Building the long-term picture
Corporate reporting is finding its purpose
Carillion’s annual reports were worthless. That is according to the MPs who grilled the auditors who signed off the facilities management and construction company’s figures before it collapsed last January with liabilities totalling almost £7 billion.
One described the reports as failing to give any ‘true sense of the assets, liabilities and cash generation of the business’ and raised serious questions about its corporate governance. The reports did give warning signs of what was to come. But only if you were willing to really delve into small-line items buried deep within its 150-page reports.
These showed that customers were taking longer to pay and debts were spiralling. No-one noticed. The end was sudden and shocking. And the repercussions? They go beyond Carillion. It undermines business credibility full stop.
‘Carillion was very short-term in its thinking and reporting, and it caused not just financial but societal damage,’ says Stephen Butler, investment engagement director at Luminous. ‘The companies that don’t take reporting seriously, that aren’t fair, balanced and understandable, are jeopardising not just their licence to operate, but the licence of all businesses to operate. According to the Edelman Trust Barometer 2018, trust in business fell to just 43 per cent. If you look at any survey of trust in business, it is at an all-time low.’
Nor was it just that Carillion botched its financials. In hindsight, its market reporting was misleading at best. ‘So many reports fail to address both the positives and the negatives of the market environment and how this is driving strategic and operational direction,’ says Brett Simnett, director of investor engagement at Radley Yeldar.
‘Carillion’s 2016 report is a prime example: a report wholly positive, with a picture of buoyant market conditions, while price pressures and massive debt on the balance sheet were totally ignored.’
Over recent years, there has been a trend towards long-term thinking in the ways companies report – with more businesses moving away from profit- driven quarterly reports to ones that demonstrate purpose, reflect properly on market challenges, and openly discuss plans to improve productivity and address societal change.
So many reports fail to address both the positives and the negatives of the market environment and how this is driving strategic and operational direction
Carillion’s failure – and its knock-on effect on stakeholder confidence – might now make that shift imperative. Anne Kirkeby, lead corporate reporting consultant at Black Sun, describes its research into the annual reports of FTSE 100 companies, as being all about building trust. ‘That’s what’s needed with stakeholders, investors… because corporate trust is a massive problem. The theme [for last year’s analysis] was ‘less perfection, more authenticity’.’
With this comes a rising call for companies to provide a more integrated view of short, medium and long-term plans: sustainability issues can no longer be shoved into a separate section of the report, ticking the ‘long- term’ box, but with little to no bearing on anything else. ‘Sustainability is no longer a bolt-on to what businesses do,’ says Leighton Barnish, head of sustainability consulting at Emperor. ‘Driven by people’s behaviours – investors, consumers, employees – it’s become part of a company’s identity and what they do.’
Investors – no doubt spurred on by the experiences of those burnt by short-termism – play a big part in this push, taking an increasingly long- term stance in their thinking too. This may be propelled by research, such as the McKinsey Global Institute’s Corporate Horizon Index of 2017, which showed that long-term firms (based on patterns of investment, growth, earnings quality, and earnings management) ‘have exhibited stronger fundamentals and performance than all others in the past 15 years’.
‘[Investors] may not use the word ‘sustainable’ but they will ask questions around long-term thinking and value creation, says Kirkeby. They want to know how short-term financials fit into the long-term plan. Yes, there are still those focused on the short-term. Butler agrees that not all investors have got around to understanding what long-term investing really means.
‘There is still pressure from investors for companies to be reporting every six months, and to be very financially driven,’ he says. It is a long-running debate. In 2003, luxury car maker Porsche sued the Frankfurt Stock Exchange over its requirements to report earnings every three months – with Porsche arguing that this produced overly short-term results. External forces can drive a dash-for- cash focus on profit.
‘Thankfully, in the UK, the Financial Reporting Council (FRC) regulator and the standards set, recognise the importance of long-term thinking, so long-term reporting and value creation is at the heart of guidance on strategic reporting and the UK Corporate Governance Code,’ says Butler. ‘The UK has moved away from quarterly reporting as a requirement.’
‘Recent corporate failures such as Carillion have raised the pressure on the likes of the FRC to ensure reporting truly reflects both the state of a company’s affairs as well as the world it operates in,’ agrees Simnett. ‘These things rely on long term thinking.’
With membership bodies such as The Investment Association also calling to abolish quarterly reporting in favour of more meaningful long-term reports, the writing may be on the wall for constant financial updates that fail to reflect important factors, such as how short-term financial hits can deliver stronger long-term returns.
Really good reporters recognise that to be in it for the long-term means planning for 20 years’ time
The practice of long-term reporting is of course harder than the theory. Kirkeby says that while companies have become more forward looking – previously it was a lot about past performance – companies still struggle to clearly articulate value creation. Simnett also questions whether the trend to long-term reporting is really embedding itself.
‘Reports still fail to give a true understanding of the extent the management team understand the market challenges and future prospects, and how their strategies are adjusting to that environment,’ he says. For a start, how far ahead should companies be looking to qualify as long-term? ‘Really good reporters recognise that to be in it for the long-term means planning for 20 years’ time,’ says Butler. ‘It means looking at mega trends affecting their businesses, long-term strategies for growth, responding to market drivers, and integrating sustainability into the longer-term picture.’
