Briefing: the Operating and Financial Review
and company reporting under UK law
ClientEarth* briefing, July 2010
The UK government has announced that it intends to reinstate the Operating and Financial
Review (OFR) in UK company reporting. It has also committed to investigate supplementary
steps to improve corporate accountability and transparency:
“We will reinstate an Operating and Financial Review to ensure that directors’ social and
environmental duties have to be covered in company reporting, and investigate further ways of
improving corporate accountability and transparency.” 1
The UK government’s willingness to make regulatory changes and its commitment to take further
steps in order to ensure that companies provide useful and relevant information on long-term
issues – such as environmental and social considerations – is welcome and much needed.
Reinstating the OFR framework as previously designed cannot achieve the coalition
government’s stated aim in taking this initiative – it cannot ‘ensure that directors’ social and
environmental duties have to be covered in company reporting’. The existing framework under
the Companies Act 2006 is similarly inadequate. The legal framework must be adequate to its
task.
There are a number of key factors that will determine the efficacy of any legal framework for
company narrative reporting on these matters, and that will determine how successfully it can
achieve the government’s stated goals. There are straightforward legislative and other steps that
can be taken to address each of these factors:
•
It is essential that the information in company reports is fair, balanced and comprehensive
– statutory requirements must be in place to that effect, and these requirements must be
objective standards.
•
Making sure that companies provide enough information on environmental and social
issues, and the right kind of information on these issues, is vital – statutory provisions
*
ClientEarth is an independent, non-profit organisation of lawyers working to secure a healthy planet. For more
information please visit www.clientearth.org.
1
must be made to set out the various environmental and social issues that must be covered
in company reports.
•
The proper use of quantitative Key Performance Indicators is a key part of non-financial
reporting – mandatory provisions must set out the way that they are to be used in
company reports.
•
Implementation of the law is fundamental to the effect of the law – the regulator
responsible for monitoring and ensuring compliance with the law – the Financial Reporting
Review Panel – must be capable of doing so, and must take positive action to enforce legal
requirements for company reports.
•
Verification of the information in company reports is essential to ensuring their reliability –
the mandatory audit should be expanded, and steps must be taken to enhance the
capability of the audit profession to provide a challenging voice to the judgements of
management in company reporting, particularly with regard to information on
environmental and social issues.
The Secretary of State has broad existing powers to make provision by secondary legislation as
to the reports that companies are required to prepare. No new primary legislation is required to
implement the government’s vision.
In this briefing, ClientEarth outlines background to the OFR; makes recommendations on the key
factors that will determine the effectiveness of the legal framework that the government
introduces; and sets out the Secretary of State’s legal powers for reforming this area of law
using secondary legislation. The annexes provide supplemental detail and background
information.
2
CONTENTS
1
Introduction
4
2
Background: the UK government’s stated legislative goal, the
5
purpose of company reporting & the Companies Act 2006
3
2.1
The UK government’s stated legislative goal
5
2.2
The statutory purpose of company reporting
5
2.3
The Companies Act 2006: central policy objectives
6
Key features for an effective OFR framework
7
3.1
The content of reports
7
3.1.1
7
Ensuring a fair, balanced and comprehensive review – a
question of objectivity
3.1.2
Specific requirements relating to environmental and social
10
matters
3.1.3
3.2
Regulating the use of Key Performance Indicators
Enforcement of legal requirements & verification of information
12
13
provided in company reports
3.2.1
Enforcement of legal requirements: the Financial Reporting
13
Review Panel
3.2.2
4
Verification of information: enhancing the audit
Powers and procedures to make secondary legislation under the
14
17
Companies Act 2006
4.1
Powers
17
4.2
Parliamentary procedure
17
ANNEXES
19
Annex A:
The development of the Operating and Financial Review
19
Annex B:
Key features of the previous Operating and Financial Review
20
framework
Annex C:
Comparison of legal requirements under the previous OFR
23
framework and the current Companies Act 2006
3
1
Introduction
The Operating and Financial Review (OFR) is a way for companies to prepare and publish
narrative, non-financial information in their annual reports. Specifically, the OFR has been
described as a narrative explanation of the main trends and factors underlying the development,
performance and position of a company, and those which are likely to affect the company’s
future development, performance and position.2
At one stage, ‘quoted companies’3 were required by law to prepare an OFR, and the law set out
requirements as to what the OFR had to contain. These requirements came into law in April
2005, but were repealed less than a year later, taking effect in January 2006.4
The Companies Act 2006 was introduced later that year, which introduced requirements for
company reporting, in the shape of the ‘directors’ report’ and ‘business review’ requirements.
Quoted companies are required to produce a directors’ report, which must contain a business
review. In this revised format, the Companies Act 2006 reinstated many of the previous OFR
framework’s requirements as to what information must be included in the company reports of
quoted companies.5
The Companies Act 2006 provides the Secretary of State with a range of powers to introduce
secondary legislation regarding company reporting.
