UK: Surveying OFRs And Narrative Reporting In Annual Reports - Part 2

Article by Martyn Jones, Sarah Kershaw, Ian Krieger, Alice Patrick, Kirsty Searles, Isobel Sharp and David Viles

THE CHALLENGES FOR 2006

Inclusion of an OFR in the annual report is mandatory for all GB quoted companies for periods beginning on or after 1 April 2005. Companies should benefit from a year in which they may produce an OFR without submitting themselves and their boards to official scrutiny by the Financial Reporting Review Panel (FRRP). However for periods commencing on or after 1 April 2006, the Panel will have the authority to hold companies to account if they fail to comply with the legal requirements relating to OFRs. The Panel will then be able to apply to the court for a declaration that the OFR of a quoted company does not comply with the requirements of the Companies Act and for an order requiring the directors to prepare a revised OFR.

The Panel’s revised Operating Procedures, published in February 2005, state that it will only seek an order requiring directors to revise an OFR where the OFR:

• omits a requirement of the Companies Act;
• purports to comply with an OFR reporting standard but does not do so;
• is factually wrong in a material respect; or
• contains an opinion which no reasonable board could have formed if it had followed a proper process of collecting and evaluating evidence.

In light of the current reporting practices outlined above in ‘How Companies are Reporting’, this section highlights areas where companies are currently falling short of future compliance with the requirements regarding OFRs. As compliance with RS 1 will be deemed to constitute compliance with the OFR Regulations the focus is on the requirements of the Standard.

Where companies are falling short
The following key areas represent the major areas for improvement in current reporting to meet the requirements of RS 1:

• preparation of an OFR addressed to members;
• forward-looking nature;
• principal risks and uncertainties;
• non-financial performance;
• environmental matters, employees and social and community issues; and
• key performance indicators (KPIs).

For each area, the requirements of the Standard are identified together with an analysis of how companies are currently falling short in meeting these requirements. Where examples of good practice have been identified in the course of conducting the survey, these have been included. An illustrative OFR is also included later in this report as Appendix 1.

Preparation of an OFR addressed to members
Reporting Standard 1 is mandatory for all GB quoted companies. The Reporting Standard requires directors to prepare an OFR addressed to members (RS 1 ‘Summary’, paragraphs a and b).

The percentage of companies including a formal OFR in their annual report was 41%. However, when added together with those companies demonstrating clear recognition of an OFR, 82% of companies are producing a review of operational and financial aspects of the business. They should find it relatively easy to convert this content into an OFR (with the necessary additions/amendments to content to comply with the Standard). The other 18% of companies are likely to need to do more work to prepare their OFRs for the first time.

Only two companies addressed their OFR to members. Whilst it should be fairly simple to rectify this for the remainder, directors will need to consider where to address the OFR and what appropriate wording they should use. In addition, this requirement mirrors the fact that the whole OFR should focus on “matters that are relevant to the interests of members” and therefore it serves as a reminder that the rest of the content should reflect members’ needs above those of other stakeholders.

An appropriate introduction should clarify “that the OFR is addressed only to members as a body (… disclaiming liability to others) and that its purpose is limited to the statutory purpose, namely to assist the members to assess the company’s strategies and the potential for those strategies to succeed.

Forward-looking nature
he OFR shall have a forward-looking orientation, identifying those trends and factors relevant to the members’ assessment of the current and future performance of the business and the progress towards the achievement of long-term business objectives (RS 1 ‘Principles’, paragraph 9).

The Standard emphasises this ‘forward-looking’ requirement throughout both its principles and its disclosure framework. In many areas of key content, it reiterates that information should be given for both the current period and the future. Areas where the future is expressly highlighted for discussion and how companies are currently performing in these areas are set out in the table below. Only the 82 companies already producing a formal OFR or showing clear recognition of an OFR are included in this analysis.

