Meeting the needs?
User views on external assurance and
management commentary
Ian Fraser and William Henry
Research summary report
Meeting the needs?
User views on external assurance and
management commentary
by
Ian Fraser
University of Stirling
and
William Henry
Glasgow Caledonian University
Published by
The Institute of Chartered Accountants of Scotland
CA House, 21 Haymarket Yards
Edinburgh EH12 5BH
First Published 2010
The Institute of Chartered Accountants of Scotland
© 2010
ISBN 978-1-904574-11-8
EAN 9781904574118
This summary report is published for the Research Committee of
The Institute of Chartered Accountants of Scotland.
The views expressed in this report are those of the authors
and do not necessarily represent the views of
the Council of the Institute or the Research Committee.
No responsibility for loss occasioned to any person acting
or refraining from action as a result of any material
in this publication can be accepted by the authors or publisher.
All rights reserved. No part of this publication may be
reproduced, stored in a retrieval system, or transmitted, in
any form or by any means, electronic, mechanical, photocopy,
recording or otherwise, without prior permission of the publisher.
A copy of the full report is available to download from the ICAS
website – www.icas.org.uk/research – or can be purchased by
contacting the Research Centre – 0131 347 0237 or
[email protected]
Printed and bound in Great Britain
by CGUK Capital Group UK
Contents
Foreword ……………………………………………………………………………………… 1
Acknowledgements ………………………………………………………………………..
2
1. Introduction …………………………………………………………………………..
3
2. Background ……………………………………………………………………………
4
3. Objectives and research approach ………………………………………….
6
4. Literature review and regulatory background …………………………
7
5. Stakeholder perceptions on management commentary …………. 12
6. Enhancing management commentary usefulness: assurance … 15
7. Enhancing the value of external assurance: process, reporting
and dialogue …………………………………………………………………………. 20
8. Overall summary and policy recommendations …………………….
27
9. Wider issues and implications ………………………………………………. 28
References ………………………………………………………………………………….. 30
About the authors ………………………………………………………………………. 31
About SATER ………………………………………………………………………………. 33
Foreword
The recent financial crisis has again brought to the fore questions
surrounding both the scope and quality of the external audit. In
conjunction with this, narrative reporting or management commentary
continues to grow in importance in the annual reports of companies and
therefore the question as to whether and, if so, how assurance should be
provided on such information is fundamental.
This project investigates views on the value and importance of
management commentary and whether there is a demand by corporate
report users for external assurance on management commentary. Users’
opinions about these issues also naturally turns attention to more
general views on the scope and value of the current statutory audit. The
study is based on a questionnaire survey to professional and private
investors, finance professionals and other users. This was supplemented
by interviews to explore the issues in greater depth.
This research summary report drafted by two of the authors of the
full report provides a good summary of the project and its findings. The
full report can be downloaded free of charge at www.icas.org.uk/fraserusers. A second stage of this project is currently in progress – this will
investigate whether auditors are able and willing to provide assurance
on management commentary.
This project was funded by the Scottish Accountancy Trust for
Education and Research (SATER). The Research Committee of The
Institute of Chartered Accountants of Scotland (ICAS) has also been
happy to support this project. The Committee recognises that the views
expressed do not necessarily represent those of ICAS itself, but hopes
that the project will add to the debate about the future of audit assurance.
David Spence
Convener, ICAS Research Committee
April 2010
1
Acknowledgements
This research project benefited from the support and co-operation of
a large number of individuals, as well as a number of organisations.
We would like to thank everyone who replied to either of the two
questionnaire surveys and we are grateful to those who agreed to be
interviewed. In this regard, we are very thankful that fund managers,
analysts, private shareholders and others, were so willing to help us at a
time of global economic and financial meltdown; the interviews for the
research were largely carried out during the autumn and early winter of
2008 in the wake of widespread corporate failure in the financial sectors
of the UK and other nations. To preserve confidentiality, our interviewees
are not named here but the researchers and the ICAS Research Committee
appreciate their contribution greatly.
