OFR legislation adapted to fit closely with EU requirements

The Government announced its intention to implement a statutory OFR regime almost two years ago when it issued a White Paper in response to the independent review of company law (ENDS Report 330, pp 40-41 ). In two important respects, however, the policy context has moved on since Whitehall's wheels were set in motion.

First, a lack of parliamentary time for a major companies Bill persuaded Ministers to abandon plans to implement the statutory OFR through primary legislation. Second, an EU Directive on accounts modernisation was agreed last year, which from 2005 will place new requirements on companies to report on non-financial matters in directors' reports.

The DTI's draft regulations, to be laid before Parliament before the end of the year, seek to implement both sets of requirements through a single instrument, using powers already available to Ministers under the Companies Act 1985.1 The result is something of dog's dinner, with numerous amendments to existing statutes which themselves have already been amended several times.

Another consequence of using secondary legislation is that the regulations, likely to be laid before Parliament in the autumn, will be subject to only minimal scrutiny - although there will be debates in both Houses of Parliament after which Ministers will have to secure affirmative resolutions.

To the extent necessary...
In many respects the 2003 Directive reinforces the Government's approach to the OFR - although, awkwardly, it uses different terminology. Where the DTI's White Paper spoke of a need for directors to disclose information that they judge to be "material" to an understanding of the business, the Directive talks about information being included to "the extent necessary".

The Directive requires that a company's annual report must include a "fair review of the development and performance of the company's business and of its position, together with a description of the principal risks and uncertainties that it faces."

"To the extent necessary for an understanding of the company's development, performance or position", the Directive says, the analysis shall include both financial and non-financial key performance indicators, "including information relating to environmental and employee matters."

The EU Directive will apply to a wider range of companies than the statutory OFR requirement but the level of detail required is considerably smaller. To ensure that companies preparing an OFR will not also have to make a separate disclosure in their directors' report, the Government has dropped the use of the term "material", and its draft regulations now use the phrase "to the extent necessary".

The revised lexicon led the Government's OFR working group on materiality - which issued draft guidance last summer (ENDS Report 342, pp 52-53 ) - to delay publication of its final guidance so that it could take full account of the wording of the draft regulations.

Indeed, in its final guidance,2 the working group has even erased the word "materiality" from its own name, now just the Operating and Financial Review Working Group. Nonetheless, it says that its work on the principles and processes that may help directors make judgements on what to include in an OFR "remains valid".

The working group's guidance will feed into the preparation of reporting standards to be drawn up by the Accounting Standards Board. An exposure draft is due in the second half of 2004, and the standard is to be finalised next year.

In preparing the statutory standard, the ASB will also build on experience in drawing up its own best practice statement on the non-statutory OFR, issued in January 2003, which updated a statement dating from 1993. The ASB statement advises companies to discuss any objectives and strategy in the field of corporate responsibility, along with relevant performance indicators such as emission levels. There should also be a discussion identifying the principal risks facing the business - including those related to environmental, regulatory and reputational issues.

OFR content
Under the new statutory regime, companies required to prepare an OFR will have to state whether or not they have followed the ASB's new statutory standard. Compliance with the standard will be presumed to demonstrate compliance with the OFR requirements.

The Government has had to resort to primary legislation to implement this system. The Companies (Audit, Investigations and Community Enterprise) Bill, currently before the House of Lords, includes a clause to give Ministers the powers to specify a body to issue the relevant reporting standards.

The aim is to give companies an assurance that if they follow OFR standards they will be presumed, unless the contrary is proved, to have complied with the statutory requirement to prepare an OFR. Meanwhile, the draft regulations will require directors to explain any departures from the standards.

The draft regulations stipulate that the OFR will be a "balanced and comprehensive analysis" of the development and performance of the business. Among other things, the review must include a description of the principal risks and uncertainties facing the business.

In addition, "to the extent necessary" to meet the general requirement for a balanced and comprehensive analysis, the OFR shall include information - including key performance indicators - concerning employees, environmental matters and social and community issues.

