The financial reporting challenge: key issues and questions for non-executive directors

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DECEMBER 2012

The financial reporting challenge: key issues and questions for non-executive directors

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Contents

1 Going concern – the continuing challenge

2 Are you on top of currency and country risks?

3 FRC Conduct Committee hot topics

4 Do you need to recognise an impairment?

5 The narrative reporting challenge

6 Can you cut the clutter?

7 Future of UK GAAP – the key challenges

8 IFRS developments – the key questions

Introduction

Businesses of all sizes face many challenges at present. Key challenges in relation to corporate reporting are to ensure that the annual report and accounts provide relevant and reliable information to stakeholders, comply with relevant law and accounting standards and tell a consistent story.

All directors, both executive and non-executive, have a legal responsibility for preparing accounts and must not approve accounts unless they are satisfied that they give a true and fair view of the assets, liabilities, financial position and profit or loss. It is important not to underestimate your legal responsibility as a non-executive director to prepare accounts that give a true and fair view and that comply with the law and accounting standards.

Grant Thornton’s guide The financial reporting challenge – key issues and questions for non-executive directors is intended to highlight some of the key financial reporting issues that companies are having to deal with currently and provide a reference for non-executive directors to help them focus on what they need to address. The guide identifies high-level issues relating to the company’s annual report and accounts and puts forward ideas for questions NEDs may wish to pose to the Board as a whole to ensure that those issues have been addressed. To help you focus on what is most relevant to you, we have flagged these issues according to whether they are relevant where you prepare your accounts under UK GAAP, IFRS or both.

Companies’ individual circumstances will vary greatly and some issues may be more pertinent than others in any given company. This guide is not intended to be a comprehensive list of issues or questions that companies may face during the financial reporting season.

Joyce Grant, Technical Partner

11The financial reporting challenge

Going concern – the continuing challenge

The continuing difficult economic conditions mean that the assumption that the business is a going concern may not be clear-cut in some cases and directors may need to make careful judgements relating to going concern. Directors need to ensure that it is reasonable for them to prepare the financial statements on a going concern basis. Where directors are aware, in making their going concern assessment, of material uncertainties relating to events or conditions that may cast significant doubt upon the company’s ability to continue as a going concern, UK GAAP and IFRS require those uncertainties to be disclosed in the financial statements.

UK GAAP IFRS

Has the Board conducted a rigorous process to assess the validity of the going concern assumption and related risks and uncertainties?

Have borrowing facilities and covenants been considered and the likelihood of facilities being maintained or renewed assessed?

Are cash flow forecasts based on relevant information and reasonable and supportable assumptions consistent with business plans?

Do forecasts extend for a period sufficient to enable all major issues to be evaluated and cover a period of at least twelve months from the date the accounts are approved?

Have forecasts and assessments been stress tested against a combination of pessimistic but plausible estimates and assumptions?

Have guarantees, indemnities and commitments been taken into account and the risks and consequences of the company being called on to honour them assessed?

Does the annual report and accounts explain clearly the basis for adopting the going concern assumption and have relevant risks and uncertainties been described?

22 The financial reporting challenge

Are you on top of currency and country risks?

A number of countries around the World are facing major economic risks and uncertainties, notably the Eurozone. The annual report and accounts need to explain the business’s exposure to these risks through financial instruments, foreign operations and exposure to trading counterparties. Stakeholders will also be interested in the potential impact of austerity measures being adopted on forecasts, impairment testing and going concern assessments. As the situation evolves, enhanced disclosure of post-balance sheet events may be necessary to inform investors and other stakeholders.

UK GAAP IFRS

Does the description of principal risks and uncertainties in the business review reflect appropriately the company's exposure to currency and country risks and the mitigating actions taken?

Have you considered how currency and country risks may affect your business and thus your going concern assessments or asset impairment testing?

Do adverse developments in country or currency risk, such as government austerity measures or credit deterioration, trigger the need for asset impairment reviews?

Have budgets and forecasts underlying going concern assessments or impairment tests been stress tested for the potential impact of country or currency events that have not been built into the underlying assumptions, such as the country’s exit from the Euro?