We wish to thank both the Securities and Investment Institute and
the UK Shareholders Association for facilitating the execution of the
questionnaire surveys. The assistance of both bodies is appreciated
greatly. Thanks are also due to three colleagues within the Accounting
and Finance Division, Stirling Management School, University of
Stirling – Donna Johnston for her help with the interview transcription,
Isaac Tabner for providing very valuable interview contacts and Tamer
Elshandidy for ad-hoc research assistance. Joanna Stevenson, former
Lecturer in Accounting at the University of Stirling, is due a special word
of thanks for her contribution to the genesis of the research.
Finally, the Research Committee and the researchers are grateful for
the financial support of the Scottish Accountancy Trust for Education
and Research, without which the research would not have been possible.
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Meeting the needs? User views on external assurance and management commentary
1. Introduction
This short publication is intended to provide a readily accessible and
non-technical summary of the first stage of a major research project
supported by The Institute of Chartered Accountants (ICAS) and the
Scottish Accountancy Trust for Education and Research (SATER) on the
future of external assurance. Those interested can obtain a much fuller
account from the ICAS monograph (Fraser et al., 2010) on the research
which is being published concurrently with this summary (download
at: www.icas.org.uk/fraser-users). The two principal issues with which
the project is concerned are: first, the provision of external assurance on
management commentary and other narrative corporate reports and,
second, perceptions regarding the usefulness of audit reports and the
robustness of contemporary external assurance. This report covers the
views of professional and private investors, as well as other users, on
the issues; the second stage, presently in progress, deals with those of
auditors; a possible third stage will investigate the perspectives of key
corporate players, both executives and non-executives.
Meeting the needs? User views on external assurance and management commentary
3
2. Background
The specific motivation for the research is the gradually increasing
importance of narrative disclosures in the context of annual corporate
reporting, both in the UK and internationally. Important examples include
the US Management Discussion and Analysis (MD&A), the UK Operating
and Financial Review (OFR) and, internationally, the Management
Commentary project of the International Accounting Standards Board
(IASB) which has resulted in an important discussion paper (IASB, 2005)
and, more recently, in an exposure draft of an International Financial
Reporting Standard (IFRS), (IASB, 2009). These developments suggest
that narratives in annual corporate reports will assume a still greater
degree of significance and the appearance of an IFRS on management
commentary appears probable. This raises an important question: Is
there a demand for external assurance on management commentary,
and other similar reports, on the part of corporate report users? This is
the primary motivation for the research.
Views on whether assurance on management commentary is
desirable may hinge partially on more general perceptions as to the
robustness of the contemporary external audit function and the value of
audit reports. Opinions on the underlying strength of the audit process,
for example, are likely to influence views on auditors’ ability to provide
assurance on management commentary, which is often likely to have a
high proportion of subjective or problematic content. Similarly, if audit
reports have only limited benefit for users then this requires resolution
before the scope of audit reporting can be usefully extended. The
research, therefore, also explores these broader issues.
Recent economic and financial events give added relevance to the
research. While the role of the audit profession in the recent financial
crisis has not yet been the subject of detailed analysis in either the
professional and business press or in academic literature, it seems
probable that, before long, there will be again be cries of ‘where were
the auditors’? The drama which reached a climax in the autumn of 2008,
revealing ever-more evidence of corporate weakness and systemic failure,
has created an opportunity, therefore, to investigate views on audit and
corporate reporting at a critical time economically. Criticisms, arguably
often inappropriate, of fair value accounting and of the opaqueness which
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Meeting the needs? User views on external assurance and management commentary
is arguably inherent in some aspects of IFRS-based corporate reporting
suggest that there may be demand for versions of corporate reporting
which are more transparent and accessible. Additionally, sober reflection
on the way capitalism works has provided an opportunity for serious
debate about how a reformed external audit function could contribute
to market economy stability. While the research does not address these
broader issues specifically, they constitute an additional dimension of
relevance.
