The Financial Reporting Council (FRC) has published its Annual Review of Corporate Reporting for 2022/23 (FRC Review). While the recent news from the Government means there remains a lack of clarity on when the FRC will transition to ARGA, we expect the FRC will remain focused on high-quality, transparent disclosures from its enforcement activities over annual report and accounts in 2024 and beyond, particularly in light of the ongoing economic uncertainty.
This article summarises key matters from the FRC Review and our thoughts on next steps for finance and reporting teams.
Surrounded by uncertainty – what has improved? where are the issues?
The number of reports the FRC reviewed in the 2022/23 cycle is up by 4%, from 252 to 263. 112 companies received queries that required substantive correspondence with the FRC—up 9% on the prior review cycle—and 25 had to restate their financial statements. While the FRC continues to focus on larger listed entities, 2 in every 5 companies reviewed were outside the FTSE 350, including AIM-quoted and large private companies, which is an increase compared to two years ago.
It is promising to see that issues related to IFRS 9, 15 and 16, which presented significant challenges for companies in prior years have reduced in prominence. With falling but still high inflation levels, the highest interest rate levels since 2008, volatile exchange rates, and climate change amongst other events driving global uncertainty, companies are facing a different set of challenges today compared to when these Standards were issued. Against this backdrop, it is unsurprising that the significant sources of issues raised by the FRC in this review cycle relate to impairments, and judgements and estimates – as well as cash flow statements which has retained its spot in the top-three ranked issues as in the last two review cycles.
In this period of uncertainty, it is even more important that the narrative reporting in the front-half of annual reports clearly reflect the risks and issues companies are facing and the specific actions being taken to address these. The FRC Review suggests companies still have some work to do to improve the quality of their narrative reports.
Financial Reporting
The top accounting areas where significant issues were identified by the FRC included:
- Impairment of assets: the FRC noted that the impairment queries raised to companies were generally the same as in last the last review cycle, but companies had not risen to the need for more robust and detailed disclosures as would have been expected in light of the ongoing uncertainties. For example, disclosures around key inputs and assumptions used to determine recoverable amounts, quantitative information on the amount of headroom, inconsistencies between the determination of CGU and information elsewhere in the annual report amongst others. Furthermore, with respect to reporting climate in the financial statements, most of the substantive queries raised related to whether climate-related risks had been appropriately incorporated into impairment testing.
- Judgements and estimates: most of the queries raised by the FRC related to estimation uncertainty disclosures. The FRC found that these disclosures did not always include detailed information—such as key assumptions and sensitivities—or were inconsistent with other areas of the annual report which indicated potential unidentified sources of estimation uncertainties. Missing information about significant judgements that had been made was also identified as an issue with some companies.
- Cash flow statements: the frequency of queries the FRC raises on the cash flow statement remains concerning. While a number of these were related to less common or more complex transactions that were not clearly explained, there continues to be common errors: for example, inconsistencies between amounts reported in the cash flow statement and elsewhere in the annual report, non-cash transactions included in the cash flow statement and incorrect classification in parent company cash flow statements. In slightly more promising news, the number of companies that required restating their cash flow statement is down 53% on the prior year, from 15 to 7.
Other financial reporting areas the FRC raised issues on included financial instruments, income taxes, revenue, provisions and contingencies, presentation of financial statements and fair value measurement. Though these topics are not in the top three ranked issues, in aggregate, they accounted for over half of the total restatements in this review cycle.
In many respects, the issues raised by FRC are not new. Greater discipline and better application of materiality is needed to ensure financial statements include relevant and sufficiently explained disclosures, particularly in light of the uncertain economic environment.
Narrative Reporting
The front half of UK companies’ annual reports is undergoing a pivotal transformation: changes to the UK Corporate Governance Code (Code) from the FRC are expected and the first two IFRS® Sustainability Disclosure Standards published by the International Sustainability Standards Board (ISSB) is set to increase the prominence of sustainability reporting in annual reports. The government is also taking a fresh look at the non-financial reporting requirements to identify potential opportunities to simplify and streamline existing reporting, so investors and other stakeholders have the important information needed to make decisions.
While we await the finalisation of these developments in the UK, companies need to be especially cognisant that their narrative reporting is not only about content that “ticks the box” on the applicable requirements. As with financial reporting, judgement is paramount – this means including additional information where existing content in the narrative report does not provide investors and other stakeholders with meaningful and company-specific information or indeed, removing information that is irrelevant, immaterial or excessively detailed.
The FRC Review provides a number of matters to consider as companies review their existing narrative disclosures.