4
2
Background: the UK government’s stated legislative goal, the purpose
of company reporting & the Companies Act 2006
2.1 The UK government’s stated legislative goal
The government’s stated intention for reinstating the OFR is to “ensure that directors’ social and
environmental duties have to be covered in company reporting”. 6
Directors’ current social and environmental duties under statute are set out in section 172
Companies Act 2006. Section 172 requires that a director of a company must act in the way he
considers, in good faith, would be most likely to promote the success of the company for the
benefit of its members as a whole, and in doing so have regard (amongst other matters) to:
-
the likely consequences of any decision in the long term;
-
the interests of the company’s employees;
-
the need to foster the company’s business relationships with suppliers, customers and
others;
-
the impact of the company’s operations on the community and the environment;
-
the desirability of the company maintaining a reputation for high standards of business
conduct; and
-
the need to act fairly as between members (shareholders) of the company.
2.2 The statutory purpose of company reporting
The statutory purpose of the current narrative reporting requirements under the Companies Act
2006 is to allow shareholders of the company to assess the performance of the company’s
directors, in relation to their statutory duty under section 172.7
The purpose of the previous OFR framework was stated as to assist shareholders to assess the
strategies adopted by the company and the potential for those strategies to succeed, although it
was also stated that the information disclosed in the OFR would also be of relevance to other
stakeholders.8
It has been argued in the past that the statutory purpose of narrative reporting should be
extended to serving the informational needs of further classes of people, such as the markets
and potential investors in the company, ‘ethical’ investors, potential customers or other
stakeholders.9
5
2.3 The Companies Act 2006: central policy objectives
The statutory duties of directors under section 172 Companies Act 2006, and the business
review requirements of section 417 Companies Act 2006 were introduced to address key policy
objectives that underpinned the Companies Act 2006 – ‘enhancing shareholder engagement and
a long-term investment culture’, and embedding the concept of ‘enlightened shareholder
value’.10
The government white paper from which the Companies Act 2006 evolved stated:
“Shareholders are the lifeblood of a company, whatever its size. We want to promote
wide participation of shareholders, ensuring that they are informed and involved, as
they should be. And we want decisions to be made based on the longer-term view
and not just immediate return. We will...embed in statute the concept of Enlightened
Shareholder Value by making clear that directors must promote the success of the
company for the benefit of its shareholders, and this can only be achieved by taking
due account of both the long-term and short-term, and wider factors such as
employees, effects on the environment, suppliers and customers...”
Sections 172 and 417 were particularly key to the realisation of these policy goals. Section 172
as the statutory provision for the duty of directors to promote the success of the company in
these ways, and section 417 as an attempt to ensure that shareholders had the information to
make a judgement regarding how the directors had performed in relation to that duty, and thus
to enhance shareholder engagement and a long-term investment culture.
6
3
Key features for an effective OFR framework
There are a number of key features that must be in place in order to construct an effective legal
framework for company narrative reporting. These issues will need to be addressed if the
government is to achieve its goals in this area, and put an effective legal framework in place.
• It is essential that the information in company reports is fair, balanced and comprehensive –
statutory requirements must be in place to that effect, and these requirements must be
objective standards.
• Making sure that companies provide enough information on environmental and social issues,
and the right kind of information on these issues, is vital – statutory provisions must be
made to set out the various environmental and social issues that must be covered in
company reports.
• The proper use of quantitative Key Performance Indicators is a key part of non-financial
reporting – mandatory provisions must set out the way that they are to be used in company
reports.
• Implementation of the law is fundamental to the effect of the law – the regulator
responsible for monitoring and ensuring compliance with the law – the Financial Reporting
Review Panel – must be capable of doing so, and must take positive action to enforce legal
requirements for company reports.
• Verification of the information in company reports is essential to ensuring their reliability –
the mandatory audit should be expanded, and steps must be taken to enhance the
capability of the audit profession to provide a challenging voice to the judgements of
management in company reporting, particularly with regard to information on environmental
and social issues.
3.1 The content of reports
3.1.1 Ensuring a fair, balanced and comprehensive review – a question of
objectivity
It is essential that the information in company reports is fair, balanced and comprehensive.
Unless it is, those relying on the reports will be unable to make informed decisions or
judgements about how company management is conducting the business of the company.
7
The legal framework for company reporting must ensure that companies are not able under law
to prepare and publish inaccurate, misleading or materially incomplete narrative reports, whether
as a result of intention, recklessness or negligence.
