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JSE proactive monitoring to improve financial reporting

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In February, the Johannesburg Stock Exchange issued its Report Back on Proactive Monitoring of Financial Statements in 2013. Given the need for good corporate governance from our listed companies, whom we invest in, it is pleasing to note that the JSE now addresses its correspondence to companies regarding the outcome of their proactive monitoring process of that company to the chairman of the Audit Committee. This should ensure that accountability for the Annual Financial Statements (AFS) and any non-compliance with International Financial Reporting Standards (IFRS) is dealt with by the appropriate body.

Under the proactive review and monitoring process of the JSE, the financial statements of every listed company will be reviewed at least once every five years, in addition to any other queries arising from public or other complaints. The JSE commenced this process in 2011 and today they report on their findings for the reviews of listed companies that took place in 2013.

This proactive monitoring process conducted by the JSE gives shareholders the benefits of a better-regulated market, as the integrity of financial information is critical element of a well-functioning market. Any errors, omissions or manipulation of financial results has a direct impact on the pricing information of a company.

It is reported by the JSE in their 2013 report that 84 cases were closed in 2013. Of those reviewed the JSE required three companies to restate their AFS and make a public announcement to that fact; 33 companies had smaller disclosure issues to correct in future results announcements; and a further 33 companies were given either “clean reports’” or “areas of improvements for the future”.

One of the main reasons South Africa – and the JSE in particular – required the use of IFRS was to be able to play in the global pool of finance and attract foreign investment by providing reliable financial information prepared in terms of the globally recognised accounting framework, IFRS.

Having read the JSE’s Report Back there are a few areas that investors, analysts and other users of AFS need to watch out for that the JSE flags as issues over the past year of reporting – revenue and earnings, and headline earnings per share.

Revenue is a key metric of a company’s performance. Not only the correctness and completeness of the actual revenue number, but also the breakdown in the notes of each significant category of revenue as this provides insight into business operations of the company. It is disconcerting to see that a number of the companies reviewed did not take the necessary care in their revenue disclosure, leading to misinterpretation of the revenue of the company.

The JSE reviews identified certain errors in the application of the earnings per share standard, specifically as it related to diluted earnings per share. These included:

The omission of the dilutive effect of options granted and shares due to be issued at a future date

Incorrect adjustments in respect of options

Calculation errors

The omission of the necessary disclosure regarding instruments (for example convertible loans) excluded from the diluted earnings per share calculation due to their antidilutive effect for the period under review, and

The incorrect application of the standard as it related to share incentive scheme shares

Various problems were also identified with the calculation of headline earnings. These included the incorrect inclusion of:

Impairments of assets, and

Profit on disposal of tangible and intangible assets

And the incorrect exclusion of:

Impairments of loans, and

The profit on disposal of an associate

Investors and analysts worldwide are of the view that there is no single number that encapsulates the performance of an entity. The market takes note of a wider information set. Nevertheless, there is still the call from users for a single earnings number that can be used as an unambiguous reference point.

One of the main uses of a single earnings number in South Africa is in the calculation of a consistent price–earnings (P/E) ratio. A P/E ratio is a useful analysis tool for comparing the market ratings of companies and for trend analysis of the valuations of companies and sectors over time, even though the earnings of the various companies are not necessarily calculated using the same accounting policies. The P/E ratio can also be regarded as the number of years’ earnings, calculated on a consistent basis, that are represented by the current share price.

The JSE advises companies to read and take note of the issues they found this year and to continually improve their financial reporting. The JSE’s proactive monitoring process is a vital part of why South Africa is consistently ranked number one in the world by the World Economic Forum’s Global Competitiveness Index for the strength of its financial reporting and auditing standards.

Going forward, South African market securities regulation, already judged the best in the world, will improve further each year owing to the JSE’s decision to monitor proactively the financial statements of all listed companies, in a bid to pick up any non-compliance with globally recognised International Financial Reporting Standards.

Authors: Sue Ludolph CA(SA) is Project Director: Financial Reporting at SAICA