1.9 - narrative disclosures and earnings quality

Learning Outcomes

• Understand the role and form of non-financial information in annual reports.

• Analyze issues and challenges associated with narrative disclosures.

• Examine impression management strategies and the use of narratives, graphs, and visuals.

Non-Financial Disclosures in Annual Reports

1. Definition:

   • Information outside of financial statements, including narratives, photographs, graphs, and images.

2. Types of Narratives:

   • Statutory (Mandatory): Directors’ reports, corporate governance reviews, audit reports.

   • Free Form (Voluntary): Chairman’s statements, strategic reports, management reviews.

Key Narrative Sections in Annual Reports

1. Chairman’s Statement:

   • Widely read and influential but not legally required.

   • Typically vague and overarching; should ideally summarize performance and prospects.

2. Directors’ Report:

   • Required by Companies Acts, outlining stewardship responsibilities and principal activities.

   • Format and content are not fixed; additional disclosures may be voluntary.

3. Strategic Report:

   • Introduced by Section 172 of the Companies Act 2006, focusing on:

     • Performance and risks.

     • Strategic objectives and uncertainties.

     • A "Section 172 Statement" emphasizing long-term success and stakeholder interests.

Why Non-Financial Disclosures Matter

1. Decision-Making Importance:

   • Helps contextualize financial data.

   • Influences investor decisions and share prices.

2. Corporate Communication:

   • Builds corporate identity and image.

   • Directly conveys company strategy and philosophy.

3. Limitations of Financial Information:

   • Does not capture future economic value.

   • Lacks qualitative insights into markets, strategy, and organization.

   • Historic cost accounting is backward-looking and risks missing forward-looking opportunities.

Issues and Challenges with Narrative Disclosures

1. Quality and Credibility Concerns:

   • Variations in quantity and quality of narratives.

   • Poorly constructed narratives can mislead users.

2. Forward-Looking Disclosures:

   • Often vague and generalized due to liability concerns and competitive risks.

3. FRC Annual Assessment (2019/20):

   • Common issues:

     • Inadequate balance in reporting.

     • Excessive use of alternative performance measures (APMs).

     • Failure to acknowledge poor performance undermines trust.

Alternative Performance Measures (APMs)

• Findings (Deloitte, 2019):

  • 93% of companies use APMs in their annual reports.

  • APMs often inflate perceived profitability (e.g., "adjusted profit").

• Challenges:

  • Lack of standard definitions.

  • Frequent exclusion of recurring costs like restructuring.

Impression Management

1. Definition (Sinha, 2009):

   • Active self-presentation to enhance a corporate image.

2. Strategies (Merkl-Davies & Brennan, 2007):

   • Concealment: Emphasizing positives while obfuscating negatives.

   • Attribution: Linking good outcomes to management while deflecting bad outcomes.

Impression Management Techniques

1. Reading Ease Manipulation:

   • Complex or poorly written reports may obscure key information.

2. Rhetorical Manipulation:

   • Persuasive language can shift focus from facts to narrative framing.

3. Thematic Manipulation:

   • Positive themes are highlighted, while negatives are minimized or omitted.

4. Visual and Structural Effects:

   • Use of graphs, visuals, and formatting to emphasize positive outcomes.

Graphical Presentation

1. Advantages of Graphs:

   • Attract attention and simplify complex data for users with limited time.

2. Issues:

   • Studies reveal systematic graphical distortion, often used as a form of creative accounting.

Theories Underpinning Impression Management

1. Agency Theory:

   • Management may disclose selectively, emphasizing successes while obscuring failures.

2. Signaling Theory:

   • Well-performing firms use transparency to signal superiority.

3. Legitimacy Theory:

   • Firms maintain a social contract by adhering to societal norms and expectations.

4. Stakeholder Theory:

   • Addresses the needs of various stakeholders, including customers, employees, and regulators.

Characteristics of Good Reporting (FRC)

1. A single coherent story.

2. Explanation of how the company makes money.

3. Transparency about risks and uncertainties.

4. Consistency in reporting style and metrics.

5. Avoidance of unnecessary complexity ("cut the clutter").

6. Clarity and conciseness.

7. Summary of key points.

8. Clear explanation of changes.

9. Adherence to "true and fair" principles.

Key Takeaways

• Non-financial disclosures are crucial for understanding a company's performance and strategy.

• Impression management strategies can distort the narrative, raising concerns about trust and transparency.

• Effective reporting should prioritize clarity, accuracy, and balance to maintain stakeholder trust.