Under the Companies Act 2006, there is a statutory requirement that “[t]he business review
must contain — a fair review of the company’s business”.11 The Companies Act 2006 also
requires that “[t]he review required is a balanced and comprehensive analysis of (a) the
development and performance of the company’s business during the financial year, and (b) the
position of the company’s business at the end of that year, consistent with the size and
complexity of the business”.12
In ClientEarth’s view, these provisions must be understood as objective standards: as requiring a
fair review and balanced and comprehensive analysis as it would be understood by a ‘reasonable
director’; or as requiring an objectively fair review, and objectively balanced and comprehensive
analysis – i.e. what the courts judge to be fair, balanced or comprehensive in the specific
context. This is necessary in order for the reporting framework to function effectively and
achieve its goals.
The alternative – that these standards relate only to the subjective judgements of the particular
directors writing the reports – would result in an inadequate and unenforceable legal framework,
and one which would render the business review framework incapable of fulfilling its statutory
purpose.
A subjective standard would relate only to the actual understanding or belief of the given
director (or board of directors) in reality. So an individual director’s (or board of directors’)
judgement as to what constitutes a ‘fair review’ of the business would be the test for compliance
with the law, regardless of how deficient that judgement was. Only in the case that the directors
did not believe the review to be fair, and where this could be demonstrated with evidence, would
reports be non-compliant with the law.
A subjective standard cannot ensure that adequate information is provided to shareholders as
necessary to achieve the statutory goal of the business review or the government’s stated goal
for reform. If a director is negligent or ignorant to matters that have a very real relationship with
the success of the company, that negligence or ignorance cannot be the yardstick of compliance
with the law, and cannot be allowed to frustrate the statutory and practical purpose of company
reporting. Shareholders or any other report users still need adequate and reliable information on
matters that in fact have bearing on the business of the company, and they need information
that allows them to make a judgement as to how directors have performed in relation to their
statutory duty to promote the success of the company. The law cannot be designed in such a
8
way that a company report can ignore issues that are objectively key to the company’s business,
and would be regarded as such by any reasonable director, and still be compliant with the law;
or that a company report can present analysis that is clearly lacking fairness, balance, context or
completeness, and would be regarded as such by any reasonable director, and still be compliant
with the law.
Arguably more importantly, a subjective standard would be almost entirely unenforceable in
practice. It would be impossible in most circumstances to prove, where a set of reports neglect a
key business issue, that the directors had not in fact believed those reports to be a fair review,
or to be balanced and comprehensive. This question of compliance would turn on hard evidence
to the effect that a given director or board of directors had in fact recognised that a material
omission had been made, or had not in fact truly believed that the review was ‘fair’ (for
example), but had chosen to publish non-compliant reports nonetheless. This leaves far too large
a gap for directors to knowingly underplay or omit key issues in their reports, because of the
extreme difficulty that would be had proving that they did so intentionally and misleadingly,
rather than on account of a genuine judgement or belief.
Further, if directors are required only to present a view of the business as they subjectively see
it, and only to include information that they subjectively deem to be relevant to the business,
there is no prospect for information or perspectives being included that challenge the decisions,
judgements and actions of company management. This would render the framework incapable
of achieving its current statutory purpose.
Subjective standards would also be contrary to another of the key statutory duties of directors’ –
to exercise reasonable care, skill and diligence under section 174 Companies Act 2006. Section
174 provides that this duty relates to the care, skill and diligence that would be exercised by a
reasonably diligent person with:
-
the general knowledge, skill and experience that may reasonably be expected of a
person carrying out the functions carried out by the director in relation to the company;
and
-
the general knowledge, skill and experience that the director has.13
The previous OFR framework
As it existed in 2005, the previous OFR framework required that the OFR be a balanced and
comprehensive analysis.14 However, it did not contain a legislative requirement that company
narrative reports must contain a fair review of the company’s business. Furthermore, the OFR
Reporting Standard (the provisions of which were ‘quasi-legal’ – see Annex B.2) contained
9
language that suggested a subjectivity to be applied in compliance judgements that would
potentially render the framework unenforceable, and could not ensure that companies
adequately disclosed on the environmental and social matters relevant to their businesses (see
Annex B.2).
Recommendations:
The central primacy of narrative reports constituting a fair, balanced and
comprehensive review of the business must be made clear, and the objective
nature of these standards must be strongly affirmed. These standards are
fundamental to the efficacy of the legal framework in providing the quality and
range of information that is needed by shareholders or others, and that is the
purpose of the legal framework. Whether these standards are questions of what
‘the reasonable director’ would view as fair, balanced and comprehensive, or a
more objective standard than that, it must be clarified that they do not relate to
the subjective view of any given director.
3.1.2 Specific requirements relating to environmental and social matters
If a legal framework is to ensure that directors’ social and environmental duties have to be
covered in company reporting, it is necessary that the social and environmental issues to be
covered in company reports be set out in law.
The Companies Act 2006 requires that the business review must, to the extent necessary for an
understanding of the development, performance or position of the company’s business, include
information about (i) environmental matters (including the impact of the company’s business on
the environment); (ii) the company’s employees; and (iii) social and community issues; including
information about any policies of the company in relation to those matters and the effectiveness
of those policies. There is no further detail provided in law as to what issues must be covered in
company reports.
