Operating and Financial Review (OFR) Q&A

Environmental consultants ERM answer a few frequently asked questions about the up coming OFR.

WHAT IS AN OFR?
An annually produced document that provides details of a company's objectives and strategies, past performance and future prospects. It will include quantitative and qualitative information on a wide range of factors, which may be relevant in order for shareholders and stakeholders to understand the business. For example, company policy towards its employees, customers and suppliers, and company social and environmental performance will be included, where such information is necessary for an assessment of the company.

WHO HAS TO PRODUCE ONE?

Approximately 1290 quoted UK companies, listed on the London, New York and Nasdaq stock exchanges.

WHY?

According to a McKinsey Investor Opinion Survey (June 2000), investors are prepared to pay 18% more to invest in UK companies with good corporate governance, compared to companies with similar financial performance but with perceived poor corporate governance.

The OFR is therefore an opportunity for companies to demonstrate that they are well run, potentially giving them a competitive advantage in securing investment.

Almost all of the top 100 global companies by market capitalisation report on social and environmental issues in some form, although, 'the OFR will improve the quality of reporting and complete the corporate jigsaw to give investors a clearer picture' (Patricia Hewitt, Secretary of State for Trade and Industry, 2004). It will increase consistency between reporting styles (assuming guidelines are sufficiently prescriptive), facilitating comparisons between companies by investors. It will increase transparency and accountability, thus strengthening confidence in the market place. According to Rachel Jackson, Head of social and environmental issues for the Association of Chartered Certified Accountants (ACCA), 'if the legislation goes ahead as planned, it will enforce far wider disclosures of environmental and social risks than UK-listed companies have historically been required to make'.

Patricia Hewitt (2004) also notes that it will 'help the owners of the business to better understand their organisations, and think about how people perceive them'.

WHEN WILL IT COME INTO FORCE?

Companies will have to prepare an OFR for the first time for financial years beginning on or after January 1st 2005, according to draft regulations, published by the government on 5th May 2004.

WILL COMPLIANCE BE MANDATORY?

Yes. However the regulations give directors the discretion to decide that social and environmental information is not relevant to their company's OFR. But, if a company reports nothing on these areas, then it must make an explicit statement to that effect.

WHO WILL DECIDE ON WHAT'S INCLUDED IN THE OFR?

Company directors will decide on what is relevant to their particular business and therefore what needs to be published in their OFR (this has been referred to as what is 'material' to their business, although 'materiality' is not referred to specifically in the draft regulations). The Government prefers to follow the Modernisation Directive which talks about information being included 'to the extent necessary' for an understanding of the business, rather than the term 'material'. This also helps to avoid any confusion with the specific use of the word 'material' in the context of accounting. Company directors can follow guidelines such as the DTI's 'Practical Guidance for Directors', and 'The Guidance', which has been produced at the Government's request by the independent Working Group.

The Accounting Standards Board (ASB) will set standards for the OFR (i.e. rules for what the OFR contains). As a first step, an independent panel has been brought together to provide guidance about what information should be included. The ASB will issue an exposure draft of the first OFR standard in the second half of this year. This will be finalised by 1st January 2005.

HOW MUCH WILL IT COST?

Relatively little extra cost may be involved for companies that already produce stand-alone social and environmental reports.

During the Company Law Review, the Industrial Society carried out research with 5 companies which prepared OFRs along the lines initially produced by the Review. The general impression was that 'time and cost allocation was relatively minimal and not burdensome'.

WHO SHOULD BENEFIT?

Shareholders and vital stakeholders, such as employees, customers and environmental groups, who will have better information on a company's objectives, strategy, past performance and future prospects.

WILL IT REALLY MAKE AN IMPACT?

The OFR could, in theory, replace existing stand-alone sustainability reports. However, Business in the Community and other SRI analysts do not believe the shareholder driven OFR will replace the need for more detailed social and environmental reporting, which allows deeper analysis.

An ERM study (2001) found that 79 of the FTSE 100 companies reviewed publish at least some information on their website or through reports on a variety of social issues related to their business. This frequency of reporting, and its depth, is likely to have increased over the last three years.