Has adequate disclosure been provided in the financial statements of impairments, provisions against receivables, concentrations of credit risk and other risk exposures?

Are key judgements and key sources of estimation uncertainty relating to currency and country issues explained in the financial statements?

Have events after the reporting date been reflected appropriately in the financial statements?

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FRC Conduct Committee hot topics

In its Corporate Reporting Review work, the Conduct Committee of the Financial Reporting Council (FRC) seeks to ensure that the provision of financial information by public and large private companies complies with relevant reporting requirements. The Conduct Committee will challenge companies whose annual reports and accounts raise questions as to whether or not requirements have been adhered to. This was formerly the remit of the Financial Reporting Review Panel (FRRP). The Conduct Committee may challenge any area of the annual report and accounts. Some key areas of focus are identified here.

UK GAAP IFRS

Are accounting policies relevant to the company's circumstances, do they cover all material areas and are they set out clearly?

Is the basis on which the company recognises and measures revenue clear and in compliance with relevant standards?

Have intangible assets been recognised and measured appropriately on a business combination?

Have impairment reviews been conducted in accordance with relevant standards and are the disclosures in the accounts clear and complete?

Are cash flows classified under the appropriate heading and does the cash flow statement include all cash flows and exclude non-cash items?

Are operating segments in the financial statements consistent with how the business is described in narrative reports?

Where the accounts identify the Board as a whole as the Chief Operating Decision Maker, do the NEDs consider themselves as making operating decisions?

Are capital risk management disclosures clear and will the reader understand how the business manages capital?

Are key judgements made in applying accounting policies and key sources of estimation uncertainty disclosed clearly?

Does the business review provide a balanced analysis including both good and bad news and are principal risks and uncertainties described, including steps taken to mitigate?

Does the corporate governance report explain clearly any departures from the provisions of the UK Corporate Governance Code, where applicable?


Do you need to recognise an impairment?

Impairment testing continues to be an important issue for many businesses, whilst the disclosures made about the impairment testing in the financial statements are an area of on-going scrutiny by the FRC Conduct Committee. The process followed in testing for impairment may be complex and involve significant judgement, whilst the disclosure requirements under IFRS in particular are extensive. Impairment issues affect financial and non-financial assets as well as goodwill.

UK GAAP IFRS

Has an assessment been made of whether there are any indicators that assets might be impaired and thus that an impairment review of assets or cash-generating units is required?

Are the assumptions underlying impairment tests reasonable, supportable and consistent with the company's budgets and forecasts and with how the company's prospects have been described in narrative reports such as the business review?

Are discount rates and assumed growth rates specific to the assets or cash-generating units being tested and compatible with requirements in accounting standards?

Do changes in the business mean that allocations of assets and goodwill to cash-generating units need to be revised?

Has appropriate sensitivity analysis been applied to test the robustness of assumptions and determine whether additional sensitivity disclosures are required?

Do the financial statements include all relevant disclosures and explanations regarding impairment testing and any impairments recognised?

Are all key disclosures and movements in the financial statements discussed appropriately in the narrative?


The narrative reporting challenge

Telling a consistent story throughout the annual report and accounts is essential to producing a good set of reports and accounts. Your narrative reporting, including the directors’ report, business review, chairman’s statement and other narrative reports, needs to communicate clearly the company’s business model, give a clear and balanced account, including information about the company’s performance in the year, both good and bad, and explain the principal risks and uncertainties the business faces and the key performance indicators which the Board uses to measure success. Where the UK Corporate Governance Code is applied, the company needs to explain how it has applied the principles and explain any departures from Code provisions. For annual periods commencing on or after 1 October 2012, the UK Corporate Governance Code will require Boards to confirm that the annual report and accounts taken as a whole are fair, balanced and understandable and disclose the Board’s policy on diversity, including gender, any measurable objectives set and progress on achieving the objectives.

UK GAAP IFRS

Does the annual report provide a fair, balanced and comprehensive review of the company's business and its performance, including an explanation of the business model?

Is the analysis supported by relevant key performance indicators used by the Board in monitoring the business?

Does the business review describe the principal risks and uncertainties to which the business is exposed, rather than set out all possible risks, and state the mitigating actions taken?

