The EU Issuers’ accounting disclosure regime and investors’ information needs. The essential role of narrative reporting

Within the EU investor protection framework, issuers are required to provide different investor groups with relevant information. Nevertheless, the current issuers’ accounting regime based on IAS/IFRS seems to be inconsistent with this regulatory approach. In fact, there are some concerns about the relevance of IAS/IFRS for investors. On the one hand, the financial reports of European issuers are becoming increasingly complex and long-winded and do not appear suited to meeting the needs of unsophisticated investors, who do not have sufficient financial, accounting and legal literacy in order to understand financial reports prepared under the IAS/IFRS regime, and who are exposed to information overload. On the other hand, the increasing complexity of financial reports can hamper the stewardship role of institutional investors, for whom issuers’ accounts represent a relevant source of information.

In a recent paper, I outline the different regulatory options that EU lawmakers could embrace in order to render the financial reports of European issuers more suited to meeting investors’ information needs. In designing possible reforms to the present regulatory framework, it must be considered that institutional investors play an essential role in financial markets because they currently originate most of the transactions performed on the markets. Therefore, any scaling back of IAS/IFRS would prove to be inappropriate, as it would deprive institutional investors of relevant information. The introduction of an abbreviated version of financial statements directed at retail investors would also appear to be inappropriate. As the regulations on the prospectus summary show, it is problematic to define the contents and ‘size’ of abbreviated disclosure. 

Since the information needs of institutional and retail investors do not coincide, and an information ‘format’ that is capable of putting all unsophisticated investors on an equal footing with sophisticated investors is lacking, the paper suggests that the narrative component of financial reports can play a crucial role in rendering EU issuers’ accounts more user-friendly for most investors. Empirical evidence and the literature on the UK Strategic Report show that a short narrative report written in non-technical language that focuses on essential aspects of the company’s business and conditions could represent a useful tool in rendering issuers’ financial reports more readable by (professional and retail) investors and limiting potential information overload. As has been highlighted by the UK legislator and the FRC, the Strategic Report regulated by sections 414A-414D of the Companies Act 2006 represents the ‘top stratum’ of accounting information, which can at the same time also provide essential information material to different shareholder groups and ‘guide’ more sophisticated investors through financial statements by indicating linkages between pieces of information presented within the strategic report and in the annual report. Thus, a Strategic Report-like narrative reporting may favour the supply of long-term financing and reduce short-termism on the part of investors, in keeping with the objectives set forth in the EU Commission’s Action Plan on European company law and corporate governance and in Directive 2017/828/EU, amending Directive 2007/36/EC as regards the encouragement of long-term shareholder engagement.

The paper recognizes that the minimum harmonization approach to narrative reporting set out by the Accounting Directive concedes a great deal of flexibility to issuers and already allows them to prepare a Strategic Report-like narrative reporting. However, the great flexibility granted by EU law limits the harmonization of narrative reporting in the EU and fosters uneven practices within the Member States, depending on the national regulatory context and on enforcement actions of national supervisory authorities. Thus, the development of narrative reporting guidelines harmonized at EU level would appear to be necessary in order to enhance the quality of narrative disclosures in the various Member States.  To this end, a regulatory approach based on flexible rules and non-binding guidelines should be preferred over the inclusion of more detailed rules into Directive 2013/34/EU, which might lead to a ‘one size fits all’ approach and render narrative reporting a mere box-ticking exercise.

In the light of the positive precedent of the ESMA Guidelines on Alternative Performance Measures, the paper argues that ESMA can play a major role in developing harmonized guidelines on the drafting of narrative reports in order to enhance the comparability, reliability and readability of narrative reporting. Following the leading example of the FRC narrative report project, ESMA should also promote proactive initiatives aimed at providing issuers with essential knowledge and practices necessary to improve the quality of narrative reporting. Finally, ESMA should focus more on narrative reporting in setting enforcement priorities for national enforcers.

Giovanni Strampelli is Associate Professor of Commercial Law at Bocconi University, Milan.