The low level of discussion about the future (consistently below 50% on average) is perhaps a reflection of the fact that directors consider it a risky style of disclosure. Often, their statements might not be objectively verified and are basically given in good faith based on their reasonable assessment of the information available to them at a point in time.

Given the extent of pressure on and risk faced by directors of quoted companies in many aspects of today’s regulatory environment, it is perhaps understandable that, in the absence of any mandatory requirement to discuss the future, they have avoided doing so. However, now that this issue is included as a legal necessity, they will have to comply.

Directors will therefore need to consider carefully the content of the OFR where they are required to discuss the future and how best to do so whilst minimising the risks of misstatement and omission. The information disclosed must be meaningful and overall should aim to aid shareholders’ assessment of the board’s strategies and their consideration of the potential for those strategies to succeed.

The Standard suggests that directors may wish to include a statement explaining the uncertainties underpinning forwardlooking information. This is something that that all boards should consider and in some cases, it may be appropriate to take legal advice in this regard. In the surveyed OFRs, only five companies had included such statements and four of these were SEC registrants who included a blanket statement about all forward-looking statements in the annual report.

The Standard explains that disclosure of information about impending developments or matters being negotiated is not required if “disclosure would, in the opinion of the directors, be seriously prejudicial to the interests of the entity”. Boards should not be tempted to utilise this provision as a means of avoiding any forward-looking disclosure but there will clearly be areas where this is pertinent and non-disclosure is justifiable. Examples may include being in active negotiations to buy or sell a company, or to recruit a new executive.

Due to the absence of any ‘safe harbour’ provision in the OFR Regulations, no exemptions from liability have been put in place for those directors acting honestly and in good faith. There might therefore be a temptation for boards to include less meaningful ‘boilerplate’ disclosures. In recognition of this and in the interests of promoting good OFR practices, the Chartered Institute of Management Accountants (CIMA) sought and published a legal opinion from Allen & Overy LLP on director liability for statements in OFRs. The full opinion can be found on CIMA’s website but the following extract is relevant here:

“The greatest concern for directors relates to potential civil liability for negligent misstatement in relation to forward-looking statements in the OFR (given the absence of a statutory safe harbour). The risk of liability is reduced by taking the following steps:

• making sure that forward-looking statements in the OFR are appropriately couched and qualified in order to clarify the degree of reliance that members should place on them – directors should, in consequence, feel more comfortable in fulfilling the Government’s objective of meaningful and informative disclosure in the OFR; and
• making it clear that forward-looking statements contained in the OFR reflect the knowledge and information available to the directors at the date the OFR was prepared and that the OFR will not be updated during the financial year, but that forward-looking statements contained in it will be considered in the preparation of the next OFR.”

[Legal Opinion prepared by Allen & Overy LLP for CIMA]

Principal risks and uncertainties
The OFR shall include a description of the principal risks and uncertainties facing the entity, together with a commentary on the directors’ approach to them (RS 1 ‘Disclosure Framework’, paragraph 54).

Of the companies utilising the OFR approach, 54% of companies are now providing some description of the principal risks and uncertainties facing the entity. However, the survey found that these tended to analyse mostly treasury risks such as foreign exchange and interest risks.

This means that many companies are not providing any analysis of risks and uncertainties and those that are need to extend their disclosures to encompass a much broader range of risks. RS 1 suggests that these should include strategic, commercial, operational and financial risks where they might “significantly affect the entity’s strategies and development of the entity’s value”. The analysis of risks should reflect the nature of the business and should include those exposing the company to negative consequences as well as those presenting opportunities.

The policy for managing principal risks should be disclosed and this is clearly to enable members to understand how the board is identifying, monitoring and mitigating the risks that threaten the successful implementation of their strategies.

The proportion of companies who outlined their risk management policies and procedures was 42%. However, in almost all cases, any disclosure made in this area gave the policy for risk management in general rather than stating the policies for managing the specific risks outlined. Directors should consider outlining their approach to managing the main or principal risks, even if they do not disclose specific policies for every risk identified.