The previous OFR framework
The previous OFR framework did not include any more specific requirements relating to the
provision of environmental and social information than the Companies Act 2006.
Furthermore, the provisions of the OFR Reporting Standard contained language that potentially
significantly watered down the specific requirements for information to be provided on
environmental and social matters (see annex B.2). The Reporting Standard explicitly stated that
10
“[i]t is for directors to consider how best to use the framework to structure the OFR and the
precise content, including the level of detail to be disclosed” (regarding, amongst other things,
environmental and social matters). It is not entirely clear how these provisions interacted with
the statutory requirements that the OFR be a balanced and comprehensive analysis.
Recommendations:
The UK government’s stated intention for reinstating the OFR is to ‘ensure that
directors’ social and environmental duties have to be covered in company
reporting’.15 Without further specific provision relating to environmental and social
matters, the government’s objectives are unlikely to be realised.
Supplemental provisions should be introduced in law to clarify the environmental
and social issues that companies must cover and the way that they must do so.
There are a number of ways in which this could be implemented, with relative
advantages and disadvantages to alternative approaches:
- Mandating the ‘Standard Disclosures’ of the Global Reporting Initiative’s
Sustainability Reporting Framework in relation to economic, environmental
and social matters. This is a strong approach, which would make a range of
specific narrative and quantitative disclosures on aspects of key
environmental and social matters mandatory for all companies.
- Introducing a framework for the reporting of environmental and social
issues that outlines the key matters – e.g. ecosystems impacts, water use,
community relations, human rights impacts – that it may be necessary to
report in order to comply with the existing business review / previous OFR
requirements, and the ways in which they must be understood to relate to
the business of the company – e.g. reputational risk, social licence to
operate, regulatory risk. This is a more flexible approach, and is dependent
on objective standards relating to fair, balanced and comprehensive review,
and on strong enforcement – particularly on the willingness of a regulatory
authority to make judgements regarding whether companies have omitted
discussion of material environmental or social matters. This is the approach
advocated by ClientEarth’s publication on company reporting under UK law
– ‘Environmental and social transparency under the Companies Act 2006:
Digging deeper’.16
11
3.1.3 Regulating the use of Key Performance Indicators
Key Performance Indicators (KPIs) are quantitative, non-financial factors by reference to which
the development, performance or position of a company’s practices can be judged.
If used correctly, KPIs can provide concise and solid data from which performance can be judged
on non-financial matters, providing a key compliment to the narrative discussion in company
reports.
However, the way that KPIs are used and explained is fundamental to their value; unless KPIs
are properly contextualised, explained, and used consistently, their usefulness is highly limited,
or they may even be misleading.
The previous OFR framework
Under the previous OFR framework, the OFR Reporting Standard included a number of specific
non-mandatory ‘comply or explain’ provisions relating to the use of Key Performance Indicators
(KPIs). The Reporting Standard provided that where a KPI were used:
-
the definition and its calculation method shall be explained;
-
its purpose shall be explained;
-
the source of underlying data shall be disclosed and, where relevant, assumptions
explained;
-
quantification or commentary on future targets shall be provided;
-
where information from the financial statements has been adjusted for inclusion in the
OFR, that fact shall be highlighted and a reconciliation provided;
-
where available, corresponding amount for the financial year immediately preceding the
current year shall be disclosed; and
-
any changes to KPIs shall be disclosed and the calculation method used compared to
previous financial years, including significant changes in the underlying accounting policies
adopted in the financial statements, shall be identified and explained.
These provisions were well judged. However, they were not binding; the ‘comply or explain’
approach limited enforceability, and limited the improvement that could be achieved in the use
of KPIs in company reporting.
Recommendations:
The requirements of the OFR Reporting Standard relating to KPIs should be
made mandatory, for wherever KPIs are used in company reports. Consistency,
12
comparability and contextualisation are absolutely fundamental to the value of
quantitative information in non-financial company reporting. It should not be
acceptable in law for companies to report in a way that does not ensure this.
3.2 Enforcement of legal requirements & verification of information
provided in company reports
3.2.1 Enforcement of legal requirements: the Financial Reporting Review Panel
In order for the law to be effective, it must be enforced. If the law cannot be or is not enforced,
in practical terms the legal requirements as to what company reports must include would be
rendered little more than guidance. An effective legal framework must include structures and
procedures that can monitor compliance with the law and enforce it where necessary.
