The Financial Reporting Council in the United Kingdom caused some concern in the quoted SME space in late 2013 when, in setting its priorities for 2014 it indicated that it would investigate the standards of reporting within that sector.
The FRC's consideration of the reporting from the quoted SME sector is a three year project, looking for a "step change" in reporting. Implicit within the FRC's ambition is a view that there is a need, namely that certain aspects of reporting by those companies is inadequate.
It is true that smaller companies struggle with some of the complexity of financial and narrative reporting, this is a factor of both resourcing as much as it is a reflection that the "think small first" principle (which was intended to guide the Companies Act 2006 when it came into force) never really translated into the detailed requirements placed on companies, including in the area of corporate narrative and financial reporting.
Smaller quoted companies find regulatory change one of the hardest things to manage. In recent years, companies have had to manage a lot of change, including remuneration reporting, narrative reporting and many other developments in company law, such as the impending registers of people with significant control brought about by the (misleadingly titled) Small Business, Enterprise and Employment Act 2015. What smaller companies need is support to assist them navigate the complex regulatory environment.
FRC Paper on Improving the Quality of Reporting for smaller companies
In June 2015 the FRC published a discussion paper setting out its findings and proposals on "Improving the Quality of Reporting by Smaller Listed and AIM Quoted Companies", namely those which congregate towards the lower end of a capitalisation table. The publication of this document was a cause for concern for many. It was therefore very welcome that the FRC stated that their objective is to better understand the "challenges faced by smaller quoted companies and to explore ways in which we might help them".
Similarly, it was very welcome to see that the FRC acknowledges that whilst it may be difficult to comply with the complex regulations, the quality of reporting by smaller quoted companies is generally good. However, the authors believe that it would be very useful for the FRC to set out the different ways in which "quality" may be demonstrated in different parts of the market.
Smaller quoted companies are resource-constrained. Naturally, investors looking at the myriad of smaller quoted companies find themselves spread thinly. Many smaller quoted companies do not believe that investors read annual reports. Accordingly, some respond by allocating a bare minimum of scarce resources to the production of such documents. However, at least for some investors, such as the small-cap focussed Miton Group PLC, little could be further from the truth. Gervais Williams of Miton Group plc emphasises the permanent nature of annual reports: "when it is published, it can't be changed. [...] People have to think quite seriously about what they put in their annual report because if they get it wrong, it's out there forever". Misconceptions need to be addressed and companies and investors encouraged to develop a deeper appreciation of the particular position of the other.
The FRC's methodology
The FRC has been looking at whether the quality of reporting matters to investors in smaller quoted companies and, if so, how to support companies to improve the quality of their reporting.
The first phase of the project involved gathering and assessing evidence of the issues and challenges in order to gain a better understanding of the barriers to higher quality reporting and exploring ways in which the FRC can support such companies to help them improve their reporting and increase their attractiveness to investors. The FRC focussed on listed companies with market capitalisation between £20m and £100m and UK companies admitted to trading on AIM with a market capitalisation of at least £5m.
Supporting smaller preparers
The current UK Corporate Governance Code (September 2014) makes it clear that the board should present a fair, balanced and understandable assessment of the company's position and prospects (main principle C1). However, this is only possible when the regulatory framework within which the reporting operates is also fair, balanced and understandable. The rule makers need to rise to the challenge to create rules which can be readily and effectively complied with, both in spirit and to the letter, by a smaller company with more limited resources that its larger listed cousins. Smaller quoted companies do not employ dedicated teams to deal with investor relations and accounts production and the primary workload for this will often fall upon the shoulders of over-worked finance director and the company secretary.
In the smaller company world, effective outcomes are vital and The Quoted Companies Alliance Corporate Governance Code for Small and Mid-Size Quoted Companies sets out a pragmatic and proportionate approach, designed to be a practical navigation tool for companies to create and maintain appropriate and proportionate corporate governance structures and processes, following the spirit of the FRC's UK Corporate Governance Code, but without the detailed provisions.
Because smaller companies often struggle to attract a good level of analyst research, the annual report and accounts may present itself as the one genuine opportunity in each year for those companies to deliver good and clear messages to investors. Such opportunities should not be squandered.
What investors wish to focus upon
The FRC's work has demonstrated that small cap investors want to see greater focus on (and explanation of):
Narrative and Principal Financial Statements
- business model, principal risks and uncertainties
- cash flow statements
- underlying financial performance
- disclosure of accounting judgements and estimates
Accounting Policies
- revenue recognition policy
- capitalisation policies
- new accounting provisions
- details of accounting provisions released during the year
Fundamentally, investors are interested in the company's story and the key judgements or decisions made in order to help them assess the risks involved, build their understanding of the current profile of their investment which is founded upon the level of trust they have in the company and its executives.
Other players
Auditors, the members of the audit committee and investors all have an important role to play in driving up quality of reporting. Investors should recognise what is good in company reporting, as well as what they may be unhappy about. Generally, all within the community should work in a co-operative manner in order to assist the development of quoted SMEs, and thereby, drive investor gains and the economy more generally.
The FRC acknowledges the role that auditors of smaller companies as a means of support for the resource constrained finance teams and understand that, currently, auditors are conscious of the existing ethical standards which preclude the auditors from providing assistance and training to improve the quality of the outputs produced. The FRC is to review the existing ethical standards as they see the auditors as key players in facilitating improvements in the quality of reporting. This is positive. It is in the interests of all for ethical principles to be applied rigorously, but in a manner which is sympathetic to the market.
FRC's recommendations to companies
The FRC set out four recommendations to companies of areas where sharper focus could help smaller quoted companies improve the quality of their annual report:
- allocate adequate time and resources to produce good quality annual reports
- ensure early engagement on the annual report by those charged with governance
- develop a deeper understanding of relevant reporting standards and requirements
- auditors must demonstrate a rigorous review process.
These recommendations complement the four stages for "Enhancing Stewardship Dialogue" guidance which the Institute of Chartered Secretaries and Administrators prepared under the commission of the 202 Investor Stewardship Working Party back in early 2013.
What the FRC intends to do
The FRC helpfully acknowledges that it has a role to play in the process of narrowing the perception gap and therefore sets itself a number of goals including:
- providing annual updates for companies
- setting out the key areas of focus for investors, common errors and suggestions for improvements
- identifying opportunities to facilitate greater dialogue
- between smaller quoted companies and investors, including through roundtables and similar initiatives
- applying more pressure on investors and rating agencies
- to provide appropriate feedback to companies on their annual report
- encouraging more participation by the quoted SME community in the practical work of the FRC's Financial Reporting Lab
- to identify ways to improve the quality of corporate reporting for quoted SMEs
These are all helpful and deliverable proposals. All involved with the quoted SME sector should be encouraged to engage with and apply pressure to the FRC so as to ensure that it delivers to these promises.
Where next?
The FRC's work so far has proven to be an important and timely intervention to raise awareness of the challenges faced by small and mid-size quoted companies and encourage collaboration through a coherent and comprehensive response by all the parties involved. The objective which should be focussed upon is to build confidence and trust through effective communication. Providing an account of the stewardship of the company and the company's performance over the past year in a clear and concise manner will ultimately improve companies' ability to access and raise capital and grow. If the FRC continues to treat its review of the sector as a process of engagement and connection with quoted SMEs there is no reason why smaller quoted companies, the investors into those companies and the FRC will not all benefit from more efficient, effective and better quality reporting, consistent with the "clear and concise" objective sought by the FRC and, indeed, those who write and read company reports.
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