Risk management is a key aspect of business management and the vast majority of quoted companies should already have relevant procedures in place. There is some crossover in this area with the Combined Code on Corporate Governance and the Turnbull Guidance on Internal Control. That guidance should also aid directors in fulfilling the disclosure requirements in the OFR. However, for those companies not already paying adequate attention to risk, a significant amount of work will be required to rectify this before drafting the relevant disclosures.

Boards should consider how to present information in this area so as to convey clear evidence that they have good risk management practices. Example disclosures may range from matrices showing types, significance and likelihood of risk, to narrative detail for various categories of risk and their management.

The following extract from the ‘Risk’ section of Emap’s annual report is a good example of an analysis of principal risks including how management is approaching them:

Risk
Emap’s diversity and exposure to over ten different revenue streams give it the ability to reduce risk across the business. It would, however, be unrealistic to claim that there is no risk in the Group’s activities, so Emap operates a continuous process of identifying, evaluating and managing risks where they are significant. Further details of this process are set out in the section entitled ‘Systems of Internal Control’ in the Directors’ Report
At Emap Consumer Media, Emap’s dependence on key brands is being offset by targeted launches and relaunches to create a broader portfolio. Developing long-term relationships with wholesale partners is important to offset the risk of the continued growth of supermarkets retailing magazines, as is the development of subscriptions for specialist titles. The consolidation taking place amongst media buyers gives them more negotiating power, and makes it all the more important for Emap to be a media owner of scale. Deal-based arrangements with advertising clients are helping to secure stability.
For Emap Communications the web presents both a threat and an opportunity, as barriers to entry, particularly for recruitment advertising, become lower. The transfer of some recruitment advertising to the web is inevitable, but Emap Communications has extended its own high quality brands onto the web and is itself attracting significant online recruitment advertising. Emap is the largest customer of the National Exhibition Centre in Birmingham, so this partnership is an important one. Strong relationships with senior management are underpinned by an emphasis on long-term contracts for key shows, and through a shareholding in National Exhibitions Centre (Developments) plc.
The radio business within Emap Performance operates in one of Emap’s most regulated markets. All of Emap’s radio stations are developing plans to respond to the potential award of new analogue licences to competitors in their transmission areas, but conversely Emap has already benefited from a new analogue licence award, for Kerrang! 105.2 FM in the West Midlands. The transfer from analogue to digital broadcasting will also need to be carefully managed to protect and enhance audiences and revenues. The consolidation taking place amongst media buyers applies just as much to radio as it does to consumer magazines, but an advertising downturn could potentially be more damaging in radio. Deal-based arrangements help to secure stability and to ensure a guaranteed proportion of an advertiser’s spend is allocated to Emap even when markets are weak.
In France, the risk in a portfolio weighted towards the highly profitable TV listings titles has already become apparent. In response both Télé Star and Télé Poche have been revitalised, and production and marketing efficiencies introduced to reduce costs. Over the last 10 years Emap’s dependence on this sector has gradually been reduced by acquisitions and launches into different markets. The changes that are taking place in the French consumer magazines market, as highlighted earlier, make major launches a real possibility for Emap France at last, bringing opportunity to grow the portfolio organically, although as always there is risk around execution. However, Emap’s strong experience and launch track record in the UK can help reduce this risk. In a more competitive environment, there is a need for more aggressive portfolio management, which could include both relaunches and closures. Although this also carries some risk, the risk involved in not adopting this new strategy would be greater.
The key risks for the Group as a whole are financial. The impact of interest rate fluctuations are reduced by Treasury policies which set limits for fixed or capped interest rate cover (currently a minimum of 25%). There is a likelihood that the Group’s current tax rate of 25%, well below the standard rate of UK corporation tax due to the resolution of prior year matters, will increase over time to something more in line with the standard rate, although the Group will continue to mitigate its tax liabilities whenever and wherever appropriate.” [Emap plc ‘Annual Report & Accounts 2005’]

Non-financial performance
Objectives will often be defined in terms of financial performance; however, objectives in non-financial areas shall also be discussed where appropriate (RS 1 ‘Disclosure Framework’, paragraph 36).

