The importance of ‘why?’ in narrative reporting - FutureValue
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The importance of ‘why?’ in narrative reporting
18/11/2015
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The FRC and IIRC each say investors are the primary audience of their respective statutory Strategic Reports or voluntary Integrated Reports. Yet investors seldom get a direct answer to ‘why should I invest, or stay invested?’ from the ever more important narrative content of these reports. This seems odd given both the opportunities that a principles-based reporting framework enables, and the growing evidence that these corporate reports can influence a company’s market performance. External reports of UK listed companies so seldom give an answer to the question ‘why?’, implicitly or explicitly. Narrative reports in support of financial statements typically contains lots about ‘what?’ and ‘how?’, frequently supported by case studies and often much corporate marketing guff, but the questions that truly influence investors’ decisions only rarely get asked or answered. So, how can a company simply give the answer to the implied question ‘why’? What are the circumstances that make this a timely issue to address? And how might it be resolved?

Investors, the primary audience of narrative reporting, dislike one thing above all others – uncertainty. Answering the question ‘why is this company profitable?’ in a logical, analytical and reassuring manner does more than anything else to reduce that sense of uncertainty. What then is the missing element from the external reporting of most companies that would provide this answer? It is quite simply a clear articulation and presentation of the business model that is the foundation of the company’s strategy. Sure, every major UK listed company is required by statute to present its business model but few of these models currently presented in Strategic Reports give the answer to the implied question ‘why?’. Most companies present an operational model that answers internally focused questions of ‘what?’ and ‘how?’ but not ‘why?’. Ask the question ‘why?’ and the answer will reveal the distinct sources of value that drive profitability in the business. And, if the narrative doesn’t answer the ‘why?’ question, the company inevitably projects a short-term operational focus; value creation over time becomes unpredictable; strategic direction is unclear; and, uncertainty rules in the minds of investors.

A project by the UK regulators’ reporting development forum, the Financial Reporting Lab, makes the matter of the ‘why?’ question particularly timely. The FR Lab’s project is undertaking an in-depth review of business model reporting. Up till now the regulator’s guidance to quoted companies on presenting a business model has focused on presenting the ‘what?’ and the ‘how?’. It is conceivable that the outcome of the project might focus more on the ‘why?’, but it is unlikely. Answering the ‘why?’ is more challenging and more revealing. Many Boards will resist it. It requires clear strategic thinking. Some will even shelter behind the questionable claim that it breaches commercial confidentiality.

There is timely international pressure, too. The IIRC’s voluntary Integrated Reporting Framework is gaining traction with a growing band of adherent companies. Major UK listed companies are even adopting elements in their statutory reporting. At the heart of an Integrated Report, modelled loosely on the much vaunted UK regulatory principles-based reporting framework, is the presentation of a company’s business model as a component of the reporting company’s value creation process. While the <IR> Framework is quite specific about the six capitals that are the components of value creation – financial, manufactured, human, social, intellectual and natural, the Framework is less than rigorous about its definition of a business model. It talks of the business model in terms of: inputs, activities, outputs and outcomes. There is no requirement to indicate why the capitals create value uniquely and in what specific combination as a foundation to enable definition of strategic direction. Consequently, the <IR>-defined business model hedges its bets, aiming to be both strategic and operational at one and the same time. The resultant Report to investors will be at best unclear and at worst vague and confusing. It is unlikely to reduce investor uncertainty.

There is good reason for this confusion about business models. It is worth noting that business strategy is only a generation or so old. Porter’s work on competitive strategy published as recently as 1980 still provides the rationale at the heart of most companies’ business strategy. Porter demonstrated that competition erodes profits, indicating that companies should look to their sources of advantage and position themselves to mitigate the effects of competition. But, it was almost another twenty years before the inception of the business model, given impetus by the network economy and the concept of value-based management. Adopted by strategists as a missing link in the strategy process, the term ‘business model’ separately slipped into the accounting lingua franca around the same time to reflect an operational model. To this day the confusion over the ’why?’ and the ‘what’ and ‘how?’ remain.

The matter demands resolution. Both FRC and IIRC could do a service to their agreed primary audiences – investors. Make companies explain specifically through their business model why they are profitable and then, through their consequent objectives and strategy, why they will continue to be profitable. The best reporting companies already understand this and are reaping the benefit in the market. The question ‘why’ only gets answered when a Board and its Executive Team recognise that a Strategic Report, or indeed an Integrated Report, is a valuable manifesto and not an imposition to be fulfilled as a chore by middle management.