Research carried out by the Industrial Society found that 'companies tend to have most of the required information to hand, or, in several cases, already publish it in some form, or at least have well established systems for compiling such information.'

British businesses publish nearly twice as many reports as those in the USA, and are well ahead of Europe. Another source estimates that approximately 60% of affected businesses already issue a review on a voluntary basis.

For these organisations, therefore, complying with the new regulations should not prove too problematic, depending on the specificity of the guidelines produced.

For those organisations that do not, however, report on their social and environmental performance, then yes, the OFR will make an impact. Greater costs are likely to be incurred, and education and support will be required at all levels of the company if their risks and opportunities are to be adequately reviewed.

WILL IT EXPOSE COMPANIES TO LIABILITY?

A poor record on environmental or health and safety matters, for example, could in theory adversely affect a company's standing and business prospects. For regulated sectors, non-compliance could potentially lead to loss of licence to operate, and in some cases, imprisonment for directors. The OFR requires such matters to be covered, both where they constitute a significant external risk to the company, and where the company's impact on others through its activities, products or services, affects its performance.

WHAT ARE THE POTENTIAL PROBLEMS?

  • OFRs could dilute what a number of the larger companies already publish, rather than build on existing best practice.
  • It becomes a mechanical exercise resulting in bland, minimalist statements.
  • The fact that OFRs rely heavily on directors' potentially subjective judgements.
  • The timetable. Regulations could come into force from 1st January 2005, but it may take time for companies to set up necessary performance measurement systems.
WILL OFRS BE REVIEWED?

The government will review OFRs after 5 years, with a view to widening the requirements to other companies.

WHAT HAS BEEN THE EXPERIENCE OF MANDATORY REPORTING IN OTHER COUNTRIES?

The 'National Regulation Economique' (NRE) is the French equivalent to the OFR. It came into affect from April 2002, obliging all companies listed on the primary French stock exchange (Bourse) to report on their EHS and social performance. Over half of these companies were already reporting on such issues, and, in many cases, broad sustainability reports required by the NRE replaced often more detailed information previously provided (i.e. the result of NRE was watered down and less specific information).

Teething problems were encountered when the NRE was first introduced. There was confusion as to how companies should comply, for example whether dual listing of companies could avoid compliance. Greater clarity was required in order to manage these initial problems.

The regulations are not enforced - companies are not penalised for failing to comply with the NRE. (The UK draft regulations note that company directors will be liable to fines if they do not comply, however this may not be the case in reality, due to monitoring costs etc?)

Financial auditors are mainly involved, as opposed to lawyers and environmental consultants. Independent consultants are favoured by many HSE directors to verify EHS and social data, because auditors of a company's financial data currently do not have sufficient experience. Financial directors generally have more power and influence, however, and financial auditors are looking to extend their influence in order to provide a fully integrated service to clients.

There are also OFR equivalents in the Netherlands and in Scandinavia.

WHAT ACTION CAN BE TAKEN NOW?

Until the ASB publishes its final standards, exactly what information must be included in each OFR will not be known for sure.

A certain amount of preparatory work can be done in the meantime however.

Companies not currently reporting on their environmental and social performance need to start gathering data, and reviewing their respective risks and opportunities.

For those companies that are already reporting, attention can be turned to what is considered material, or fundamental, to each business, and what therefore will be likely to be published in an OFR. There is an opportunity for companies to fix problems now, before having to report to the market, and prepare themselves for what they will have to do, come the beginning of next year.

REFERENCES

Press Releases

Accounting Standards Board (13/5/04) 'ASB announces the way forward on the Operating and Financial Review'

Press notice issued on behalf of the Operating and Financial Review (OFR) Working Group (5/5/04)

DTI news release (5/5/04) 'Hewitt announces new plans to strengthen corporate Britain'

Ethical Performance (6/5/04) 'Operating and Financial Reviews will be required from next year'

Websites

http://www.pwcglobal.com/

http://www.edie.net/library

http://www.frc.org.uk/asb/technical

http://www.dti.gov.uk - Draft Regulations on the Operating and Financial Review and Directors' Report



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