Meeting the needs? User views on external assurance and management commentary
5
3. Objectives and research approach
The specific research objectives are to identify and explore the views of
investors and, where appropriate, other stakeholders on:
(1) the value and importance of management commentary and the
factors that inhibit its usefulness;
(2) the need for external assurance on management commentary and
the extent and scope of the assurance that should be provided; and
(3) the extent of confidence in the present external audit process, the
perceived usefulness of current audit reports and views as to how
that usefulness might be enhanced.
There were two sequential stages to the research carried out.
First, two questionnaire surveys were carried out. The first of these
was administered to professional and private investors and to other
finance professionals (206 respondents – response rate 12.1%). The
second questionnaire, an abbreviated version of the first, was sent to
representatives of various non-investor users. (82 respondents – response
rate 11.6%). Second, twenty-six semi-structured interviews were carried
out which explored in greater depth issues which had either been
included in the questionnaire surveys or highlighted in the questionnaire
responses. Twenty of the interviews were carried out with investors and
six with non-investors.
Prior to the primary research, a literature review was carried out to
establish the existing state of knowledge on the issues and to inform the
preparation of the questionnaire surveys and, in due course, the interview
agendas. The following section summarises the research background
in terms of both strategic legislative and regulatory developments and
key literature. References to the research literature, as opposed to some
regulatory material, are not given here for the most part in the interests of
brevity of exposition; interested readers are referred to Fraser et al. (2010).
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Meeting the needs? User views on external assurance and management commentary
4. Literature review and regulatory background
Corporate reporting
Over the past decade, various researchers have concluded that corporate
reporting to the financial markets is likely to take on increasingly a
narrative as opposed to a numerical character. One reason for this is
that contemporary reporting entities have an increasing proportion
of their asset base in intangibles such as brands, relationships and
expert-knowledge, which are ‘off-balance sheet’ and which, therefore,
require narrative disclosure to enable users to understand key business
dimensions. Certainly within western economies such as the UK,
the standard manufacturing company, with assets mainly consisting
of tangibles such as plant and machinery, is partly becoming a past
phenomenon. In addition, contemporary organisations operate in high
risk environments characterised by political, economic and technological
change. Purely numerical or financial reporting is likely to capture an
increasingly small proportion of the available information for such
entities.
During the 1980s, the US Management Discussion and Analysis
(MD&A) developed into an evaluative document to meet user demands for
better information although there were mixed views on the document’s
usefulness. In the UK, the ASB proposed the Operating and Financial
Review (OFR) as a voluntary document in order to encourage open
and flexible reporting by companies on their operations, finances and
shareholder return and value. Research conducted in the 1990s found that
UK reports were more flexible and offered more voluntary and forwardlooking information than their US counterparts and although misgivings
were expressed about the voluntary approach, preparers did not wish it
to be as prescriptive as the US MD&A.
Since the advent of the OFR the extent of UK narrative reporting
has grown impressively. The proportion of UK listed companies’ annual
reports consisting of narrative reporting had increased to over 70% for the
top 350 companies by 2007. However, there was wide variation in the form
and content of the information provided. There was overlap between
the OFR and corporate social responsibility reports and disclosures in
respect of future prospects were perceived to be ‘opaque and non-specific,’
Meeting the needs? User views on external assurance and management commentary
7
although 75% of OFRs did mention risk in some way. Proposals for a
statutory UK OFR were unexpectedly replaced in November 2005 by a
lesser requirement for an ‘Enhanced Business Review’. Concern has been
expressed that abandoning the more onerous statutory OFR may have
impacted negatively on directors’ willingness to engage in dialogue with
shareholders through enhanced narrative reporting.
In 2005 the IASB issued its discussion paper Management Commentary
(IASB, 2005) which proposed that entities should disclose information on
the nature of the business, objectives and strategies, key resources, risks
and relationships, results and prospects and performance measures and
indicators. At present there is a wide variation in corporate disclosures
in these areas; this is unsurprising given the voluntary nature of
management commentary. There is evidence, however, that users
envisage a need for narrative reports; this bodes well for the future of
management commentary which has very recently become the subject
of an IASB exposure draft (IASB, 2009).
