Recommend: IFRS financial statements in the small and medium-cap listed space

Anecdotally, preparers of small and medium-cap listed companies complain that IFRS annual financial statements (AFS) are too complex and require too much time and money to prepare. This is especially because preparers feel AFS are not the primary source of detailed financial information for their capital and credit providers. It is thought that significant shareholders likely hold positions in the company or its board, and creditors can demand management accounts. Insignificant shareholders most likely don’t bother trying to read the financials and use non-sophisticated techniques to make investment decisions.
The perceived complexity, expense and low use of IFRS AFSs lead to preparers feeling a kind of resentment towards IFRS. This may result in the preparation of boilerplate financial statements that are less useful and, ironically, fulfil their preparer’s expectations of being of little value to users.

To investigate the validity of these perceptions, Wits’ SOA MCom student Leigh Brooks interviewed auditors and preparers of small and medium-cap JSE-listed companies. The criticism by these preparers may seem quite intuitive to many. Smaller listed companies generally have fewer complex operations, leading to less complex accounting. Given the lack of complexity of operations, the benefit and relevance of increased disclosure required by more recent accounting standards such as IFRS 7 (Financial Instrument Disclosure) may not be apparent to the preparers of smaller listed companies, where, for example, the most complicated financial instruments that they have are trade receivables. Significant portions of the company’s limited time and money are spent on the preparation of financial statements with limited obvious benefits other than ensuring compliance with IFRS. The result, in many cases, is financial statements that provide boilerplate qualitative disclosures that contribute little to providing a good understanding of the entity’s performance and position. So, why do the financial statements of these smaller listed companies lack the usefulness that users and the IFRS are desperately seeking, and why is there so much push-back to increased disclosure?

The answer is two-fold. There are external factors (investors and lenders) and internal factors (resources) that play a role. Let’s consider the position of a potential investor. Looking at the available options, the investor may decide to invest in an index (which to a large extent are focused on larger listed companies) or may decide to invest in specific shares. A quick Google search to identify which shares to purchase brings up the top-performing shares of 2021, all of which appear in the JSE Top 100. There is limited demand for smaller company shares and, as such, limited demand for information relating to these shares. The smaller size of these companies often results in them not meeting the minimum criteria for investment by large institutional investors. This prompts the question, what is the incentive to improve financial statements to increase their usefulness to users? The pool of potential users is limited in these smaller companies. The few investors that do exist often have access to the management accounts of the company on a real-time basis due to being members of the management team where they are directly involved in the daily operations of the company.
The next factor to consider is the resource availability of these smaller companies. CAs(SA) are drawn to the profession for numerous reasons. For many of us, this is prestige. We may at some point in our careers be able to say that we are the CFO or FM of one of South Africa’s major listed companies. So where does this drive for prestige leave the supply of CAs for smaller listed companies? There are, of course, factors to consider other than status. These include work-life balance, corporate culture, and financial and non-financial benefits.

Smaller listed companies pride themselves on the fact that their employees are more involved in daily operations. There is a ‘closer’ corporate culture where everyone knows one another. This may come at the expense of financial gain, which many overlook for the prospect of a better work-life balance. This close relationship and ability to be intimately involved in key decision-making puts smaller companies in a better position to attract and retain talented employees. These employees are likely to produce high-quality, tailored disclosures due to their detailed understanding of the business.

Smaller teams with diverse roles and responsibilities also mean that there are fewer people with whom to collaborate and discuss issues. This makes it more difficult to solve complex financial reporting challenges. It also means that with the sometimes-onerous reporting requirements of IFRS, the workload of the smaller finance team is increased, making it a challenge to prepare compliant financial statements when all other tasks remain and there are limited resources available.

With the challenges small-cap firms face coupled with the perception that financial statements are not the primary focus of capital providers, it is understandable if some of these companies focus on compliant financial statements instead of striving to make their statements as useful and easy to follow as possible. Their focus would likely rather be fixed on ensuring that they do not miss the reporting deadline and on running the operations as best as possible. Smaller listed companies face a trade-off between costs associated with producing more tailored disclosures and the benefit these disclosures provide users of financial statements. With the perception that shareholders make limited use of the financial statements of these smaller listed companies, in most cases the costs seem to outweigh the benefits.

These two broad factors further impact the quality of the financial statements produced through the controversial auditor-client relationship. The often-tense relationship may worsen when the audit partner and manager recommend that additional company-specific information should be added to the financial statements that have already taken months to produce. As compliance rather than improvement may be the priority for many smaller companies, auditors may limit disclosure recommendations made, potentially further negatively impacting the usefulness of the financial statements. Auditors, too, suffer from resource shortages, and this may limit the capacity that they have to make recommendations based on the resources allocated to the job.

After all of this, the question that should be asked is: if users of smaller listed financial statements are limited and these users are not looking at detailed disclosures due to their involvement in daily operations, should these companies be preparing financial statements under IFRS? This may be one of the factors contributing to the increase in smaller companies delisting from the JSE.

Reference
1 Available at https://www.bizcommunity.com/Article/196/511/218698.html.

Author
Kayleigh Greenslade CA(SA), Senior Lecturer, School of Accountancy, WITS