An example is the consideration of climate change over ten to 20 years. The Taskforce of Climate-related Financial Disclosures (TCFD), which is chaired by Bank of England governor Mark Carney, has published wide-ranging recommendations calling for listed firms to report on climate risks and undertake scenario analysis to assess how they would be impacted by various carbonisation paths.
At the same time, however, Black Sun’s analysis of reporting trends last year found that very few companies as yet include any kind of time frame in their reporting: just ten per cent report on strategies looking ahead five years or more.
‘It depends on the industry,’ says Kirkeby. ‘For some companies things change so fast their time frame might be shorter than someone in the oil industry or natural resources.’
And there are immediate complexities in the next few years, not least how companies plan around Brexit-related economic uncertainty, where investment decisions and objectives may quickly and radically change. For some it comes down to materiality – talking about the relevant issues that impact your industry and company and that could impact your long-term success.
A real obstacle to integrated thinking is that corporates are very siloed still; functions don’t think together or plan in that way
For Rolls Royce, for example, this might be a shortage of engineers; for an insurance company, the impact of technology. It is not necessarily hard numbers or time frames that are important, so much as coming across as well prepared and being willing to describe the journey.
‘You may not know the consequences of certain things, but we have a plan if this or that happens,’ says Kirkeby. ‘It’s providing evidence that you are reflecting on the future – market context, digital trends, regulations et cetera.’
If companies are reluctant to do this, it’s often due to companies not wanting to divulge long-term thinking that could benefit competitors. ‘We hear regularly that companies are unwilling to discuss [future challenges] as they are competitively sensitive, but investors and wider stakeholders need to see the business understands its environment and critical resources,’ says Simnett.
‘If they don’t get that information, they will either seek it from other resources or read between the lines and assume they are not under control.’ It’s not about going into the minutiae either, he adds, but talking about trends and drivers, how companies are addressing potential problems and turning them into a positive. ‘So many annual reports are either overly positive or incredibly neutral and don’t deal with the challenges,’ he says.
Long-term reporting may be hampered by the make-up of a company too. ‘A real obstacle to integrated thinking is that corporates are very siloed still; functions don’t think together or plan in that way,’ says Butler. As a result, many annual reports simply feel like a set of individual disclosures.
Kirkeby adds that there are often issues around internal resourcing to bring it together: too few people, and you may not pick up on all the points; too many and you won’t be able to make the connections and section holders won’t work together. ‘Reports can pick up some good indicators of a company’s long-term thinking but the problem is that those indicators are spread out across the annual report,’ says Kirkeby.
Reporters who are now looking at a more integrated reporting approach are identifying what is material to business success and using this to frame the structure of their report.
‘How they are investing in the future might be at the back end while the market review section is at the front, for example, but there’s no cohesive narrative that brings it all together,’ she says. She cites the example of Coca Cola HBC – also known as Coca Cola Hellenic – one of the largest bottlers of the Coca Cola company, which she thinks has done a good job in its report of bringing many long-term issues together in a spread right at the front of the report.
‘It’s one of the first pages, and talks about everything from their unique strengths, to their diverse portfolio, how they’re investing in future capabilities, how they are aware and proactively dealing with issues impacting their industry, such as obesity, and extending their portfolio to deal with that,’ she says.
Butler advises companies to start by defining their purpose and the reason they exist and then to demonstrate how the business model aligns to the purpose and value it creates, across the short, medium and long-term.
‘Companies need to report on the resources and relationships they draw on to create value, in particular the hidden ones such as people, environmental assets, technology, brand and reputation,’ he says. ‘Another area which contributes to a company’s long-term value-creation story is risk and opportunity, particularly strategic risk disclosures around sustainability, culture and values alignment and strategy – detail of these is sorely lacking in many annual reports.’
‘Report on what’s material,’ says Simnett. ‘So many reports start from a regulatory disclosure position. Reporters who are now looking at a more integrated reporting approach are identifying what is material to business success and using this to frame the structure of their report. What comes from this approach is a more connected story, and by design, covers regulatory disclosure.’
He thinks European financial services company NN Group has got it right, structuring its annual review around its business model and critical resources. ‘The report also explicitly links materiality, marketplace and risk to provide a detailed and balanced view of how the business is operating and why.’ Corporate reporting is shifting to a more long-term view. But it’s not an easy proposition. Good long-term reporting comes from aligned business operations in companies that understand their place and role in the world.
Not all companies are there yet. Or if some are, they are not yet communicating this in a coherent narrative. Denmark’s Novozymes makes it clear that good long-term reporting stems from within – the biotech company has a strong and highly developed sense of purpose in which business operations are completely integrated into the sustainability agenda. It has gone so far, in fact, that in 2015, the company declared that sustainability would be its company purpose and collaboration its strategy. This has made its reporting far easier. It genuinely reflects the company’s identity.
The new European Single Electronic Format (ESEF), which comes into place next year, will require companies to prepare and file their annual financial report in a single electronic format to enable easier comparison. This may raise questions over where the strategic report and wider communications should sit – to avoid them getting lost in a regulatory filing. At the same time, however, corporate failures, the urgent need to rebuild trust, and the increasing desire to prove that business can have a positive impact on the world will ensure there’s no real turning back: the long-term report is the way of the future.