While 50% of the 82 companies producing some form of OFR included non-financial objectives, the smaller companies in this group fared less well and will have to consider what further information they might need to include. Only 19% of these smaller companies by market capitalisation discussed objectives in nonfinancial terms and they may therefore need to widen their objectives to include aims beyond financial targets.

Many companies did include such information, if not in the OFR then elsewhere in the annual report, and they will simply need to move or duplicate some of that information into the OFR.

Those that do not already discuss non-financial objectives will need to consider whether they have such objectives and then, what, if any, appropriate disclosure(s) should be made. However, the emphasis is always likely to be on financial objectives and therefore except in terms of environmental, employee, social and community matters (see further below), this is less likely to be an area of significant attention.

A good example of discussion of performance in terms of nonfinancial objectives was found in Cadbury Schweppes’ summary financial statement and an extract of this discussion is shown below:

“Our fourth goal is to ensure our capabilities are best in class. In 2004 our two priorities were to ratchet up innovation and hone our people and systems capabilities. For innovation, we set the bar high, with a stretching internal goal of 15% from new products by 2007. We increased our innovation rate by 50% in 2004 to 9%, up from 6% in 2003. To radically improve our innovation rates we’ve improved our science and technology capability. We reorganised our research and development facilities into a new sixth global function and retained a highly experienced professional to lead our new Science and Technology function. We put in place a new strategy, coordinating our global resources as a whole to provide discrete centres of excellence and remove duplication. This enabled us to focus our resources and expertise. We are investing in a major new Science and Technology facility in North America that will come on stream in late 2005, replacing our Morris Plains centre ...”

[Cadbury Schweppes plc ‘Annual Review and Summary Financial Statement 2004’]

Environmental matters, employees and social and community issues
The OFR shall include the policies of the entity in relation to environmental matters (including the impact of the business on the environment), employees and social and community issues. It shall also include the extent to which those policies have been successfully implemented (RS 1 ‘Disclosure Framework’, paragraphs 29-30).

Figure 7 above shows that, of all the non-financial areas discussed, these three areas were covered in fewer companies’ annual reports. Only 54% discussed the environment and social and community issues in the annual report and those discussing employees represented 67%. The disclosures relating to environment, social and community issues were largely in the corporate and social responsibility report. Whilst much of the necessary information might be included in these cases, the majority of companies will still need to give further detail on policy and especially on whether or not such policy has been successfully implemented.

Key performance indicators (KPIs)
Those Key Performance Indicators (KPIs) judged by the directors to be effective in measuring the development, performance and position of the business of the entity shall be disclosed, together with information that will enable members to understand and evaluate each KPI (RS 1 ‘Summary’, paragraph e).

The inclusion of KPIs is one of the most challenging ‘new’ mandatory aspects to narrative reporting introduced by RS 1. The Standard states that KPIs shall include both financial and, where appropriate, non-financial indicators. It also specifies that for each KPI, the OFR will explain its definition, calculation method, source data and underlying assumptions, purpose, future targets and where appropriate, comparatives for the preceding year and reconciliations to financial statement figures.

The current practices with respect to including KPIs and providing information on those KPIs, is analysed in figures 13 to 15 above, together with the related commentary. It is clear from the numbers in that analysis that more than half of companies are not including KPIs at all and those that are do not provide all of the information suggested above. This area is therefore likely to be the most onerous in terms of achieving compliance with the Standard.

The steps that directors could usefully take in respect of KPIs are as follows.