The Financial Reporting Review Panel (FRRP) is the regulator responsible for making sure that
company accounts and reports are compliant with UK law.17 It was delegated statutory powers
for these purposes: the FRRP can require information and documentation from companies where
it suspects that company reports may be non-compliant,18 and it can make applications to court
for a declaration that company reports are non-compliant, and for an order that the reports be
amended.19
Under the current legal framework, the FRRP is the only person or body, other than the
Secretary of State, that has the legal powers and resources necessary to investigate, pursue and
secure compliance by companies with reporting requirements.20
Without the possibility of the law being enforced, the power of the law to achieve its goals is
minimal, and so given that persons or bodies other than the FRRP or the Secretary of State do
not have access to the courts to enforce the law, and do not have the extensive investigative
powers under statute that the FRRP or the Secretary of State do, the FRRP has a crucial role.
At present, the FRRP is not actively enforcing narrative reporting requirements. In 2008/09,21 the
FRRP reviewed 326 sets of accounts and wrote letters to 112 companies.22 The FRRP reported
that it questioned some companies regarding their reporting on the principal risks and
uncertainties facing the companies (in the context of the economic downturn and deteriorating
capital markets).23 The FRRP also judged the legal compliance of a number of narrative reports
to be doubtful.24 However, according to currently available information, the FRRP has not taken
any enforcement action in any of these cases. Where the FRRP identified a doubt as to legal
compliance, it reports that “[t]he Panel did not ask for a substantive response to the matters
raised but asked that they be considered when the directors prepare the companies’ next
13
financial statements if they were relevant or material to the company’s reporting”. 25 This is far
from the robust approach that is necessary to ensure compliance with a legal framework.
Further, there is no suggestion from any publicly available information that any of the FRRP’s
reviews or inquiries had specific regard to information provided by companies in relation to
environmental or social matters, or compliance with the requirements of the Companies Act 2006
relating to that information.
The previous OFR framework
The FRRP had the same regulatory role described above in relation to the previous OFR
framework.26 However, as the previous OFR framework was repealed so swiftly, the FRRP’s
activity in relation to the OFR was necessarily limited.
Recommendations:
The FRRP must be willing and able to take robust enforcement action where
companies do not comply with legal requirements. Accordingly, it requires
adequate capacity to take on this role in relation to environmental and social
reporting: adequate overall capacity to monitor compliance and proactively take
action, and adequately expert and independent capacity. It must also take
proactive steps to monitor and ensure compliance of company reports with legal
requirements for environmental and social reporting. For further discussion of
the FRRP and its role, see ClientEarth’s publication ‘Environmental and social
transparency under the Companies Act 2006: Digging deeper’. 27
3.2.2 Verification of information: enhancing the audit
In order for the information in company reports to be trusted and relied upon, it must be
checked and verified by independent parties.
The audit is an evaluation, by an independent person or company (the auditor), of the accuracy,
reliability and quality of a company’s accounts and reports. The auditor prepares an audit report
that must then be presented by the company alongside its accounts and reports. Statutory
requirements set out the scope of audit that must be undertaken and the content that the audit
report must contain. The auditor has extensive rights of access to information from the company
for these purposes.28
14
An adequate audit is a vital part of an effective reporting framework. It is one of the main ways
in which company reports can be scrutinised for accuracy, and for compliance with legal
requirements and standards. The audit should make sure that shareholders and others have a
second opinion on the analysis given by company directors in the annual reports, and the auditor
should provide a voice of challenge to the claims and judgements of company management. The
audit is key to ensuring that company reports provide information that can be relied on.
The previous OFR framework included a higher standard of mandatory audit than is required
under the Companies Act 2006 (details below). The reason that this higher standard was
removed was the added cost to business that an enhanced audit of narrative reporting entails.29
However, despite costs, it remains the case that an adequate standard of audit is a vital part of
an effective reporting framework. Without it, there must be serious doubts as to the standard
and reliability of information that the framework can ensure.
Under the Companies Act 2006, the mandatory audit is limited to making a statement of whether
the narrative information provided by the company is consistent with the backward-looking
financial information in the company accounts.30 If there are omissions or misstatements in the
broad narrative of company reports, it is highly unlikely that they are demonstrably inconsistent
with narrow, backward-looking financial information. Only a narrow class of the most serious
narrative misstatements would be identified by this scope of investigation and assessment.
Adequate verification of or challenge to the accuracy and quality of judgements made about
environmental or social matters requires reference to a far broader range of information. The
audit requirements of the Companies Act 2006 can therefore provide only extremely limited
verification for the accuracy of the narrative provided in company reports.
Furthermore, there are currently practical limitations to the effectiveness of the audit, particularly
with regard to company reporting on environmental and social matters. In practice, it is widely
considered that the audit profession is not currently fulfilling its intended role adequately in
relation to all company disclosure.
