Risks and opportunities posed by draft OFR regulations

The Government's plans to require quoted companies to publish an annual operating and financial review (OFR) are likely to bring a step change in the number of companies disclosing at least some information on environmental matters. But observers in the socially responsible investment (SRI) community are warning companies against the temptation of relying on publication of an OFR as an alternative to comprehensive stand-alone environmental or sustainability reports.

The Department of Trade and Industry's consultation paper, released in May, drew a mixed response. Environmental groups and accountants alike urged Ministers to strengthen the draft regulations - while the Confederation of British Industry said they have "gone too far" already.

The CBI's concern focuses on a proposed legal duty in the draft regulations (see box ) that auditors must report on whether, in their opinion, directors prepared their OFR after "due and careful enquiry". This poses a more onerous test than that traditionally applied to company accounts, which must represent a "true and fair" view of financial health.

CBI deputy director general John Cridland describes due and careful enquiry as "one of the highest legal standards", and warns that it could expose firms to "unnecessary and excessive reporting burdens, not to mention damaging litigation."

Companies caught by the OFR regulations will also have to tackle "forward looking" reporting - a practice which companies have struggled with to date when publishing OFRs on a voluntarily basis. Moreover, directors' "due and careful" enquiry will have to address environmental, social and community matters to the "extent necessary for an understanding of a company's development, performance or position."

As a result, the CBI foresees a scenario where companies are forced to pay consultants and accountants substantial sums to ensure that they comply with the new law.

After all, under the draft regulations, a director will face unlimited fines if it can be proved that he or she was "reckless as to whether the report complied" and "failed to take all reasonable steps" to prevent the defective OFR being approved. This prospect has been seized on as headline material by the press in the UK and overseas.

The Association of Chartered Certified Accountants shares the CBI's dislike of the new "due and careful" test, which it says has "come straight out of nowhere."

ACCA's head of business law, John Davies, warned: "At a time when directors and auditors are expressing serious concerns about their liability and new responsibilities, they will both have to deal with this new, untried standard of care."

Notwithstanding the OFR standards, to be drawn up by the Accounting Standards Board (ASB), Mr Davies believes that uncertainty over the practical meaning of the test will "inevitably" continue until a legal challenge is mounted and a court ruling made on the issue.

Scope not to report
But in contrast to the CBI, ACCA's overriding view is that the draft regulations do not go far enough - its press release was headed "Brave new world of stakeholder engagement on hold". ACCA feels that the draft regulations give directors "ample opportunity" to decide that they do not have to report comprehensively on environmental or other non-financial matters which they feel do not have sufficient influence on their business and development prospects.

"We consider that the Government has missed the chance to make the OFR into a comprehensive tool of stakeholder engagement," ACCA says.

ACCA predicts a significant new market for its members in auditing and verifying the new OFRs as required under the regulations. However, auditors' role will be confined to assessing whether companies' processes for preparing OFRs meet requirements. Auditors will not be required to judge the material content of OFRs and companies will feel only limited pressure to disclose non-financial information.

Mr Davies points to experience of the "very, very, high failure rate" of companies complying with a statutory requirement to disclose their practice on payment of creditors. "We have to recognise that companies will not do it unless they have to," he concludes.

ACCA is calling on the Government to strengthen the disclosure requirements. It also calls for the OFR rules to be made applicable to all large public and private companies, not just those that are quoted on the stock exchange. This would increase the number of reporting companies from around 1,300 covered by the draft regulations to some 5,000.

"There are many entities other than listed companies which have a public interest character and which could be covered by the new statute," the body concludes.

Environmental groups under the banner of the Corporate Responsibility Coalition (CORE) agree with ACCA's two main criticisms. They add another - that the draft regulations do not impose a duty on directors to reduce adverse environmental and social impacts, only to report them in certain instances.

According to CORE's chair, Deborah Doane, "any benefit derived from the requirement for companies to report could be undermined by a lack of strong standards and explicit enforcement mechanism."

Ms Doane has since been placed in a position to have direct influence on the statutory standards to be produced later this year by the ASB. She is a member of the ASB's new OFR Advisory Committee (see box below), whose terms of reference are to guide a review of the ASB's existing statement on OFR best practice and agree changes to comply with the new regulations.

Some commentators, including the Institute of Chartered Accountants, have expressed concern that the Government's proposal to bring the legislation into force from next year would not allow adequate time to prepare and consult on the ASB standards. Their concerns will therefore not be assuaged by a direction to the OFR Advisory Committee to "take account of what is realistic and practicable to introduce for financial years beginning 1 January 2005."

The Committee is also to take account of:

  • The Government's stated objective for quality, not quantity of reporting and for the OFR to reflect the directors' view of the business.

  • The "principles of good regulation" issued by the Better Regulation Task Force.

  • The report of the OFR working group on practical guidance which was published alongside the draft regulations.

  • Current international best practice.