Directors are free to decide not to report any information on employee, environmental and social issues. But the Government is considering adding a requirement to make directors state explicitly that they have decided there is nothing to report. "Silence would not be an option," the consultation document says, but directors would not be required to state their reasons for deciding a matter is not relevant.

Auditing and penalties
The consultation paper says that the role of auditors in providing quality assurance will be "critical" - but it acknowledges that "the very nature of the OFR, and the fact that it relies heavily on the directors' judgements, present particular challenges."

The role of auditors will centre on a review of the process used in preparing the OFR, as distinct from a review of the content. Auditors will be required to express an opinion on whether the directors have prepared the OFR after "due and careful enquiry". The auditors must satisfy themselves that each statement made in the OFR has been made after due consideration and is not inconsistent with the accounts and other matters that have come to the auditors' attention.

The DTI says it will be an offence for a director to knowingly or recklessly approve an OFR that does not comply with the legislation, leading to a fine of up to £5,000 in summary proceedings or an unlimited fine on indictment. The test stated in the regulations has two components. Directors will be guilty of an offence where they both:

  • Knew that the OFR did not comply or were reckless as to whether it complied, and

  • Failed to take all reasonable steps to prevent it from being approved.

    Under the regime, the Financial Reporting Review Panel will have powers to require information from companies in relation to the OFR. The Panel will also be able to obtain a court order requiring directors to revise a defective OFR. However, the consultation paper notes that, on some aspects of content, matters might not be clear cut and the enforcer could face practical difficulties.

    "The Government's expectation is that in practice difficulties should be capable of resolution without recourse to court action, as has been the case when revisions have been made to accounts following FRRP intervention," the paper says.

    Quoted companies only
    One important change in policy is that the Government has now decided that only quoted companies should be required to prepare an OFR - and that the requirement should apply irrespective of the company's size. In contrast, the 2002 White Paper proposed that the requirement should apply to public companies with a turnover above £50 million and at least 500 employees - and it would also apply to private companies with a turnover above £500 million and more than 5,000 employees.

    The DTI explains its change of tack by arguing that "increased transparency is likely to be more helpful" to shareholders of public companies, particularly for institutional investors. "The discipline of the market will also help to ensure that directors prepare high quality OFRs."

    By implication, therefore, Ministers appear to be saying that the OFR is less likely to have a positive influence on the governance of private companies. Another factor, however, is that the EU Directive will in any case require large private companies - with sales in excess of £22.8 million or more than 250 staff - to disclose non-financial issues in directors' reports.

    While the Directive applies to all medium and large companies, it allows Member States to exempt medium-sized companies from the requirement to publish non-financial performance indicators. The DTI is minded to apply this exemption in the case of private companies.

    Nonetheless, under the Government's plans, small and medium-sized quoted companies will have to prepare an OFR. "There is an argument that smaller listed companies might find the OFR a burden. However, the Government believes that the importance of improved governance for such companies outweighs that argument."

    The DTI expects the OFR requirement to apply to some 1,290 companies in total, the overwhelming majority of which are listed on the London Stock Exchange. It will also apply to British companies listed on European or US markets, but not those on OFEX or the Alternative Investment Market.

    More than 60% of listed companies already produce an OFR, according to a recent survey by Deloitte & Touche. However, the Government's company law review found that the content and rigour of reporting varies widely, with a significant proportion of large companies falling well short of meeting the ASB's recommended practice.

    The Government intends that the OFR should be produced as a separate self-standing report rather than being contained within another report such as the directors' report. It remains to be seen how many companies which currently produce sustainability or corporate social responsibility reports will continue to do so once the OFR requirement kicks in - or, conversely, whether the process of producing an OFR might encourage more companies to publish stand-alone sustainability reports. For its part, the DTI sees the OFR as "complementary to, and not a substitute for, such reports, which the Government continues to encourage on a voluntary basis."

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