The Financial Reporting Council (FRC) has now published its Annual Review of Corporate Reporting for the current season. The report sets out the key themes arising from the FRC’s ongoing monitoring activities during 2022 and their key messages to companies ahead of the 2022/23 reporting season. Whilst these are targeted at large corporates, the messages generally apply across all middle market businesses.

Key findings of reviews completed in 2022

Businesses should consider the items most frequently identified by the FRC in their 2022 reviews when preparing their upcoming financial statements, including:

1. Cash flow statements

The FRC continues to identify a significant number of errors in cash flow statements, despite its 2020 Thematic review on Cash Flow and Liquidity Disclosures. Over half of the re-statements identified this year were in respect of the misclassification of cash flows. In addition, businesses had inconsistently applied accounting policies for similar items, such as interest payments on leases and interest on borrowings. The FRC also noted discrepancies between amounts presented in the cash flow statement and amounts disclosed elsewhere in the financial statements.

Businesses should ensure that they carefully review their cash flow statements to ensure the classification of cash flows complies with the requirements of the relevant standard, accounting policies for cash flows have been consistently applied and adjustments for material non-cash transactions are disclosed.

2. Financial instruments

The FRC found that accounting policies and disclosures did not fully explain how particular financing arrangements or transactions were reflected in the financial statements, in particular with respect to the accounting for derivatives and cash flow hedges. In addition, disclosures for non-banking entities applying IFRS did not always include the inputs, assumptions, and estimation techniques in applying the ECL model.

Businesses should ensure the nature and extent of material risks arising from financial instruments (including inflation and rising interest rates) and related risk management methods are adequately disclosed, including the methods used to measure exposure to risks and changes in the year.

Expected credit loss (ECL) models should be revisited to ensure assumptions reflect the current and future economic conditions as appropriate, including default rates, and disclosure of ECL should include the approach and significant assumptions applied, and concentrations of risks.

Banking covenants should be disclosed (unless the probability of any breach is considered remote) together with an explanation of the effect of refinancing, and changes to covenant arrangements.

3. Income taxes

The two main issues identified by the FRC were a lack of evidence to support the recognition of deferred tax assets and insufficient explanations for significant items in the effective tax rate reconciliation.

Businesses are encouraged to disclose the nature of evidence to support the recognition of material deferred tax assets, along with the significant judgements and estimation uncertainty underpinning the recognition at the reporting date. Companies should ensure they adequately explain material items in their effective tax rate reconciliation.

Key messages for 2022/23 accounts

Reporting in uncertain times

Businesses are facing unprecedented challenges due to unstable economic conditions with rising inflation, increasing interest rates, constraints in supply chains and labour markets, as well as changes to consumer behaviour.

The financial statements should clearly explain the risks and changes in the business environment, including how these risks and uncertainties are reflected in the strategy, business model, and going concern and viability assessments.

Impact of rising inflation and interest rates

The FRC specifically stated that entities need to consider the impact of both rising inflation and interest rates on their annual reporting:

• The Strategic Report should include how resilient the business model is to an inflationary environment, changes to the principal risks and uncertainties and any mitigating actions, and the impact of inflation on suppliers, customers, and employees.
• Inflationary clauses and features embedded in contracts may need to be separated and accounted for as derivatives. These contractual features will need to be disclosed in the financial statements, including the nature of the inflationary feature, the accounting policies for inflationary features, significant management judgements, and the actual or potential impact of these features on the financial statements.
• Discount rates will need to follow a consistent approach incorporating the impacts of inflation, with nominal cash flows discounted at a nominal rate and real cash flows discounted at a real rate.
• Where inflation is a material assumption, entities should explain how they have been calculated and disclose sensitivities.
• In light of the recent turmoil in the pensions market, entities with a defined benefit pension scheme should clearly explain their investment strategy and the associated risks, including liability-driven investments.
• For businesses receiving any government support, the financial statements should disclose their use, the accounting policy, and whether these funds have been incorporated into cash flow forecasts for impairment testing, going concern, and viability assessments and the recognition of deferred tax assets.

Wider economic environment

In addition to rising inflation and interest rates, the financial reporting impacts of changes in the wider economic environment, as further explained in our Macro-economic factors: latest financial reporting insights article, are likely to include:

• Assessing the net realisable value of inventory, taking into account increasing costs and the impact on changing business and consumer behaviour on demand;
• Asset impairment assessments reflecting the most recent expectations, budgets and forecasts, with the financial statements disclosing significant judgements and sensitivities;
• ECL measurements will need to be adjusted for historic default data and updated for forward-looking information;
• Recognition of deferred tax assets will need to be revisited to ensure that these are still considered recoverable;
• Potentially more onerous contracts will be identified with an associated increase in liabilities;
• Revising investing, financing, or hedging strategies, requiring reflection in the financial statements, including information about banking covenants if there is an actual or likely breach;
• Increased areas of the accounts are likely to involve significant judgements and estimation uncertainty, such as going concern assessment and fair value measurement, with the determination of these clearly explained including sensitivities.

Overall expectations for disclosures for 2022/23

The FRC’s overall expectations for disclosures include:

• A concise description of the risks facing the business and their impact on strategy, business model, going concern, and viability, with clear linkage to the relevant disclosures in the financial statements.
• Specific, balanced, and well-integrated information about the impact of climate change in narrative reporting with reflection of climate-related risks and uncertainties in the financial statements. The relationship between assumptions and sensitivities to TCFD scenarios and those applied in the financial statements should be clearly explained.
• Impairment disclosures should explain and assign values to the key assumptions, including sensitivity of reported amounts to assumptions used.
• Transparent disclosure of the nature and extent of material risks from financial instruments, including changes in arrangements, the use of factoring in working capital, approach and assumptions used in ECLs, concentration of risks, and material covenants.
• Disclosures should include company-specific information, rather than boilerplate disclosure requirements of specific standards. Companies are encouraged to include additional disclosure, not required by a standard if this helps the user to understand a particular transaction, event, or circumstance.
• Concise explanation of the significant inflationary features in revenue, supply, leasing, and other financing contracts and their associated impact on the financial statements.

For further information, please get in touch with Lou Ward, or your usual RSM contact.