Strategy & Operations » Governance » Hard to grasp: How finance departments are getting to grips with non-financial reporting

Hard to grasp: How finance departments are getting to grips with non-financial reporting

With the UK set to transpose EU rules around non-financial reporting into law by the end of the year, reporting on intangibles is still a work in process, find Neil Hodge & Richard Crump

SPEAK to many management teams about the pressures of frequent market updates and quarterly reports and they will often speak of their frustration at the short term focus of investors. Interim management statements are a case in point. Corporates have been able to ditch the process since 2013? But have so far chosen to keep them. The view that it is in response to market appetite is widespread.

Nevertheless, investors can also complain of the fact that management is too focused on driving short-term value often at the sacrifice of long-term growth at the altar of immediate earnings performance. Such arguments can go round in circles.

Historically, the nature of corporate reporting has been backwards in nature; dialogue between management and investor was based on previous earnings performance. But increasingly company reports are taking on the narrative, business driver-related nature of wider company/investor discussions.

The move towards the reporting of non-financial value drivers is on the one hand a response to the limitations of historical financial statements.

“The historical financial statements will tell you whether revenues are growing but they won’t necessarily tell you whether the customer base is getting stronger,” writes Larry Bradley, global head of audit at KPMG International, in the professional service firm’s ‘better business reporting’ study.

“Said another way, the financials may tell you how much money the company made, but not necessarily how it makes money. And more importantly, whether the current year earnings provide provide a long term sustainable proposition for value creation,” he adds.

Additionally, companies have been busy adopting rules – introduced as part of the UK’s narrative reporting framework in October 2013 – that require the reporting of information about their business model.

As part of the non-financial report, companies must provide the principal risks to the business, any relevant non-financial key performance indicators, as well as information relating to its policies (and their impact and effectiveness) on environmental, social and employee matters (such as diversity policies), respect for human rights, and anti-corruption and bribery.

The UK most now adopt the European Union’s own rules around the reporting on long-term risks and strategies as part of the new EU Non-Financial Reporting Directive. The directive’s provisions, which aim to harmonise and improve non-financial reporting across the EU, must be transposes into law by 6 December 2016 with the UK government is considering the findings of a Department of Business, Innovation & Skills consultation.

A developing area

The KPMG survey of business reporting
The KPMG survey of business reporting

Although UK companies have been reporting on non-financial issues for some years, it does not necessarily mean that they are particularly good at it. According to David Hicks, partner in financial services at law firm Charles Russell Speechlys, “there is always a danger that prescribed content requirements lead to tick-box, compliance-driven reporting” and adds that companies have struggled with disclosure on remuneration, simply due to how complex and technical the issue has become.

Indeed, an impact assessment conducted by the European Commission indicates that only 2,500 of large companies in the EU currently prepare some form of separate non-financial report. This means that 94% of large companies across the 28-member bloc do not report their non-financial data.

Matt Chapman, a reporting leader at KPMG, says that non-financial reporting is still a developing area. “Many companies don’t identify know-how as a core part of their business model, so they don’t report progress in managing it,” he suggests.

Indeed, a KPMG study, which looked at the annual reports of 90 companies across ten countries over a five year period, finds that very few company reports state whether the business was winning and retaining customers. For instance, 21% of companies did not provide any operating measure of performance, while only 7% of companies provided performance data on customer satisfaction.

Andrew Hobbs, EY’s corporate governance and public policy partner in the UK, says that some companies fail to explain clearly the linkages between their business model and strategy.

According to a report that the firm released last year which examined 100 annual reports in the FTSE 350, only 9% included a narrative that threads everything together from a company’s strategy and key performance indicators, to the principal risks and remuneration of its board directors.

“We also found that almost half do not explain clearly how the company makes its money, which we believe is a key test of a business model disclosure,” Hobbs says.

Relevant measures

non-financial-reportingExperts have plenty of advice on how companies can improve. Referring to the FRC’s guidance is an obvious step, says Hobbs, as well as listening to the views of stakeholders. However, one of the underlying messages from the KPMG survey was that additive changes to the annual report are unlikely to bring about the degree of change required.

Chapman says that companies should look at the relevance of the measures they are reporting and target those that are most closely aligned to the business’s priorities. “The best company reports include a range of relevant measures covering, for example, brand, research, staff, customer base, product base, and efficiency. UK companies typically provide KPIs over two or three of these areas, but German companies average four or five, so, a broader view is possible,” he says.

But what does this mean in practice? For one, reports must exhibit more focus on the operational drivers of performance, while providing more focus on the resources on which the business depends, and provide readers with the information to form their own views on future performance.

Christian Herzig, professor of business and sustainability at Nottingham Trent University’s Business School, says that the guidance provided by standards-setters like the Global Reporting Initiative (GRI), an international independent standards organization that helps businesses, governments and other organizations understand and communicate their impacts on issues such as climate change, human rights and corruption is useful.

“The GRI can be considered to be a de-facto standard for corporate responsibility reporting and is regarded by many as a standard setter that plays a crucial role in developing reporting principles and standard disclosures for corporate responsibility reports,” he says.

Others suggest preparers of annual reports draw guidance from the IIRC’s integrated reporting framework. However, the IIRC has had its detractors – former Pearson Group CFO Robin Freestone has previously suggested annual reports already include much of the information required under integrated reporting – and clarity is needed about what businesses must to differently.

As the head of finance function, CFOs must present a common vision for the annual report. Responsibility for preparing the report is often spread across a range of departments. Unless these individual reporting strands are brought together into a coherent whole, reports can become a series of disconnected issues, leaving the reader unable to assess the implications of the matters raised despite wading through 1,000 pages to do so.

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