Searching for gold in the gobbledygook

In the current complex and dynamic economic environment, the information needs of investors are continually evolving. Financial reports may not fully help the investor understand the company or value it. The biggest grouse of investors is that companies often treat financial reporting as a compliance exercise and not a communication tool for investors. The Audit Committee Leadership Network organised by Ernst & Young threw up several thoughts and ideas.

Investors increasingly value non-audited information, including what comes from investors’ presentations, road shows, and management discussion and analysis (MD&A). The information contained in these sources, such as key performance indicators and other non–GAAP (Generally Accepted Accounting Principles) measures, could be of higher quality, and auditing this information would be valuable to investors. Investors want to know the management’s strategy, which is not always apparent from the numbers.

Sophisticated investors work on non-GAAP numbers in any case. Non-GAAP and operational metrics, such as average revenue per user or customer acquisition cost, are highly valuable to investors. With the growing reliance on key performance indicators, audit committee members should closely scrutinise the use of these metrics.

While companies provide a great deal of valuable information, what investors really want is a cohesive story about the company that ties together disparate data points, and “connects the dots” about its performance. Audit chairs can help companies do this by ensuring that their information is consistent, provides insights into how it is addressing key economic or regulatory debates, and the management — including the CFO and investor relations — communicates effectively.

Improvement of financial reporting involves many stakeholders including standards setters, regulators, issuers, and auditors.

As part of efforts to converge the world’s dominant accounting standards, the International Accounting Standards Board and the Financial Accounting Standards Board are co-developing a project on financial statement presentation, and the latter is developing a disclosure framework to make financial disclosures more effective and integrated with the other parts of a company’s reporting.

In the wake of the recent financial crisis, regulatory initiatives have focused on expanding disclosures for investors; for example, new disclosure requirements from the US Securities and Exchange Commission include proxy disclosure enhancements involving risk oversight, director qualifications, and compensation.

Despite their clear value, however, audited financial statements have a limited use for investors. They offer a retrospective view. Yet, investors try to understand as much as possible of the past in order to predict the future.

They value the company by looking at sustainable operating cash flow. There are three ways to enhance cash flow reporting: report cash flow by segment; use the accrual method on the capital expenditure line (including the effect of non-cash transactions, such as leasing activities); and disclose the cash effects of unusual and non-recurring items.

Investors want detailed explanation for various reported items, such as revenues and off-balance-sheet entities. One of the core principles of the IASB and FASB project on financial statement presentation is disaggregation. Investors like to know what different businesses are doing in different markets. In most businesses, revenue and customer acceptance determine company performance.

So, revenue prediction preoccupies investors’ thinking. Yet, not much of the financial report is devoted to how revenue is created? The reporting model already calls for extensive details on costs — pensions, taxes, parts of costs of sales, advertising, R&D and so on — but not enough information is available on what drives the company’s future. Investors also seek more insight on tax in multinational companies. When tax rates are low, investors want to know if it is sustainable.

Investors say they would value an expanded audit scope. The question of expanding the scope of independent audit is now a priority among investor groups and standards setters. In its guidance on non-financial reporting, the International Corporate Governance Network states, “Independent assurance about the extent to which non-financial business reporting has followed established measurement and reporting standards can be useful to enhance the credibility and reliability of the reported information.”

The Public Company Accounting Oversight Board’s concept release on auditor’s reporting model solicits feedback on whether auditors should provide assurance on information outside the financial statements, such as the MD&A and non-GAAP measures.

There are significant benefits in an expanded audit scope. Non-GAAP measures are often important and investors rely on them as if they were audited. So investors would value auditor assurance of non-GAAP measures.

Dolphy D’Souza is Partner and National Leader, IFRS services in a member firm of Ernst & Young Global

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