Draft regulations on the Operating and Financial Review and Directors' report
A consultative document from the DTI
Comments from ACCA
August 2004
Overall Comments
The Association of Chartered Certified Accountants (ACCA) is pleased to have the opportunity to respond to this consultative document on the draft regulations for an Operating and Financial Review (OFR) and Directors' Report.
ACCA welcomes the statutory OFR outlined in these regulations as an important improvement in corporate reporting in the UK .
We consider, however, that an opportunity has been lost to make this form of reporting a more comprehensive means of engaging with stakeholders. The Government have chosen to make the primary focus of the OFR the members or shareholders in the company and not the needs of a wider group of stakeholders in the performance and activities of a company. In line with this objective, certain of the matters to be covered by the OFR have been specified as mandatory and others as only required to the extent necessary to meet the overall objectives of the OFR. There is a risk that directors may avoid these important disclosures by claiming that they are of no relevance to their shareholders. In this context we welcome the direction in some of the explanatory material that the directors' judgments on these issues need to consider the long term interests of its shareholders in the business operating, and being seen to operate, in a responsible way in relation to its employees, society and the environment. We hope that this will be borne out more fully in the OFR standard to be issued by the Accounting Standards Board (ASB) in due course.
At several points in our comments to the DTI's specific questions we have noted that there are issues that will need to be elaborated in the ASB's standard. It would have been much easier to comment on these proposals with some knowledge of that standard or standards.
Furthermore an ASB standard and whatever other official guidance will be produced are a prerequisite for companies to begin a proper preparation of the new OFR. Even though a majority of listed companies currently produce an OFR or comparable material, a significant minority do not. Three quarters of listed companies currently produce no quantified environmental disclosures for instance. The new OFR will be different to current ones and require all companies to review and re-consider what should be included and how this should be prepared. The Regulations for the OFR should, therefore, be available for application in 2005 as proposed, but not compulsory until a year later. The DTI would still be able to implement that part which deals with the Modernisation Directive's requirements by that date.
It is better for the introduction of this significant improvement in corporate reporting to be done properly than rushed in. We have some concerns, for example over the wording of the directors' responsibilities to report only �after due and careful enquiry' and also over any potential conflict between commercial confidentiality and transparency of reporting.
Answers to DTI's specific questions
Q1. Do you have any comments on the means by which paragraph 1 of the OFR schedule implements the CLR objective
The intention in the draft regulations appears to be to identify the �review objective' and then, subsequently, to identify what preparers will have to do to achieve that objective. But paragraphs 1 and 2 of new section 234ZZA are a mixture of disclosure items and objectives. It would be better to retain the gist of the CLR's draft objective, amended to take account of revised EU terminology, on the following lines:
�The objective of the OFR shall be to provide a balanced and comprehensive analysis of the development and performance of the business of the company and its main subsidiary undertakings during the financial year and of the main trends and factors underlying the results and financial position and which are likely to affect its performance in the future, so as to enable members to assess the strategies adopted by the company and the potential for successfully implementing them.'
The mandatory and discretionary disclosure items could then follow.
The term comprehensive analysis has been interpreted by some as meaning exhaustive and complete. Paragraph 3.5 states that the term adopted from the Modernisation Directive is not designed to require directors to cover all possible matters. The DTI also says that the objective is quality, not quantity, of content. It will be important that this is made clear in the proposed OFR standard.
We note that the objective in the regulation is to report to members to enable them to assess the company's strategies. Furthermore paragraph 3.24 says �The primary purpose of the OFR is to improve transparency in the interests of better corporate governance and shareholder engagement�. The information contained in it is solely intended to allow the body of shareholders to exercise its stewardship functions (and to provide relevant information which may be of interest to other stakeholders). In other places, however, in this material and in the guidance for directors published, more emphasis is placed on individual shareholders or potential shareholders and their investment decisions. We think this may be unhelpful in changing the boundaries of strict responsibilities (as derived from case law including that in Caparo for example) and in encouraging safer but more �boiler-plate' material.
Q2. Do you agree that quoted companies comprise the appropriate class of companies to be required to prepare an OFR?
