The OFR - better reporting?
Senior researcher and consultant Leon Olsen, of the Ashridge Centre for Business and Society, explains the implications for the environment of the Operating and Financial Review
The government has proposed that all listed companies should prepare an Operating and Financial Review (OFR). Supported by quality assurance processes this should ensure that valuable information is included in the OFR, including environmental and employee matters, leading to a more rigorous approach to reporting on the most important non-financial issues - but will it be sufficient to meet the information needs of stakeholders?
The OFR is expected to become mandatory for almost 1,300 listed companies and must be part of their annual reports for years starting on or after 1 January 2005. The requirements are still only in a proposed bill and specifics may change. However, it is unlikely to alter significantly, as the proposals are part of consultation the government has had with key audiences for several years.
The purpose of the OFR should be "to enable shareholders to assess the strategies adopted by the company and its subsidiary undertakings and the potential for those strategies to succeed". The basic rationale for this is:
- Companies are run for the benefit of shareholders;
- Listed companies are run by directors appointed by and responsible to shareholders;
- Shareholders need information to hold directors to account; and
- Current mandatory reporting lacks important non-financial information to achieve this.
The OFR should "improve transparency and accountability, with improvements in the quality, timeliness and accessibility of information available for shareholders". Enlightened shareholders' information needs?
The government believes that the OFR will be useful for more than just shareholders. It states that good corporate governance "is a crucial element & in meeting wider public expectations about the behaviour of businesses as employers, suppliers and consumers of natural resources with social and environmental responsibilities". It goes on to assert that "it is through shareholders exercising informed influence over companies that their expectations and those of the wider community will best be met".
The central assumption is therefore one of enlightened shareholders needing information to hold companies and their directors to account, both for delivering long term shareholder value and for being good corporate citizens. The examples taken from the guidance document demonstrate this: There are many different stakeholder groups that may have the capacity to significantly affect the value of the business. They may do this directly or indirectly, by reflecting the norms and expectations that society has of business, anticipating future changes in consumer behaviour and influencing regulatory change. Foodstuffs is a good example, affecting both producers and retailers. Failure to understand consumer concerns around the possible health implications of pesticides, or more general concerns about obesity or genetically-modified foods, can significantly affect sales and damage customer brand perceptions. Conversely, recognition of these concerns can lead to brand reinforcement and increased sales and market share.
Another example is the safety and security - matters of great significance to customers of airlines and to airline companies. Substantial steps have been taken by airlines over many years to reduce their exposure to such risks, rendering air travel safer than many other forms of travel. The risks are constantly evolving and therefore it is likely that the OFR should include the directors' assessment of the significance of such matters today, but also in the future.Information in the OFR
The intended content and information in the OFR reflects this view of enlightened shareholders' information needs. If this view prevails it will probably generate OFRs that will meet wider information needs of more stakeholders, even if they have no legal protection of these needs.
The proposed regulation is supposed to form only an overall framework with very few detailed requirements for specific information. Such detail is devolved to forthcoming OFR standards, which in part will develop as best practice OFR reporting emerges.Directors' responsibility
The thrust of the legislation is to make directors responsible for considering what to include in the OFR. This is an attempt to avoid so-called 'boiler-plate reporting' and instead encourage reporting on what the directors of the company consider is of significant importance to the past, current and future performance of the company. In achieving this, directors must perform a process of "due and careful enquiry" to decide what should be included. The auditors of the company must confirm that in their opinion the directors have done this, thereby adding quality control to the process.
It is proposed that directors who are party to the approval of defective accounts, either deliberately or as a result of recklessness, commit an offence and may be liable to an unlimited fine. This has been the cause of some concern among businesspeople, especially as there are no generally accepted standards on what satisfactory reporting mean. An OFR standard is expected to be ready during 2005 in time for the first mandatory OFR in early 2006 (in annual reports for 2005). It is, however, unlikely that such a standard will be prescriptive, which could result in sustained uncertainty.Guidance document
As a result, practical guidance for directors has been prepared. This guidance is not prescriptive. It explains the principles and process directors can use to ensure that the OFR is up to standard.
For example, a company is fined a nominal amount for significant pollution incidences. The initial effect on the company is virtually negligible and thus, potentially, might appear not to require disclosure in the OFR. But the ongoing effect on the reputational value of the company is higher and, against this criteria would merit inclusion.
For a component manufacturer the 'promise' to the customer means delivering products that work, on time and at the best market price. For a retailer or branded goods manufacturer it may mean ensuring that the promise of trust and quality inherent in the brand is delivered to the customer and that the attributes are recognised by all stakeholders. By linking strategy to promises in this way it becomes possible to structure a framework supported by appropriate metrics, such as customer satisfaction and product performance. All of this is highly relevant for the OFR's objective.Reporting on environmental performance
In principle, environmental matters should only be included in the OFR if they are necessary for shareholder assessments of the development, performance and position of the company. However, directors should consider wider concerns. Other environmental matters that may be necessary to consider include:
- explanation of risk management approaches in relation to storing, transporting or use of hazardous or toxic substances that risk damaging the health of workers or others or polluting the environment;
- how a company that is a user of potentially scarce natural resources intends to reduce its dependency on them;
- current and likely future compliance record for companies operationally dependent upon legal consents for discharges to air, land or water; or
- explanation of risk management approaches to assess the operational impact on biodiversity where failure to avoid or mitigate damage would put development consents at risk.
There are a number of challenges that are worth noting:
- Even as there is a clear growth in enlightenment among shareholders it must be noted that at present most are not as enlightened as the draft regulation assumes.
- The requirements must therefore be seen as a route to enlightenment. By reporting on wider matters, companies and shareholders are believed to become more aware of them and incorporate them in decision-making. However, if this fails it is doubtful that the OFR will be useful, especially for stakeholders other than shareholders.
- The implication of the required process of "due and careful enquiry" by directors is uncertain. If this is so, how can directors and auditors decide if the process is satisfactory?
- Are financial auditors competent to do the intended independent review?
- OFR standards are intended to address some of these uncertainties, but must be expected to avoid prescriptive standards, thereby sustaining some uncertainties.
- With no trial period and the potential liability for directors being unlimited, it may prevent useful experimentation to develop good practice for OFRs.
It would therefore be wiser for the government to relax some of the more legally binding requirements, at least initially. This could include limitations to directors' liabilities or assurances that directors that in good faith experiment to make informative OFRs will not be committing criminal offences in the first 2-3 years of mandatory reporting.Don't hold your breath
The proposals for a mandatory OFR have a lot of merit. The focus on avoiding prescriptive regulation, concentrating on an enabling framework should be commended. The encouragement for directors to consider what is relevant for the OFR through a process that will be controlled by independent auditors is the right way forward. It must be expected that corporate reporting will improve substantially as a result of these new requirements.
But don't hold your breath. There will be a lot of push back from some companies, directors and business associations that oppose the need for further transparency and argue that it is additional unnecessary red tape. The Daily Telegraph has, for example, stated that the OFR will become the "Other Futile Report". Some push back may be warranted and result in a more phased introduction of the requirements. After all, it is at the moment still suggested regulation for public consultation.