Assurance
Developments in narrative reporting highlight the possible need for
associated independent assurance. Management Commentary (IASB, 2005)
itself suggests that the issue of assurance on management commentary
reporting invites investigation. The last twenty years have seen calls
for research focused on users’ evolving assurance needs. Because of
the blurring between the content of management commentary, and
that contained elsewhere in annual reports, assurance on management
commentary would necessitate a clearer delineation of audited and
unaudited material. In addition, external assurance on management
commentary would require clear prescription of required management
commentary content to prevent director manipulation.
Concerns, however, have been expressed about the feasibility of
providing assurance on some elements of management commentary,
for example, future forecasts and risk assessments, and three possible
forms of assurance have been suggested:
• Consistency: whether the information in management commentary
is consistent with that given in the entity’s financial statements and
8
Meeting the needs? User views on external assurance and management commentary
other information that has come to the attention of the assurance
provider.
• Process: whether procedures followed in producing management
commentary are designed to ensure that the content is truly and
fairly stated.
• Content: whether the content of management commentary is truly
and fairly stated.
The third option may be problematic since much management
commentary content constitutes an expression of opinion rather than of
fact; completeness checks may also be difficult to execute. The question
of whether reporting on management commentary should be couched in
positive, negative or exceptional terms is a further issue. It may be that
statements by directors, for example, to the effect that forward-looking
information should be treated cautiously, would enable helpful assurance
to be offered without exposing auditors to undue litigation risk.
For the most part, the attitude of the UK auditing profession to
assurance on management commentary has been extremely cautious
regarding the scope and extent of assurance, with the proposed assurance
being restricted for the most part to consistency reviews:
The type of work required to make any judgment on the adequacy
of the OFR is of quite a different type to that normally carried out
retrospectively in an audit… it is also aiming at a much wider set of
inputs to the process… some of which may lie outside the auditors’
competence to comment upon… (ICAS, 2004)
Guidance from the International Auditing and Assurance Standards
Board (IAASB) also reflects a cautious attitude and the recently revised
ISA 720 The Auditor’s Responsibility in relation to Other Information in Documents
Containing Audited Financial Statements (IAASB, 2009) continues to mandate
a consistency approach with the auditor’s only responsibility being
to read the non-financial statement information in order to identify
inconsistencies with the financial statements themselves. In the
US, however, requirements for assurance on MD&A go beyond what
is currently required by the IAASB, although these are restricted to
Meeting the needs? User views on external assurance and management commentary
9
commenting on the present and past, with a much more tentative approach
taken to future information.
The limited prior research, in the US and the UK, suggests significant
demand for some assurance on non-financial and forward-looking
information. UK users have indicated a preference for a ‘true and fair’
opinion on management commentary, arguing that bland statements as
to consistency with the financial statements are inadequate. This suggests
a need for assurance on management commentary content.
Submissions to the IASB on Management Commentary (IASB, 2005)
demonstrate a wide variety of view. The most popular argument appears
to be for consistency reviews with some negative views articulated on
the subjectivity of much management commentary content and the cost
of assurance. There is, however, evidence that some users, including
non-investors such as environmental groups, would expect more robust
assurance on management commentary than that of consistency reviews;
there may therefore be a potential expectations gap in terms of the
assurance desired by users and that which may be offered by the auditing
profession or other providers.
While the audit profession appears reticent about providing assurance
on management commentary, the adoption of audit approaches grounded
in business risk by the large audit firms in the 1990s may provide a
platform for auditor engagement with the risk dimension of management
commentary content. Although there has been something of a retreat from
business risk auditing, its introduction was instrumental in the creation of
a new series of international auditing standards with a professed business
risk orientation; these may provide some basis for substantive assurance
on management commentary.