  • Guidance being developed by the International Accounting Standards Board in partnership with national standard-setting bodies to help implementation of the OFR legislation and similar requirements in other countries, including the "management discussion and analysis" reports in the US.

    A number of observers point to the ASB standards as a crucial next step in determining the effectiveness of the OFR regulations.

    Rob Lake of Hendersons Global Investors, a member of the DTI working group which produced the practical guidance to accompany the draft OFR regulations, said: "The way in which the ASB standards are formatted will have a big impact on the way people then report. If that process goes significantly awry then the usefulness of the OFR will be undermined."

    It would be important, he said, for the standards to oblige directors to take a strategic overview of the issues likely to affect their company's performance and development and not simply to "cut and paste" information from one report into another.

    Mr Lake pointed to the emphasis in his own group's guidance that directors should consider issues cumulatively and collectively rather than individually. For example, this would lead them to consider the effect of environmental issues on community and employee relations rather than in isolation.

    Value to SRI community
    If applied correctly, Mr Lake said, the OFR requirements would pave the way for his firm and others in the socially responsible investment (SRI) industry to hold strategic discussions with companies. But he said that SRI analysts would continue to look to firms to produce separate sustainability reports containing more information to enable a deeper analysis by those who want it. He envisages OFR reports containing summary information from sustainability reports together with a discussion of their materiality.

    The OFR legislation will introduce a new dynamic into a row that has been raging in recent months between companies and investors over the latter's interference in corporate matters ranging from executive pay to climate change.

    Companies feel particularly sore at the increasing tendency of investors' to talk publicly at shareholder meetings and to the press about perceived weaknesses. At a recent meeting of 30 or so chief executives and fund managers a process of dialogue was set up to alleviate tension between the two sides.

    Against this background, Mr Lake pointed out that "the OFR is supposed to be the director's take on what matters within his company, it is not an imposed view.... It should enable grown-up conversations to take place between companies and investors, but some companies might not interpret it in that spirit."

    Environmental expertise
    Environmental consultants are gauging how the OFR requirements will affect their businesses. There will be some discussion about who is best placed to audit OFR reports. But according to Tom Woollard, corporate advisory services director at ERM, consultancies would need to maintain firm boundaries around their advisory work and may well be excluded from offering auditing services. He predicted that accounting firms would be on a recruitment drive for people with environmental expertise.

    Dr Woollard feels the OFR regulations will push laggard large firms into reporting and that they will flag the importance of non-financial factors within all companies.

    But he is concerned that companies producing an OFR may put less effort into wider sustainability reporting. This could result in companies losing some of the internal benefits that come from preparing such reports.

    Environmental managers within OFR-reporting companies, he predicts, will find that their roles stay much the same but that the reporting process is broadened to include deeper discussions with the finance and human resources department as well as the company secretary and lawyers. More integration of information gathering and reporting processes is also likely to take place at corporate head office.

    Powerful tool for NGOs
    OFRs are likely to provide a powerful tool to the NGO community, Dr Woollard believes, because they require a director to have made decisions about which issues are material to the company. This opens the door to potential challenges of these decisions.

    This possibility would be strengthened by a proposal in the Government's consultation paper that, where there is no discussion of environmental issues in the OFR, directors should be asked to make a statement to affirm that they had considered and rejected any such discussion.

    NGOs point to the example of issues such as products containing palm oil, which they say the draft OFR regulations preclude companies from addressing. The small quantities of palm oil used by most companies might not be considered directly significant to the company in question - yet cumulatively the growing of palm oil in plantations has major environmental impacts.

    However, Dr Woollard argues that the high profile of such issues in the public eye and the threat of consumer boycotts could make decisions to ignore them open to challenge. "This will force out whether or not reputational risk is a material issue."

    Competition to disclose information...
    Legislative backing is likely to transform the nature of competition between leading firms on corporate social responsibility, according to AccountAbility chief executive Simon Zadek. He points to the possibilities of challenging firms which decide that a certain issue is not material to their business where a peer decides that it is.

    The draft OFR regulations leave considerable room for interpretation, he says, but if leading companies can be encouraged to take a progressive approach to compliance, then this will provide powerful leverage on other firms.

    Auditors' interpretation of the standards will be fundamental to the quality of implementation. But Mr Zadek observed that there is often a division within the largest accounting firms between those who want to stick to auditing numbers and those who see opportunities in offering assurance based on long-term value drivers.

    The ASB standards will be an important factor in determining how auditors carry out their work, Mr Zadek said.

    He described the proposed regulations as a "reasonable enabling framework" that could influence practice in bigger arenas, including the EU accounts modernisation Directive and the Sarbanes-Oxley Act in the US which also imposes reporting and accountability obligations (ENDS Report 331, pp 24-26 ).

    However, he stressed, companies' willingness to engage would be the key determinant of achieving the OFR's aims. "We must not fall back into 1980s mentality in thinking that public policy defines practice. If we have learned nothing else we have learned that [best] practice drives policies."

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