Risky business (English only)

Risky business

By Thomas Toomse-Smith

There is no doubt that the investment process is intrinsically linked to understanding and assessing risk, and that a key source of information about risk is a company’s annual report. With the annual reporting process for many companies now firmly underway it is a good time to think about how to focus and improve risk disclosures.

The evolution of risk reporting

Risk reporting in the UK has undergone a significant evolution since the 2008 financial crisis. This has been driven by investor demands for better disclosure and the UK Corporate Governance Code’s introduction of the viability statement in 2014. However, these changes have not always led to better reporting. In order to understand what investors consider good disclosure and why, the UK’s Financial Reporting Lab interviewed and surveyed more than 220 retail and institutional investors. Our full report, “Risk and viability reporting”, was published in November. Here are some of the highlights from our report.

Do investors care about risk disclosures?

We began by seeking to understand, if investors wanted risk disclosures, and if so, what they did with them. The answer to the first question is: yes, they do. There is a clear indication from investors that understanding the risks faced by a company is essential when making investment decisions; both before investing and during the holding of that investment.

The interaction between a company’s risk profile, an investor’s risk appetite and views on the overall reward from those investments is a complex and ever-changing assessment that investors make. To do this they need regular and detailed information.

Where do investors go for risk information?

Investors see the annual report as a regular and reliable source of risk information (from the company). It forms a part of the risk material they use for their assessment of risk. Other sources of company-specific risk information they use include investor presentations, prospectuses and meetings with management. This is important context; the annual report disclosure is only part of what investors look at and as such it needs to be a consistent and integrated part of the whole suite of risk information.

Are companies getting it right?

Investors in our project consider that, since the financial crisis, there was an increasing focus on risk management when they had discussions with companies. Overall they also felt that companies had improved their risk disclosures in the annual report and encourage all companies to consider the following questions:

  • How the risks identified will specifically impact the company? – Does the description of principal risks describe how they are specific to the company?
  • How substantial are the risks identified, which are the most important? – Is it clear how the company categorises and prioritises principal risks?
  • How are the risks changing over time? – Are movements in principal risks, including shifts into and out of the principal classification, explained?
  • What do these risks mean for the strategy and business model? – Is it clear how the principal risks link to other parts of the annual report and accounts, in particular, the viability statement, business model, strategy, KPIs and the risk reporting in the financial statements?
  • How is the company managing these risks? – Do the mitigating activities include specific information that allows the reader to understand the company’s response?

What to do?

Our analysis of risk disclosures (over the last five years) showed that they have become ever more comprehensive, but they are still not delivering fully for investors. We worked through some example disclosures with investors and identified areas of good practice. The full Lab report provides a detailed explanation of what investors liked about each example. However, they shared the following characteristics:

  • They are specific and focus on implications for the company rather than high-level generic issues.
  • They are well structured, and essential information (such as whether they are presented before or after the impact of controls) is easily understandable.
  • They truly reflect what the board have been thinking about in the current period and are likely to think about in the future.
  • They make sense in the context of the full annual report and specifically the company’s strategy and business model.
  • They balance investors’ desire for detailed information with companies’ concerns about conciseness and over-disclosure.

Overall investors want risk disclosures to be useful information and not an exercise in management liability avoidance. Companies that focus on communicating their perspective on the risks and challenges that they face are of far greater value to investors.

Moving further – viability

The desire for longer-term information from investors is a consistent theme across many corporate reporting initiatives, for example, integrated reporting, non-financial reporting and, in the UK, strategic reports.

In 2014, the UK introduced the requirements to make a viability statement which requires companies to discuss long-term prospects and make a statement confirming viability over a longer-term period (selected by management).

The introduction of this requirement has led to some positive changes in regards how boards consider the longer term. However, companies’ concerns about making forward-looking disclosures have reduced the value of disclosure on viability to investors. This will need to change. Investors demands in this area are only likely to grow. Telling a balanced, future-focused story of company prospects and associated risks increasingly becomes key.

The full Lab report provides detailed examples of good practice and is available for free from the FRC’s website frc.org/lab.

 

About the author

Thomas is Project Director of the Financial Reporting Lab. The Lab was set up by the Financial Reporting Council to improve the effectiveness of corporate reporting in the UK by providing a safe environment for companies and investors to explore innovative reporting solutions.

Thomas is now leading “Corporate Reporting in a Digital World”, a project looking at how the use of digital reporting might be optimised in the future. Before joining the Lab, Thomas worked in the Corporate Reporting team at a FTSE 100 company and as an auditor in the UK and US.