The Financial Services Authority and Financial Reporting Council recently issued a discussion
paper on this matter, in which a number of these concerns are highlighted:
“In some cases the FSA has seen concerning valuations, provisions and disclosures, the
auditor’s approach seems to focus too much on gathering and accepting evidence to support
managements’ assertions, and whether managements’ valuations and disclosures comply with
the letter of accounting standards, rather than whether the standards’ requirements have
been applied in a thoughtful way that would better meet the standards’ objectives. In some
areas, it can be questioned whether auditors always exhibit sufficient professional
scepticism.”31
15
The Chief Executive of the Financial Reporting Council also recently identified one of the key
structural problems that constrain the voice of auditors:
“...there are clearly some key issues that we need to address: How do we achieve a strong
alignment between the auditor and the interests of the shareholder? Shareholders are remote
from audit. Management are in the room.” 32
There is also a question as to whether the mainstream auditing profession is currently
adequately equipped to address the new challenges presented by the auditing of reports on
environmental and social matters. The firms that carry out the majority of audits on the reports
of quoted companies bring financial accounting expertise to the table. But are these firms and
individuals yet well placed to ensure the adequate integration of environmental or social matters
into business reporting, and to make judgements as to the adequacy of company reports’
treatment of these matters?
The previous OFR framework
The previous OFR framework required a higher standard of audit of the narrative information
provided in company reports than is now required under the Companies Act 2006.
The previous OFR framework required that, as well as making a statement regarding the
consistency of narrative reports with the company’s accounts, auditors had to state whether any
information had come to their attention during the performance of the audit that was
inconsistent with the narrative information given in the operating and financial review.33 This
standard of mandatory audit provides considerably greater scope for scrutiny and meaningful
verification of the accuracy of the information provided in the narrative reports than that of the
Companies Act 2006.
Recommendations:
An adequate audit of company reports is fundamental to ensuring that the
information contained in them is reliable for the use of shareholders and others.
As such, the mandatory audit under law should be expanded so as to ensure
that auditors can provide proper scrutiny to the information contained in
company reports. Furthermore, initiatives must be undertaken and supported so
as to ensure that the audit profession is up to this role in practice, both
particularly in relation to company reporting on environmental and social
matters, and more broadly in providing a truly challenging voice to the
judgements of company management in company reports.
16
4
Powers and procedures to make secondary legislation under the
Companies Act 2006
The Secretary of State has broad powers to make provision by secondary legislation as to the
reports that companies are required to prepare. Regulations made to implement the
government’s vision and address the key factors outlined above would be subject to affirmative
resolution procedure in Parliament.
4.1 Powers
Section 468 Companies Act 2006 provides the Secretary of State with comprehensive powers to
make legal provisions, by regulations, about the reports that companies are required to prepare.
Section 468(1) provides that the Secretary of State may make provision by regulations about the
accounts and reports that companies are required to prepare; the form and content of the
accounts and reports that companies are required to prepare; the categories of companies
required to prepare accounts and reports of any description; and the obligations of companies
and others as regards and aspect of the procedure for approving, sending, laying, delivering and
publishing the accounts and reports.
Section 468(2) explicitly provides that the Secretary of State may add to, alter or repeal
provisions of the Companies Act 2006 in relation to company reporting.34
The only statutory limitations on these powers are that regulations may not amend: the
requirement for financial accounts to give a ‘true and fair view’ under section 393 Companies Act
2006; or the provisions relating to the Secretary of State’s powers to seek revision of defective
accounts and reports.35
The wording of section 468 Companies Act 2006 is clear, and gives specific and highly extensive
powers to the Secretary of State to make provision for company reporting by regulations.
Limitations under the common law are therefore minimal.
Section 416(4) Companies Act 2006 also specifically provides the Secretary of State with powers
to make provisions by regulations as to additional matters that must be disclosed in a directors’
report.
4.2 Parliamentary procedure
Regulations made by the Secretary of State under the Companies Act 2006 regarding company
reporting are subject to either affirmative or negative resolution procedure in Parliament.
17
Where regulations seek to make reporting requirements more onerous than previously, as must
be the case in order to achieve the government’s stated objectives and address the key matters
identified above, the regulations are subject to affirmative resolution procedure.36 Therefore in
order for the regulations to pass into law, the government must lay draft regulations before each
House of Parliament, and the draft regulations must be approved by resolutions in both
Houses.37
18
ANNEXES
Annex A:
The development of the Operating and Financial Review
The Operating and Financial Review (OFR) is a narrative explanation, provided by companies in
their annual report, of the main trends and factors underlying the development, performance
and position of a company, and those which are likely to affect its future development,
performance and position.38 The preparation of OFRs has been required, governed or guided in a
number of ways since the concept first developed. It has gone from voluntary, to mandatory,
back to voluntary, and the UK government has now announced its intention to make it
mandatory again.
The OFR originally existed as a ‘Reporting Statement’, made by the Accounting Standards
Board39 in July 1993.40 At this stage there was no mandatory requirement to prepare an OFR –
the Reporting Statement was an outline of 'best practice' for companies when preparing the
narrative sections of their annual reports.