As in the prior review cycle, issues relating to the strategic report and other Companies Act 2006 matters ranked 4th in the top ten issues. The key points that emerge include:
- Fair, balanced and comprehensive: the FRC queried companies where their strategic report did not explain material balance sheet and cash flow items, including significant movements from the prior year.
- Section 172 statement: many companies, including large private companies failed to provide a compliant section 172 statement.
- Distributable profits: the FRC also challenged companies on the lawfulness of dividends and questioned whether amounts from certain transactions had been treated as realised or unrealised profits.
The FRC reminds companies about the principles-based guidance to preparing a high-quality strategic report it published in June 2022. The guidance encourages companies to see the report as a way of telling its story in a cohesive manner that results in providing a fair, balanced and comprehensive picture across all strategically significant aspects of the business.
The FRC Review gives a preface to what can be expected from its annual review of corporate governance reporting, which is expected to be published later this year.
Based on a review of 19 companies, the FRC identified 13 companies that fell short of the high-quality corporate governance disclosures it expects. Consistent with prior years, the issues raised with companies relate to potential undisclosed departures from the Code, inadequate explanations for any departures and a lack of clarity on how the Code Principles were applied, particularly when disclosures lacked detail about actual actions and outcomes of governance arrangements.
While the Code applies on a comply or explain basis, it appears many companies still find it difficult to provide genuine and transparent explanations in case of departures. With the proposed changes to the Code—where ‘outcome reporting’ looks set to become an explicit Code Principle—a more proactive and impact-led approach to governance practices should be high on your Boards’ agenda.
The FRC’s second year of reviewing climate-related reporting by premium listed companies shows very different stages of maturity among companies reviewed. In its correspondence with these companies, the FRC raised a number of substantive queries on their TCFD-aligned disclosures. The issues mainly related to missing compliance statements on the extent to which disclosures are consistent with the TCFD framework, lack of clarity on the plans/timelines for future disclosures and specific queries across the four pillars as follows:
- Governance: lack of clarity around board oversight and management’s role in the process.
- Strategy: descriptions of risks and opportunities did not provide enough clarity on the financial and transition plans as well as the scenario analysis performed.
- Risk management: disclosures provided did not sufficiently address the process for managing climate-related risks and how climate-related risks are integrated into the overall risk management process.
- Metrics and targets: information on scope 1, 2 and 3 emissions were either missing or unclear as were explanatory information on defined targets. During the year, the FRC also conducted a targeted thematic review on metrics and targets where it noted that companies could do more to link metrics and targets to identified risks and opportunities; provide company-specific metrics and explanation of targets; and aid comparability by using cross-sector and industry-specific metrics.
The FRC’s approach to date has been to encourage companies to consider improvements to their TCFD reporting in future reports. However, as practice becomes more established, it expects to enter into substantive correspondence more often when disclosures do not meet its expectations. Companies should also seek to work on addressing the identified issues as this will move their disclosures forward in a practical way and provide a better basis to prepare for the upcoming ISSB requirements.
So, what does this mean for your next annual report?
Simply put, there is more work to do to ensure annual reports and accounts, as a whole, meet investors’ and other stakeholders’ need for high-quality, decision-useful information.
For your 2023/24 annual reports and accounts, the FRC expects to see:
- disclosures about uncertainty that are sufficient to meet the relevant requirements and allow users to understand the positions taken in the financial statements.
- clearer description in the strategic report of risks facing the business, their impact on strategy, business model, going concern and viability with cross-references to relevant detail in the annual report and accounts.
- transparent disclosures of the nature and extent of material risks arising from financial instruments.
- for listed companies, a clear statement of consistency with the TCFD framework which explains, unambiguously, whether management considers they have given sufficient information to comply with the framework in the year. However, companies in scope of the UK-CFD1 requirements under Companies Act are reminded that those requirements apply on a mandatory basis and only some are subject to materiality assessment.
- sufficient critical reviews of the annual report and accounts and robust pre-issuance reviews that consider the issues the FRC has commonly raised to companies.
Companies could look at the specific issues from the FRC Review and seek to address these as they apply to them. However, a more pragmatic approach would be to question whether the overall content of the annual report is fit for purpose and use the required disclosures – alongside FRC’s findings and disclosure expectations – as an opportunity to report in a company-specific way that provides relevant and connected information for investors and other stakeholders.
Please get in touch if you would like to discuss these findings further.
1Mandatory climate-related financial disclosure requirements for certain listed companies, large private companies and limited liability partnerships. These entities are required to disclose specified climate-related financial information that is aligned with, but not identical to, the TCFD recommendations.