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Upward trend in quality of financial reporting comes to a halt

Report

Report

The quality of financial reporting has been in an uptrend for several years, however this did not continue in 2015. The reviews conducted this year by the Netherlands Authority for the Financial Markets (AFM) of the financial reporting of selected listed companies for 2014 produced a relatively large number of (preliminary) findings. Quality with respect to certain aspects was not satisfactory, especially with respect to compliance with the reporting standard for pensions.

These findings come from the AFM’s regular supervision in 2015 of the reporting in financial statements and from three thematic reviews of compliance with reporting standards for pensions, the disclosure of interests in companies and bank covenants. The findings are included in the report ‘In Balance 2015’.

The findings relate to numerous issues, ranging from simple to complex. The AFM identified a number of deficiencies that it had already mentioned in its review of financial reporting last year. This recurrence is surprising.

A relatively large number of the findings relate to the reporting of changed situations, such as the acquisition or disposal of business divisions, changes in ownership interest in other companies and classification of newly issued loans as equity or financial liabilities. The AFM has notified companies listed in the AEX and AMX indices and smaller companies of its (preliminary) findings, and requested them to provide an explanation.

Gerben Everts, Executive Board Member at the AFM: “After years of improvement, it is notable that as a supervisor we have a relatively large number of findings to report this year. These have emerged from our regular risk-driven supervision and our reviews of specific themes, such as pensions. We are therefore less positive regarding the overall quality of the reporting in comparison to previous years. Investors need to have good insight into the continuity risks of funding and business operations in general. Stagnation implies a risk of decline. It is in the interests of investors and businesses themselves that this should be avoided and that work should continue on further improvement.”

The disclosure for each theme:

Compliance with reporting standards on pensions is inadequate

In view of the social relevance of transparent reporting on pension obligations (and expenses), the AFM has devoted further attention to this issue. From its first review in 2014, it emerged that compliance by companies with the majority of the disclosure requirements on pensions was poor.

The most recent review a year later shows that the market has not improved in this respect. There are virtually no differences in the findings of the two reviews. In addition, in some cases the same multi-employer pension fund has been classified as a defined benefit pension plan by one company and as a defined contribution plan by another.

The AFM will take action against companies with the poorest compliance with the disclosure requirements, also taking into account the size of their pension obligations. The financial reporting of pension obligations for 2015 has to improve. The AFM will contact the companies and audit firms concerned with respect to the inconsistent classification of multi-employer pension funds.

Disclosure of interests in companies has to improve

New standards with respect to the disclosure of interests in companies became mandatory with effect from the 2014 financial year. The AFM has reviewed the extent to which these disclosure requirements have been applied and whether the users of the financial statements have better insight into the composition of a company and the risks associated with interests in other companies.

The majority of the companies reviewed still have to make progress on making their disclosure more company-specific. This will increase investors’ insight into the structure of the company and the effect of interests in other companies.

The AFM moreover sees potential for improvement in the disclosure relating to the company structure. It is not clear in all cases which segments and operations are connected to which interests – minority interests, joint ventures and joint operations. Companies also provide only cursory disclosure of joint operations and the effect of these on the company. Lastly, companies could disclose more clearly which minority interests, interests in associates and joint ventures are material to the reporting company and why this is the case.

Greater insight into calculation methods for bank covenants is needed

In view of the recent financial problems at a number of companies, transparency regarding bank covenants is an important and current theme. Transparent reporting with respect to bank covenants by companies is important to users of financial statements. The ratios agreed, the exact method of calculation used for these ratios by the credit providers, the results at year-end and the potential sanctions in case of breach of the bank covenants by companies constitute relevant information.

The AFM has chosen to focus its review on companies with a weak financial position where there is a risk that covenants will be breached. In these cases, transparent disclosure of covenants is certainly crucial information for investors. The AFM notes that greater transparency on the calculation methods for covenants is required. The results of the calculation of the covenants are disclosed, but it is difficult for users to make the calculation for themselves. Furthermore, in the majority of cases a disclosure of the consequences of a breach of the covenant is lacking.

Financial reporting for 2015

The AFM calls on companies and their auditors to devote attention to a number of specific issues in the preparation and audit of their financial reporting for 2015. These concern the effect of the current economic conditions on the financial reporting, the cash flow statement and the related disclosures and the determination of the fair value of non-financial assets and the related disclosures.

The AFM supports the development and application of integrated reporting, also in the coming years.

The AFM is committed to promoting fair and transparent financial markets.

As an independent market conduct authority, we contribute to a sustainable financial system and prosperity in the Netherlands.

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