Narrative reporting for financial reports – risk and governance

This second post on narrative reporting for financial reports, focuses on contemporary discussions on:

  • Risk reporting (market, credit, liquidity and estimation risks)
  • Governance reporting
  • Environmental, Social and Governance (ESG) Risk Reporting

It briefly sets out where narrative disclosures could be improved – and why they should be.

Risk reporting (market, credit, liquidity and estimation risks)

A number of issues have been identified with the current level and quality of risk reporting and strong arguments put forward regarding benefits to both users and reporting organisations for better reporting (Elshandidy et al 2015; FSB, 2012; Ryan, 2012).  Arguments put forward by the ACCA for better risk reporting include:

  • Increased investor confidence in the quality of management
  • Provides a better idea how a company’s performance will be affected if a risk materializes
  • Demonstrates Board accountability

As a result, it adds value to the reporting organisation.

Regulation and Stock Exchange requirements for risk reporting vary considerably across jurisdictions (ACCA, 2014; Elshandidy et al, 2015).  As might be expected, the extent and nature of mandatory risk reporting requirements in different jurisdictions have been found to be significantly associated with the nature of the legal system and culture (Elshandidy et al, 2015).

There have been calls to improve the quality of risk reporting to:

  • increase clarity, balance, understandability, comprehensiveness, relevance, consistency over time, comparability across an industries and timeliness(Financial Stability Board’s Enhanced Disclosure Task Force, 2012)
  • present risks in a tabular or other well-structured format (Ryan, 2012)
  • separate components of comprehensive income that are primarily driven by variations in cash flow versus those primarily driven by variations in the cost of capital (Ryan, 2012)
  • use fair value accounting or other information-rich accounting measurement attributes (Ryan, 2012)
  • disclose primary historical and forward-looking attributes with respect to model-dependent risk disclosures (Ryan, 2012)

Governance reporting

Good governance is essential to quality reporting. The increase in corporate governance disclosures over the last few decades can be attributed to:

  • corporate governance scandals (such as Enron, Worldcom and VW) (Hermalin and Weisbach, 2012)
  • reporting frameworks which require Board involvement in reporting and/or specified governance disclosures (see Adams, 2017)
  • excessive executive pay (Hermalin and Weisbach (2012)
  • calls for improved gender diversity and breadth of experience of the Board

These issues have raised concerns about accountability and organisational performance.

Boards are required to take responsibility for financial reporting and integrated reports which follow either the King IV Code (in South Africa) or the International <IR> Framework. But they have traditionally had little or no involvement in sustainability reporting (although Chan et al, 2014 nevertheless found a link between governance quality and CSR disclosure). Adams (2017) found that Board involvement in reporting, specifically integrated reporting, could improve the Board’s understanding of the purpose of the business and their responsiveness to, and understanding of, ESG risk.

Environmental, Social and Governance (ESG) Risk Reporting

ESG risk and opportunity can have a major impact on an organisation’s ability to create value and, should be reported on to the extent that they have a (potential) material impact.  ESG risk consideration tends, however, to be an add-on rather than something considered and reported alongside other risks the organisation faces.

ESG risks should be considered alongside other risks and included in risk registers. Material ESG risks should be incorporated into the development of the organisation’s strategy to create value.  Material sustainable development risks and opportunities which impact on strategy and capitals (such as natural, human and manufactured capital) needed to deliver on it should be considered and disclosed.  Reporting should also consider how the organization delivered on its previous year’s strategy and any unexpected impediments to that process.

Research has demonstrated that including ESG risks when assessing material risks and opportunities in the external environment is driven by reporting frameworks and leads to improved long term value creation.

A way forward…

Recent regulatory initiatives such as the UK’s Strategic Report requirement (UK Companies Act 2006, as amended in 2013) and the requirements Australian Securities and Investment Commission (ASIC) Regulatory Guide 247 that listed companies prepare an Operating and Financial Review (OFR) which discusses environmental and other sustainability risks help address these shortfalls in risk and governance reporting.

The <IR> Framework encourages organizations to think of multiple capital inputs to the process of creating value for the organization and its stakeholders.  The process of thinking about what value means for an organization and how it is created is referred to as integrated thinking. It has been found to be particularly valuable in articulating and developing a shared understanding of what an organization does.  The multiple capital model broadens and deepens understanding about how value is created (or diminished) (see Adams, 2017).  It encourages a wider range of risks and opportunities to be considered and can, if it isn’t just used as public relations exercise, improve governance of risks and governance reporting.

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