4 minute read 15 Oct 2020
Financial statements and private equity investors: it’s time for a new approach

Financial statements and private equity investors: it’s time for a new approach

Authors
Laurent Capolaghi

EY Luxembourg Partner, Private Equity Leader

Entrepreneur, passionate and keen to assist our clients navigating the changing landscape of Private Equity.

Valerio Bove

EY Luxembourg Accounting, Compliance and Reporting Partner

Private Equity expert with audit background. Passionate about kayaking and squash.

4 minute read 15 Oct 2020
Related topics Private equity

One of the new priorities in financial reporting is to encourage the preparation of financial statements which are easy to understand by investors and business analysts with information presented in a clear and simple manner without omitting useful information.

S
ince 2001 there has been a remarkable increase in the use of IFRS around the world, including within the fund industry, with the result that companies can now benefit from access to debt and equity capital both inside and outside their respective countries to an extent never experienced before. 

Important progress has also been made in training a new generation of accountants capable of applying IFRS on a consistent and rigorous basis when preparing financial statements. 

In spite of the important results achieved, recent studies carried out by the IASB show financial statements are still often difficult to understand due to three interrelated issues: too much irrelevant information, not enough relevant information and ineffective communication of information.

There is a common view among stakeholders that too many financial statements, in spite of being fully compliant with IFRS, still struggle in achieving their main objective which is to provide investors with information useful for making investment decision.

For example, the language used is very often perceived as being too technical since there is a tendency to copy entire paragraphs from the relevant IFRS standard. 

The disclosure related to the accounting policies, which is frequently very lengthy, is also considered by many investors to be of little use if it only includes a long list of general accounting principles without being tailored to the company’s specific circumstances.

Following a number of meetings with investors and analysts, the IASB has started a broad-based initiative -  the Disclosure Initiative - which comprises a number of projects to explore how disclosures in IFRS financial reporting can be improved looking at matters such as materiality, the structure of the primary financial statements and the implication of technology on financial reporting.

This issue commonly known “disclosure problem” is also affecting the private equity sector. It’s not a surprise that fund managers still spend a considerable amount of time in replying to questions raised by investors who struggle to find or understand the information they need.

Ineffective communication in financial reporting has wide implications as it increases uncertainty around the fund managers’ ability to generate value, leading ultimately to a higher cost of capital.

What can be done in practice to improve communication in financial reporting?  How can fund managers better describe their success stories to investors?

Improved communication requires first of all a change in mindset as the main obstacle to effective communication is behavioral in nature.

The preparation and presentation of the financial statements should not be a compliance exercise but rather a tool to facilitate communication with stakeholders as disclosures are key in enhancing the usefulness of financial reporting to investors and stakeholders.

In our experience and as demonstrated by a recent research programme carried out by the IASB a series of minor changes can often lead to improved communication in the financial statements.  These changes include the following:

  • Information should be entity-specific and tailored to the fund’s business rather than generic “boilerplate” language;
  • The language used should be clear and concise without avoiding useful information;
  • Information should be better formatted, for example replacing narrative description with tables, graphs and charts when deemed useful;
  • Information should be better organized by for example avoiding separate notes for immaterial captions;
  • Fund managers should not hesitate, when useful, to restructure the notes by presenting them in a new order and adding a brief introductory paragraph explaining the nature of the caption. Currently it’s common practice for example to describe all key accounting policies, judgements and estimates in a separate note. Relocating each of these key items to the relevant note where the transaction is described, we believe, it’s another step towards effective communication as it changes the reader’s perspective on the information provided. 

Improving the disclosure in the financial statements beyond being a mere compliance with IFRS also involves some challenges.

Firstly, it’s not a one-off task but it needs to be constantly monitored in light of the fund’s business evolution. It’s also a time-consuming exercise as it requires close scrutiny of the existing disclosure and a creative mindset to identify what can be communicated better. In this respect the questions raised by investors during the annual general meetings or sent to the investor-relation teams are extremely useful.

Improving communication requires teamwork and the involvement of different departments across the fund including finance, legal and investor-relationship and most importantly the full and active support of the senior management whose attention is often caught by other more urgent matters.

Summary

It’s too early to conclude whether the Disclosure Initiative will reach its final objective, nevertheless this initiative has the biggest merit of having highlighted an issue which exists since many years and whose impact over the efficiency of the capital market was often underestimated.

About this article

Authors
Laurent Capolaghi

EY Luxembourg Partner, Private Equity Leader

Entrepreneur, passionate and keen to assist our clients navigating the changing landscape of Private Equity.

Valerio Bove

EY Luxembourg Accounting, Compliance and Reporting Partner

Private Equity expert with audit background. Passionate about kayaking and squash.

Related topics Private equity