The legal requirements for quoted companies to produce an OFR, and what was to be included
in the OFR, were introduced by secondary legislation in March 2005 (effective from April 2005
onwards). However, these requirements were repealed less than a year later, taking effect in
January 2006.41
The OFR ‘reporting standard’ (see Annex B) was converted to a ‘reporting statement’, which
serves as best practice guidance to companies when preparing their reports.
19
Annex B:
Key features of the previous Operating and Financial Review
framework
When the OFR was originally made mandatory in 2005, the ‘OFR framework’ consisted of
mandatory statutory requirements for the OFR’s publication and content, introduced by the
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations
2005 (the ‘previous OFR Regulations’), and a more detailed ‘Reporting Standard’, produced by
the Accounting Standards Board, the provisions of which were quasi-legal (explained further
below).
The previous OFR statutory requirements applied to UK-based ‘quoted’ companies. Quoted
companies are those companies which are listed on the UK stock exchange, listed in a state in
the European Economic Area, or listed on one of the major New York stock exchanges.42
Narrative reporting under the previous OFR requirements was subject to a higher standard of
scrutiny than it is under the Companies Act 2006, via an enhanced statutory audit.
B.1
Legal requirements for content
•
The previous OFR Regulations required that all quoted companies prepare an OFR.
•
The previous OFR Regulations also set out mandatory legal requirements as to what
information needed to be included in OFRs prepared by quoted companies.
•
These content requirements were broadly similar to the requirements subsequently
introduced for quoted companies by the Companies Act 2006 for the preparation of an
‘enhanced business review’, with some exceptions. A table setting out a side-by-side
comparison of the content requirements of the two frameworks can be found in Annex C.1.
•
A fundamental omission from the previous OFR statutory requirements, differing from the
business review requirements of the Companies Act 2006, was that they did not include a
requirement that the OFR contain a fair review of the company’s business.
B.2
•
The ‘Reporting Standard’
The statutory requirements relating to the preparation of OFRs were supplemented by a
Reporting Standard (‘RS1'),43 issued by the Accounting Standards Board (ASB).
•
The business review requirements of the Companies Act 2006 are not supplemented by any
Reporting Standard.
20
•
RS1 consisted of a set of reporting ‘principles’, a ‘disclosure framework’ to guide directors
when preparing OFRs, and a section relating to Key Performance Indicators (‘KPIs’).44 RS1
was also accompanied by ‘implementation guidance’, which was not technically a part of
RS1.
•
The content of RS1 had quasi-legal status. The principles and imperatives contained in them
were not strictly legal requirements. Companies were not required by law to report in
accordance with RS1 – they could depart from it when preparing their reports, provided that
they explained how and why.45 However, compliance with RS1 was presumed to constitute
compliance with statutory requirements.46
•
RS1 set out a number of principles relating to the OFR, ‘regarded as essential to the
preparation of an OFR’.47 These principles were broadly expressed. They were principles,
not rules – meaning that flexibility was inbuilt. The generality and malleability of the
principles had obvious implications for the possibility of making judgements as to
compliance. The extent to which the principles can be regarded as anything but guidance is
therefore questionable.
•
The ‘disclosure framework’ in RS1 set out some key content elements for an OFR. However,
RS1 stated that “[t]his framework is not a template... Its purpose is to set out the key
content elements that shall be addressed within an OFR. It is for directors to consider how
best to use the framework to structure the OFR and the precise content, including the level
of detail to be disclosed, relating to the key elements, given the particular circumstances of
the entity”.48
•
RS1 also included a number of rules relating to the use of Key Performance Indicators,
setting out how companies should define, explain and contextualise KPIs that they use. As
discussed, these rules were quasi-legal – they were non-mandatory, but where companies
departed from them, they were required to state how and why.
Concerns relating to enforceability
•
There were a number of provisions in the OFR Reporting Standard (‘RS1’) that in
ClientEarth’s view deferred to a concerning degree to the subjective judgements of the
directors preparing the reports, and put the ability of the legal framework to achieve its
intended goals at serious risk.
•
RS1 set out as its first principle:
21
Reporting Standard 1: Operating and Financial Review
5.
The OFR shall set out an analysis of the business through the eyes of the board of
directors.49
•
RS1 also stated, regarding the ‘disclosure framework’ (the section in which RS1 addresses
the requirements for the OFR to include information on environmental and social matters),
that [emphasis added]:
Reporting Standard 1: Operating and Financial Review
27.
This framework is not a template... Its purpose is to set out the key content elements that
shall be addressed within an OFR. It is for directors to consider how best to use the framework to
structure the OFR and the precise content, including the level of detail to be disclosed, relating to
the key elements, given the particular circumstances of the entity.50
B.3
•
The enhanced audit
The previous OFR Regulations required a higher standard audit of the narrative information
provided in company reports than is required under the Companies Act 2006. A table setting
out a side-by-side comparison of the audit requirements of the two frameworks can be
found in Annex C.2.
