6 October 2014 Advice, Community

Member clinic: room for improvement

Last year saw several changes to business reporting requirements, so how have companies responded?

To find out, EY has studied the output from the FTSE 350. And as firms with December year-ends start compiling their next annual reports, BV asks Ken Williamson, EY head of corporate governance, for his advice on best practice.

Q. There has been a lot more focus recently on what good reporting looks like. Have companies responded in the spirit of the regulatory changes, or more with compliance?

A. I believe that many companies followed the spirit of the regulatory changes and made a concerted effort to improve their 2013 annual reports and accounts (ARAs). 

That said, both the extent of change and the lead time companies were given to adopt the changes meant that some had to limit their focus on compliance – understandably so.  
So now there is an opportunity for companies to reflect, look at how reporting practice has developed, and use the guidance issued since the regulations were finalised to enhance their annual reports this year.

Companies also have to understand what their shareholders want, and how to communicate this in an accessible and understandable manner. 

This process will be unique for each company – so it cannot be just a box-ticking exercise. The fundamental thrust of the recent changes was to ensure that the annual report of a company reflects the tone and character of the board, and the narrative they want to convey.

Q. Is the move to integrated reporting being accompanied by signs of more integrated thinking?

A. Companies adopting this reporting model certainly seem to be running their businesses in a more sustainable and integrated way.

And there are clear benefits to doing so, including better connections across different functions within companies; a better understanding of supply chain risks, and improved operational efficiencies; and business planning and decision making that are focused on the creation of longer-term value. 

But it will be some time yet before we know whether this new reporting model creates more sustainable companies, or simply reflects practices and processes already embedded into sustainable companies.

Q. How much scope remains for reporting innovation, around structure or format in particular?

A. There is scope to think about how and where to make disclosures in the ARA. Companies should think about structuring their ARAs in a manner that facilitates effective communication. 

For example, they are still structuring their report by “author” – chairman, chief executive, chief financial officer and so on – as opposed to telling the story in a logical narrative flow. There is no requirement for each executive board member to have their own section.

But there are still regulatory and legal barriers. For example, despite the fact that information being reported in the directors’ reports is very technical and unlikely to change vastly or at all from year to year, it still has to be in the ARA by law.

Q. When it comes to governance, the roles and expectations of the remuneration, nomination and audit committees are all changing. How is this being reflected in reports?

A. Given the recent changes in regulation and law, audit committee and remuneration committee reports have been enhanced, in terms of the insights they provide on the workings of these committees and some of the judgements they have exercised. But there is room for improvement. 

With the focus on these two committees, the nomination committee has remained the poorer cousin – at least in a reporting sense. It is time to put the spotlight on the workings of this committee, and for reports to provide better insights on what it has done during the year, and the outcomes. 

It is the nomination committee that is essentially responsible for board and committee composition, and shareholders need to have confidence that the processes for selecting, recruiting and replenishing the board are working.

Q. Gender diversity has risen up the agenda. Should reports always capture a company’s approach to this issue?

A. There is a legal requirement for quoted companies to disclose the number of men and women they employ – throughout the company and at senior manager level. But reporting these figures in the absolute makes them less relevant and understandable. 

Companies should link their gender diversity statistics to their strategy and business model, explain whether it is important to have a specific gender mix to achieve their strategy, and address the question “so what?” At board level, the requirement is slightly different. The UK Corporate Governance Code includes a provision for premium-listed companies to disclose on a comply-or-explain basis the board policy on diversity, and to report their achievement against that policy. 

This provision is supposed to be about diversity in its broadest sense – the mix of skills, talent, sector expertise, age, gender, ethnicity, personality types and so on – rather than just gender. 

Some companies have narrowed down their disclosures to gender, but it is crucial that the broader definition of diversity is used, to determine the effectiveness of the board as a team.   

Q. There has also been a growing interest in companies’ tax affairs. How should this be addressed in reports?

A. Initiatives to help streamline ARAs have led to an increase in voluntary disclosures appearing outside the ARA – for example, on company websites. More boards are disclosing reviews of their tax policies, and reporting on the principles underpinning their tax decisions. Others are also including explanations of commercial issues that influence their effective tax rates. 

Stakeholders become used to receiving the same categories of information on tax, so it’s easier to introduce new tax reporting than to stop disclosures that were provided in the past. Accordingly, reporting changes on tax policy and related matters should be viewed as a long-term commitment. 

Where appropriate, such disclosures should meet UK Corporate Governance Code requirements for fair, balanced and understandable reporting. It’s critical to ensure tax disclosures are robust and correct, regardless of whether they are compulsory.

Q. What was the biggest missed opportunity in the 2013 reporting season, and how do you hope to see that rectified in 2014?

A. The main opportunity that many companies missed, in my view, was to clearly articulate the links between key components of the report. 

After reading the key narrative sections of an ARA, my acid test is to check whether I can answer the following questions with relative clarity and ease:

  • How does this company make its money? 
  • What are the key inputs, processes and outputs in the value chain, and do I understand how its key assets – including its people and technology – are engaged in the value chain? 
  • What does the company do better than its competitors, and how will it sustain this competitive advantage over time? 
  • Do the key performance indicators (KPIs) specifically help to measure progress against the company’s strategic objectives? 
  • What are the risks that may affect the successful delivery of the company’s strategy? Can I see the direct link between the two? 
  • Do the KPIs that measure progress against strategic objectives also drive executive remuneration? Is this link visible? 

If I can answer all these questions, then the company concerned has succeeded in communicating key messages in an accessible manner in its ARA.

Download EY's review of December 2013 annual reports in the FTSE 350