Yes. Quotation is the easiest way of defining companies with a wide body of members not engaged with the management of the company. We consider, however, that this new form of OFR will be taken up more widely by entities with significant public interest such as larger unquoted enterprises and also in the not-for-profit sector. This should be on a voluntary basis and not required by law.
Q3. Do you agree that the draft regulations should include a specific requirement to include a description of the capital structure, treasury policies and objectives and liquidity of the company?
These areas are likely to be extensively covered by disclosures in the financial statements deriving from IAS1 and by IAS32. We would see no point in the OFR repeating material already in the financial statements. There may be a need for the management to present their strategies in terms of financing the business, but this emphasis is not evident in the draft regulations. It will be important for the ASB to consider the integration and overlap in this area in drafting their standard.
Q4. Do you agree that the directors should be required to state the fact where they have concluded that there is nothing relevant to report in respect of the items covered by paragraphs 4 to 7?
Yes. The directors would have to have considered the question in any event. The disclosure would help users of the OFR � what has been chosen to be omitted from the OFR could in some cases be as significant as some of the matters covered. The disclosure would also help the auditors reporting on the OFR and the Financial Reporting Review Panel (FRRP) when reviewing annual reports for compliance.
Q5 Do you agree with the approach in drafting the OFR schedule 7ZA?
We support the requirement in paragraph 6 of the schedule for the OFR to include clear measurements in the form of KPIs. This will help to avoid vague statements and claims being the currency of the OFR. Directors will in our view require some guidance on the selection of these KPIs, balancing both the measures of performance selected for use internally with the external benchmarks expected by users of the OFR. The standard from the ASB will need to address this and should include cross references to widely accepted sources of general and sectoral benchmarks in the different areas � employee, environmental and social matters.
We have the following recommendations for improving the text of the schedule.
Paragraph 3 should simply provide that the �discretionary items' should be disclosed to the extent necessary �to comply with the review objective in paragraph 1'.
Paragraph 4 states that the OFR should �include information about' (the matters set out in sub-headings). This sounds rather vague. While the proposed standard will give guidance in this area, it would be better for the legislation to require disclosure of �strategies and performance' with regard to the given items.
The word �also' at the outset of paragraph 5 is unnecessary.
The disclosure requirements in sub-paragraph 5(a) are too vague for proper application (both in terms of definitions and of content) and will require further elaboration and explanation in the standard, including any areas of overlap with related party disclosures under IAS24.
Sub-paragraph 5(b) is another example of an area where much of the factual information will already be included in the accounts.
In paragraph 7, in place of the term �amounts' it would be more correct to refer to 'financial information' or 'figures' in this context.
Q6. Do you agree with the proposed role of the auditors as set out in regulation 8, including whether �due and careful enquiry' is a reasonable and practicable standard to require of directors?
We agree with the proposals that the process employed by the directors to produce the OFR should be subject to review by the auditor. The supporting guidance on the preparation of the OFR which might comprise the intended ASB standard and the updated guidelines to directors, will need to be developed appropriately. They will need to produce criteria suitable for assurance engagements in line with the IAASB Assurance Framework and ISAE3000.
We support the positive requirement for the auditor to consider and report on any inconsistency between the OFR and the audited financial statements, rather than a report only in cases of inconsistency.
There should also be a report to the members that the auditor considers that the statutory requirements as to content have been met, comparable to the statement of compliance with the Companies Act in relation to the accounts.
The test of �due and careful enquiry' is currently a phrase used in connection with a company's prospectus or other introductory listing documents. This would be relatively onerous for the OFR and might imply strict documentation for any matter referred to in it. There is a resulting risk that boiler-plate disclosures will predominate which would reflect more the need for legal protection of the directors than communicating relevant and useful information to users. A phrase such as �using reasonable care' might be more helpful.
Q7. How much do you estimate such a review of process by the auditors might cost?
We note the estimate of £19,000 for the average listed company. We are not satisfied with the reliability of this and would expect it to be significantly in excess of this figure.
Q8. Do you agree with the Government's approach to the OFR enforcement regime?