1. Identify KPIs used by the directors and executive management to measure the delivery of their strategies and to manage their business effectively.
2. Review those KPIs commonly used and accepted in the entity’s industry to consider whether these may carry additional weight (due mainly to increased comparability).
3. Decide which KPIs from 1. and 2. above are most appropriate for inclusion in the OFR. The interests of members and the usefulness to them of each KPI should be given due consideration at this stage. A sensible number of KPIs is likely to be between 4 and 6 but this may vary by industry and entity.
4. Review chosen KPIs for non-financial measures and if none selected, consider whether one or more non-financial KPIs should be included.
5. Review each KPI in turn to determine:
• appropriate disclosure of its definition and calculation method.
• whether there is a reasonable level of confidence in the relevant source data integrity (see further step 6. below).
• what purpose the KPI is used for within the business and how to convey this clearly in the OFR especially in terms of the link to strategy.
• whether a comparative would be helpful and if so, whether one is already available or can be calculated.
• what reconciliations to financial statement figures are required, if any.
6. Ensure that controls surrounding production of data used in KPIs are reviewed as part of ongoing internal controls procedures.
7. Consider and design an appropriate structure for the disclosure of KPIs in the OFR so that the detailed information is as easy to use as possible. Examples 1-23 in RS 1 ‘Implementation Guidance’ provide illustrative examples of KPIs and their required disclosures. (See also the illustrative OFR included later in this report at Appendix 1).

Once companies have performed and completed the above steps for their first ‘RS 1 compliant’ OFR, less work should be required in subsequent periods. However, the above steps should still be completed each time in case the nature or details of the KPIs have changed. It will also be important for companies to monitor the KPIs that their competitors or other entities in their industry are disclosing so that they can compare both their calculation methods and the resulting figures.

An example disclosure and description of KPIs is included below.

... Interest margin has been calculated by reference to average interest earning assets. Interest spread represents the difference between interest receivable as a % of average interest earning assets and interest payable as a % of average interest bearing liabilities. Average balances have been calculated on a monthly basis.

In 2004 interest margin and spread were 0.82% and 0.73% respectively compared with 0.85% and 0.77% in the first half of the year (2003 full year – 0.97% and 0.90%). During the second half of 2004 spreads on lending were stable compared with the first half, consistent with the mix of lending volumes. Throughout 2004, liability spreads were, however, adversely affected by money market rates anticipating increases in bank base rate, resulting in a net increase in our cost of funding. The differential in rates is expected to return to more normal levels in 2005 as evidenced by the reduction in money market rates towards the end of 2004.”

[Northern Rock ‘Annual Report and Accounts 2004’]

Other challenges
Overall, directors will need to give more information in relation to their strategy for the business, the related objectives and the proposed method of implementing that strategy. For some companies, this will be a major shift in emphasis from reporting mainly historical, financial information to providing much more forward looking, strategic and non-financial information.

Timeliness of reporting represents another challenge for some companies. The EU Transparency Directive, finalised in December 2004 and due for implementation in the UK no later than January 2007, will require that quoted companies make public their annual financial report not later than four months after the end of their financial year. Seven companies from our survey sample did not approve their annual report within four months of their year end and another five only approved the report in the last week of month four. Although the Directive may not be implemented before 2007, such companies should review their reporting procedures and take appropriate action to ensure that they improve their speed of reporting ahead of the introduction of the new deadline.

There are several other areas of specific content where RS 1 requires some discussion but where the survey shows that a relatively low percentage of companies currently include all the requisite information in their OFR (for example, key dependencies including relationships with suppliers is an area where less than 15% of companies are currently providing information). However, the annual reports reviewed were all issued before OFR became mandatory and mostly before the Standard was finalised. There will clearly be work required to address these areas so as to comply with the Standard in full. Some of this will involve moving or repeating information from elsewhere in the annual report and some will involve preparing disclosures for the first time.

To assist with this task, a disclosure checklist for the new statutory OFR is included at Appendix 2. An illustrative OFR is also included at Appendix 1.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.