following headings:

■ Organisational overview.

■ Strategy and resource allocation.

■ Business model.

■ Performance assessment and outlook.

■ Risks and uncertainties.

■ Corporate governance.

■ Remuneration committee report.

■ Audit committee report.

This is intended to provide a better narrative than current arrangements whereby reports from individual executives tend to overlap, and would provide consistency in the nature of content between different businesses. Audit committee and remuneration committee reports have been included because, over the past few years, BDO found that reports written directly by committee chairs have a greater impact by speaking directly to the shareholder.

Of course, advances in technology and shareholders' preferences for accessing information could mean that the days of the printed report and accounts are limited. Yet while looking at something online is no different from the printed article, refinements could be developed so that readers could self-select those aspects of a company report that they feel are most relevant to their individual needs. However, BDO has identified two fundamental issues that will remain.

Firstly, what is corporate reporting for?

The obvious answer is to inform shareholders of what a company is doing and how well it is doing it. But in more recent times this has been more open to debate. What a company does affects people other than shareholders – an exploration company, for example, will attract considerable attention from people living in the area it proposes to operate, witness the latest fracking furore. Moreover, corporate reporting is being used more and more by governments and the EU as a sort of public policy implementation tool – whether it relates to directors’ remuneration or country-by-country activities.

Secondly, what are the appropriate value and measurement criteria?

The lack of success in bringing together and forming one set of international accounting standards has led to a re-examination of the whole process, in addition to a general reappraisal following the financial crunch in 2008. Attention has focused on the stewardship and prudence aspects, both of which have attracted criticism, and the lack of understanding of some standards has sapped business confidence in them.

There is, however, a current review of international financial reporting standards' (IFRS') conceptual framework, that it is hoped will address these issues. There is another problem with IFRS reporting, in that the numbers as presented are less useful for steering the business, which is usually managed internally by a set of non-IFRS numbers. Inevitably, this can lead to directors feeling uncomfortable about providing guidance to capital markets based on IFRS numbers. They don't need to converge, but companies should be allowed to present both sets of numbers.

In fairness, there is another side of the coin that shows that, even with good intent - and plenty of money to spend on accounting practices - the accounting goalposts have been shifted significantly and several times in the past few years. Interpretation of capital requirements and ongoing changes to EU regulatory standards, notably affecting banks and insurance companies, are still a work in progress, and have left questionmarks studded all over the regulatory spectrum. Some progress has been made, however, notably on directors’ remuneration, including a revised disclosure regime that is due to come into force in October.

The audit side has also come under scrutiny from BDO. Many investors are surprised to find out that some information in annual reports, including some numbers, is not officially audited and BDO has proposed changes whereby companies can provide additional assurance to give investors confidence in such areas. It is also important to ensure that risk responsibility does not leak out of the boardroom. Having an efficient audit committee is laudable, but primary risk assessment should remain inside the boardroom.

Looking ahead

Any improvement in clarity will also have other far-reaching effects. Financial statements before 2008, for example, contained a number of warning signals of the impending crash, but they were not obvious. But it is important to concede that even without the financial crash there was a need for corporate reporting to move on.

Times have changed indeed. Does the duty of a board director remain exclusively with the shareholder, for example. Wherever allegiances should rest, one aspect of reporting that needs to change is the emphasis on forward thinking. Investors want to know about a company's plans and how it intends to create sustainable long-term value. Communications with investors need to be refined - some companies have prospered here better than others. And tellingly, regulators want company boards and managers to be held more accountable.

However, there needs to be a balance because there is a danger that some directors will spend more of their time chasing bits of paper, arranging informative meetings and liaising with accountants to the detriment of actually running the company. Getting the blend just right will be a difficult task, especially as there are so many different opinions on how corporate reporting should be best modified. According to Sandra Peters of the CFA Institute, members have stressed that it is not the volume of information that is the key, but the lack of a comprehensive story that needs to be addressed.

There have also been calls for greater use of 'plain English'. Moreover, investors should be able to be given a greater understanding of the risk process, and will almost certainly tolerate more risk if the opportunities are greater and made clear. This is crucial because, in doing so, directors will be able to present a convincing argument to investors on the sustainability of a company's business model.

Dumping ground

In short, a company's annual report and accounts should not be used as a dumping ground for a mish-mash of uncoordinated information left for investors to rake though in the hope that something useful or relevant might come to light. Indeed, there are concerns that the sort of information that is circulated internally within a company is different to that conveyed externally, so why can't this be made available to investors?

And shareholders also need to feel more relaxed and confident about how the directors are taking their company forward, and whether they are clearly in control of monitoring the company's performance. A classic example of where this is not happening is in assessing performance risk. The idea here is that less is probably more, because currently, in order to cover themselves against accusations of lack of disclosure, some companies are producing long lists of risk, much of which are irrelevant, and some so generic they are largely pointless (like economic collapse).

In short, with one eye on avoiding litigation and/or incurring the wrath of the regulatory bodies, corporate accounts have degenerated into a situation where it is more efficient to adopt a checklist approach to disclosure rather than to evaluate the materiality of each disclosure.

Directors will also have to make the decision on how many non-financial measurements to include in the company accounts. Employee satisfaction, for example, would have more relevance for a people business such as a financial services group, as opposed to company where a lot of the work and workforce are sub-contracted out. Directors should also be given discretion to allow for commercial sensitivity.

Of course, bringing all of the proposals together might require decisions directing securities regulators to tell companies what to include and how to proceed. Voluntary participation will be more difficult to achieve, and companies must be faced with a level playing field whereby they all have to conform to an agreed set of standards. But, difficult though it may be to achieve, improved annual reports should be something that benefits everyone.