Yes. We agree that a similar regime should apply to both the financial statements and the OFR as they are both potentially important to users of the annual report.
We would expect the FRRP, like the auditors, to concentrate on the considerations of completeness and process rather than content of the OFR. While it would be right for the FRRP to investigate whether the OFR was consistent with the other information for shareholders, it should not attempt to re-perform the judgments of the directors reflected in the OFR.
Q9. Do you agree with the Government's proposal to implement the member state option in the Modernisation Directive by providing an exemption for medium-sized companies from the requirement to include non-financial information?
Yes.
Q10. Do you agree with the Government's proposals to bring the OFR Regulations into effect for years beginning 1 January 2005 ?
No. We welcome the statutory OFR as an important improvement to corporate reporting and consider that companies should try to implement it therefore as soon as practicable. It seems unreasonable, however, for the OFR to be made compulsory for listed companies for 2005, when the regulations will be barely finalised by the end of 2004 and the supporting, but compulsory, standard from ASB will not be in final form until well into 2005. As explained in our overall comments above, the new OFR will be a significant change for many companies requiring either new disclosures or a review of existing statements. From 1 January 2006 seems a more appropriate start date for the statutory OFR.
Q11. Do you have any general comments or specific suggestions on the drafting of the Regulations at Annex A?
We agree with the extension of the duty of auditors to report on consistency of the directors' report with the accounts, rather than merely when there is inconsistency. In addition to this, there should be an obligation to consider the completeness of the contents with the statutory requirements. At present obligations to report on items such as creditors' payment periods are frequently ignored by companies, and attract no comment from auditors.
Q12. Do you agree that all shareholders should receive the OFR? Do you agree that it is not appropriate to legislate to permit companies to send a summary OFR in place of the full version?
No. Shareholders should all be entitled to a copy of the full OFR. They may opt for summary financial statements (SFS) and so likewise a summary OFR should be an option. The contents of the OFR will overlap with the financial statements and a full OFR should be able to cross-refer to them to avoid repetition. This might not be possible if shareholders are sent SFS and a full OFR. The ASB standard should explore the possibility of a summary OFR to go with SFS.
Q13. Do you believe that the draft regulations should omit any requirement on directors to include information on corporate governance in their OFR, or do you think that such information is sufficiently key to company performance that repetition is justified?
The OFR regulations should make no reference to corporate governance information. Such information is required of quoted companies by the Combined Code and the extent to which auditors can or should report on them already established. While individual companies may decide to include corporate governance matters to meet the overall objectives of an OFR, we see no reason for specifically mandating this. Such issues are not always going to be key factors driving the performance of businesses. In any event the European Commission is expected soon to issue a Recommendation for all listed companies to publish free-standing corporate governance statements, so this issue is being dealt with separately.
Q14. Do you agree with the Government's proposal that a provision for confidentiality should not be included for the OFR?
No. Price sensitive information must already be disclosed. Given the use, however, of the word �comprehensive' in the OFR objective, confidentiality is bound to become an issue for reporting companies. The boundary between comprehensive disclosure and justified non-disclosure must be addressed either in the statute or in the reporting standard.
Q15. Do you agree with the omission of �safe harbour� provisions?
Yes.
Q16. Please comment on the costs and benefits identified in the Partial Regulatory Impact assessment at Annex D.
We have noted above our concerns over the estimated costs of an auditor's review.
We have comparable concerns over the estimated costs of preparation of an OFR. It is easy to understate the full value of time spent by all people in the company in preparing and reviewing the report. The guidance for directors issued at the same time as the draft regulations appears to envisage a wide ranging process. We also note that less than a quarter of listed companies make any quantified environmental disclosures. A similar position probably applies to disclosures of community and social issues. For these companies there may be significant consultancy costs in considering areas of impact and gathering information for the first time.
Q17. Can you identify and quantify any additional costs or benefits resulting from these proposals that have not been identified in the RIA?
We are not clear whether the RIA has allowed for the costs of legal advice in reviewing the OFR and the costs of printing and distributing the OFR.