Has the Board taken into account all relevant issues that have come to its attention during the year when deciding what matters merit discussion in narrative reports?

Are the key messages given consistent across narrative reports and with the financial statements?

Does the corporate governance report, where prepared, explain how the main principles of the UK Corporate Governance Code have been applied and are any departures from specific Code provisions explained clearly?

Has the Board established a policy on diversity, including gender, and has the Board set any measurable objectives for implementing that policy? If not, is the Board ready to explain its departure from the new Code provision on this matter, where applicable?


Can you cut the clutter?

Annual reports have been growing longer and longer each year amidst increasing concerns about the complexity of financial reporting. Repetition and inclusion of immaterial detail in annual reports add unnecessary clutter and may obscure key messages. A key challenge is to make the communication in your annual report and accounts focused, open and honest, clear, understandable, interesting and engaging.

UK GAAP IFRS

Are your accounting policies specific to the circumstances of your company?

Do you have irrelevant or immaterial accounting policies that add clutter and could be deleted?

Do you duplicate information unnecessarily within the annual report, for example by repeating messages in several places where one would do?

Specific disclosures generally need not be provided if the resulting information is not material. Are your judgements on materiality of disclosures appropriate or over-cautious?

Have you assessed the clarity of expression and the language used in your annual report, and are you satisfied that information is communicated in a clear way that users will be able to understand?

Does the structure of your annual report and accounts allow users to find the information they need easily?


Future of UK GAAP – the key challenges

The FRC plans to replace current UK accounting standards with new requirements based on the IFRS for Small and Medium-sized Entities. Changes will take effect from 1 January 2015. Parents and subsidiaries will have the option of applying IFRS with reduced disclosures in their individual accounts. The FRC began issuing the new standards in November 2012 and the framework is expected to be complete by early 2013. Early adoption will be permitted.

UK GAAP IFRS

Will transitioning to the new UK GAAP affect your loan covenant compliance?

If you prepare your group accounts under IFRS, should you move your UK subsidiaries to IFRS with reduced disclosures under the new FRS 101 Reduced Disclosure Framework?

Could the group structure be simplified to reduce the costs of transitioning to the new regime?

Will you need to determine fair values of financial instruments for inclusion in your accounts under the proposed FRS 102 The Financial Reporting Standard applicable in the UK and the Republic of Ireland?

Who in your finance team will need training, and when?

How will your company communicate the impact of the changes to key stakeholders?

Should your company adopt the new standards early?


IFRS developments – the key questions

Major changes to IFRSs on consolidation, joint ventures, fair values and accounting for defined benefit pension schemes begin to come into force from 2013 onwards. The entities included in the scope of the consolidation may change. Companies with joint ventures may find that their accounts look very different. More disclosures relating to fair values will be needed and these disclosures will reach far beyond financial instruments. Changes to treatment of defined benefit schemes are also on the way. Implementing these changes may require new or different information on which to make key judgements or meet disclosure requirements. You will need to communicate the likely impact of these changes to shareholders and other users of your annual report and accounts.

UK GAAP IFRS

Will applying the revised IAS 19 Employee Benefits affect your reported profits or change how you treat actuarial gains and losses?

Have you considered whether IFRS 13 Fair Value Measurement will change how you measure any assets and liabilities carried at fair value, including fair values on business combinations?

Do you have the systems in place to provide the information required to meet IFRS 13's disclosure requirements, which cover a wide range of fair values and extend beyond financial instruments?

Have you assessed whether the introduction of IFRS 10 Consolidated Financial Statements will alter which entities are included in your consolidation?

Have you evaluated how the accounting treatment of your jointly controlled assets, operations or entities will change when you begin to apply IFRS 11 Joint Arrangements?

Have you identified the key information you will need to be able to make the key judgements required in applying IFRSs 10 and 11 and provide the enhanced disclosures that will be required by IFRS 12 Disclosure of Interests in Other Entities?

Are key judgements and key sources of estimation uncertainty relating to the application of new and revised standards explained in the financial statements?

Have you considered how you will communicate to your key stakeholders the impact of new and revised standards on your reported position and performance?

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The financial reporting challenge: key issues and questions for non-executive directors