At the same time, there are concerns that contemporary audits are too
focused on checking numbers created by increasingly complex IFRS-based
financial reporting – at the expense of auditing the business. Assurance
on management commentary might help to link the statutory audit with
greater business understanding and improve audit quality. Anecdotally,
there appears to be a view that some recent audit failures have resulted
from a lack of business understanding. Calls for reformation of external
auditing have emerged, not only from academics, but from the profession
itself. These calls have suggested that the profession should review
its societal obligations and provide assurance that goes beyond purely
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Meeting the needs? User views on external assurance and management commentary
accounting information. Unwillingness to engage with management
commentary may result in other providers supplying the assurance
required by stakeholders.
Calls for audit reporting which deals with management commentary
lead naturally to consideration of the value of audit reports more generally,
with suggestions being made that these should provide more companyspecific information. This in turn prompts consideration of the value
of the audit product itself. There is a long-standing ‘critical’ accounting
literature which has questioned the professionalism and independence
of the audit profession and recent writers have directed attention to the
role played (or not) by external auditors in the recent global financial crisis
and, more specifically, in the failures within the corporate financial sector.
As a result, the research deals with user perceptions of the value of present
audit reports and of the robustness of the audit process.
In summary, the key issues emerging from the prior literature and
regulatory developments are:
• Corporate reporting is likely to increasingly take on a narrative, as
opposed to a numerical, character.
• Developments in narrative reporting have highlighted a possible need
for assurance on management commentary, but there are concerns
about how easy it may be to provide this for some information
categories; there are also various opinions on the assurance that should
be provided. Three possible forms have been suggested: consistency,
process and content.
• External auditors appear cautious about providing assurance on
management commentary but fairly recent audit methodologies
grounded in business risk may provide a platform for developing
management commentary assurance.
• Considering assurance on management commentary prompts
reflection on more general issues regarding the value of contemporary
audit reports and the audit itself.
The following sections of this summary deal sequentially with the findings
relating to each of the three principal research objectives.
Meeting the needs? User views on external assurance and management commentary
11
5. Stakeholder perceptions on management
commentary
Corporate reporting and management commentary
To put the research in context, research participants were asked about
their knowledge of management commentary and corporate reporting
generally. A minority of investors responding to the questionnaire
claimed a good or better knowledge of the IASB discussion document
on management commentary. This applied almost as much to those
claiming good levels of knowledge of corporate reporting as to those who
indicated less familiarity. Investors agreed generally that future corporate
reporting would increasingly incorporate narrative information. Noninvestors were asked a similar question about their use of the narrative
elements of corporate reports. The responses from all non-investor
groups surveyed, indicated that the narrative sections of corporate reports
were important to them.
In the interviews, further insights were gained as to how users
envisaged management commentary being used. Themes emerging
included the desirability of a holistic approach to reporting and the
usefulness of management commentary both in clarifying aspects of,
arguably, increasingly opaque IFRS-based financial statements and
in acting as an entry point for more detailed analysis – by facilitating
dialogue between users and company directors on business prospects,
risks and challenges and the benchmarks against which corporate
performance might be assessed. One fund manager observed:
I think… that companies will feel increasingly a greater obligation
to tell their own story and to get their message across clearly.
Management must want to get back to telling more clearly their
version of the performance of the underlying operation rather than
having it clouded by a load of other stuff. And that therefore must
make narrative more important to their perceptions of the business
that they want to explain to users.
Professional investors, in particular, tended to emphasise the
historic aspects of management commentary and its ability to shed
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Meeting the needs? User views on external assurance and management commentary
light on the financial statements. Forecasts, whilst recognised as
important, were seen as often bland and nebulous; being constrained
by confidentiality and litigation concerns. Corporate reports were often
perceived as lacking in serious discussion of future risks. Social and
environmental reporting was highlighted by some interviewees; both
fund managers and non-investors. It was stressed, however, that there
was uncertainty about how best to report environmental issues and that
much environmental reporting was selective and not very useful.
Some investors, most especially analysts on the sell-side, have
very limited use for management commentary and for corporate
reports generally; relying more on interim announcements, conference
calls, private briefings and other privileged information. All groups of
research participants, however, regarded management commentary as
important in understanding corporate dimensions such as key resources,
risks and relationships, past results, future prospects and performance
indicators. At the same time, there was recognition that information
on many of these attributes was vulnerable to management distortion.
While private shareholders generally appeared to place more emphasis
on management commentary than other stakeholders, one professional
investor stated that:
Accounts comprise numbers and a certain amount of narrative and
investors really do value the management commentary. Not only does
it paint a clearer picture as to what has happened in relation to the
reported results but it can also give an indication of the risks of the
business, how it is progressing and potential future developments.
What investors want is more colour and more company-specific
information on what has happened and on prospects for the business.
Barriers to management commentary usefulness
Various factors were highlighted as significant in limiting
management commentary usefulness. Most mentioned were ‘boilerplate
language’ and misleading management ‘spin’. Several interviewees
expressed frustration at the blandness of much management commentary
content, although recognising the inevitability of companies seeking
to present themselves favourably and director concerns about being
Meeting the needs? User views on external assurance and management commentary
13
accountable for unrealised predictions. The key issues for users were to
make sure that narrative comments were interpreted with an appropriate
level of scepticism and to confirm that the message given in the
management commentary was consistent with the numbers. This was
brought out by one fund manager’s comment:
…management commentary in accounts is sometimes used as a way
for management to get across particular messages that they want
shareholders to have, either about their strategy, an acquisition
they’ve made or a policy they have in place and very often what you find
is that it’s only when you get down to the numbers that you find out
whether the commentary ties in accurately with the numbers behind it.
This statement, representing the views of many investors, may
indicate the need for reasonably robust assurance in order to ensure
confidence in management commentary reporting.
Structure of management commentary: prescription or
corporate discretion?
Generally speaking, users appear likely to welcome the IASB
establishing at least some minimal regulatory framework for
management commentary but there are concerns that too prescriptive
an approach would lead to more box-ticking and boilerplate. Most
interviewees favoured ‘light-touch’ regulation to give directors a free
hand in ‘telling the story’ of companies in terms of performance, future
prospects and risks. It was argued, however, that total laissez-faire was
inappropriate and that a broad framework required to be established by
the IASB supplemented by examples of good practice.
Other users stated their preference for a more prescriptive approach,
fearing ‘cherry-picking’ by directors. Thus, while there was a variety of
view within the broad ‘business’ constituency of users, the prevalent
preference appears to be for ‘light-touch’ regulation.
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Meeting the needs? User views on external assurance and management commentary
6. Enhancing management commentary
usefulness: assurance
Assurance on management commentary
Both questionnaires asked users to score the importance of assurance
on management commentary as a whole and on the various elements
that might be expected within management commentary. Generally
both investors and non-investors believe that some external assurance
should be provided. Fund managers and analysts appear significantly less
positive about providing assurance on management commentary than
the other two investor groups but there is a wide diversity in the views of
professional investors. Generally, analysts were less positive about the
desirability of assurance than were fund managers. However, there was
agreement, even among those not convinced of the need for assurance,
to the effect that auditors could at least report on the consistency of
management commentary with the financial statements.
In the interviews, individuals who were positive about assurance
cited alleged inconsistencies between narrative statements and the hard
data currently audited. They argued that auditors should curb excessive
optimism in management commentary and encourage directors to be
more transparent. One fund manager commented:
I think there has to be some independent review of what actually is
going into the financial statements in a written form. I think the
auditors are the most appropriate people to undertake that review
because you cannot have a situation where you have a set of numbers
being produced, which have been subject to audit and then have a
completely separate commentary, which is not subject to review or is
not examined in context or for consistency in terms of what it refers to…
If management commentaries are not subject to review, management
could put in whatever they like.
One private shareholder suggested that the answer is for auditors
to be involved at an earlier stage:
Meeting the needs? User views on external assurance and management commentary
15
Perhaps auditors ought to be editing the content before it’s put down
and saying ‘Well you can’t say that.’ … I don’t know who writes annual
reports but some of the ones I’ve seen do seem to be absolutely over
the top in the way of verbiage and pages and pages of pretty pictures
about supposed social res