•
The audit is an evaluation, by an independent person or company (the auditor), of the
accuracy, reliability and quality of the company accounts and reports. The auditor prepares
an audit report that must then be presented by the company alongside its accounts and
reports. It is one of the main ways in which company reports are scrutinised for legal
compliance and accuracy. Statutory requirements set out the scope of audit that must be
undertaken and the content that the audit report must contain.
•
The OFR Regulations required that, as well as making a statement regarding the consistency
of the narrative reports with the company accounts, auditors had to state whether any
information had come to their attention during the performance of the audit that was
inconsistent with the narrative information given in the operating and financial review.51 This
standard of mandatory audit provides considerably greater scope for scrutiny and
meaningful verification of the accuracy of the information provided in the narrative reports
than that of the Companies Act 2006.
22
Annex C:
Comparison of legal requirements under the previous OFR
framework and the current Companies Act 2006
Below is a side-by-side comparison of the statutory requirements that were applicable to quoted
companies under the previous OFR framework, and those currently applicable to quoted
companies under the Companies Act 2006.
C.1
•
Legal requirements for content
The requirements regarding what information needed to be included in company reports
under the previous OFR Regulations were broadly similar to the current requirements on
quoted companies under the Companies Act 2006 for the preparation of an ‘enhanced
business review’, with some exceptions.
Previous OFR requirements
An operating and financial review must be a balanced
and comprehensive analysis, consistent with the size
and complexity of the business, of:
•
the development and performance of the business
of the company during the financial year,
•
the position of the company at the end of the
year,
•
the main trends and factors underlying the
development, performance and position of the
business of the company during the financial year,
and
•
the main trends and factors which are likely to
affect the company's future development,
performance and position...52
An operating and financial review must be... prepared
so as to assist the members of the company to assess
the strategies adopted by the company and the
potential for those strategies to succeed.55
-
Business review requirements under the
Companies Act 2006 (as applicable to
quoted companies)
The review required is a balanced and comprehensive
analysis of—
•
the development and performance of the
company’s business during the financial year, and
•
the position of the company’s business at the end
of that year,
consistent with the size and complexity of the
business.53
[T]he business review must, to the extent necessary
for an understanding of the development, performance
or position of the company’s business, include—
•
the main trends and factors likely to affect the
future development, performance and position of
the company’s business...54
The purpose of the business review is to inform
members of the company and help them assess how
the directors have performed their duty under section
172 (duty to promote the success of the company).56
The business review must contain—
•
a fair review of the company’s business57
23
The review must include •
a statement of the business, objectives and
strategies of the company;
•
a description of the resources available to the
company;
•
a description of the principal risks and
uncertainties facing the company; and
•
a description of the capital structure, the treasury
policies and objectives and the liquidity of the
company.58
To the extent necessary to comply with the general
requirements [set out above]...
The review must include •
information about environmental matters
(including the impact of the business of the
company on the environment);
The business review must contain—
•
a description of the principal risks and
uncertainties facing the company.59
[T]he business review must, to the extent necessary
for an understanding of the development, performance
or position of the company’s business, include—
information about—
•
environmental matters (including the impact of the
company’s business on the environment),
•
information about the company's employees, and
•
the company’s employees, and
•
information about social and community issues.
•
social and community issues,
...[and] must, in particular, include •
information about the policies of the company in
each area mentioned [above], and
•
information about the extent to which those
policies have been successfully implemented.60
To the extent necessary to comply with the general
requirements [set out above]...
The review must also include •
information about persons with whom the
company has contractual or other arrangements
which are essential to the business of the
company; and
•
information about receipts from, and returns to,
members of the company in respect of shares held
by them.62
The review must include analysis using financial and,
where appropriate, other key performance indicators,
including information relating to environmental matters
and employee matters.
"key performance indicators" means factors by
reference to which the development, performance or
position of the business of the company can be
measured effectively.64
including
•
information about any policies of the company in
relation to those matters and the effectiveness of
those policies.61
[T]he business review must, to the extent necessary
for an understanding of the development, performance
or position of the company’s business, include—
•
subject to subsection (11), information about
persons with whom the company has contractual
or other arrangements which are essential to the
business of the company...
...(11) Nothing in subsection (5)(c) requires the
disclosure of information about a person if the
disclosure would, in the opinion of the directors, be
seriously prejudicial to that person and contrary to the
public interest.63
The review must, to the extent necessary for an
understanding of the development, performance or
position of the company’s business, include—
•
analysis using financial key performance
indicators, and
•
where appropriate, analysis using other key
performance indicators, including information
relating to environmental matters and employee
matters.
“Key performance indicators” means factors by
reference to which the development, performance or
position of the company’s business can be measured
effectively.65
24
To the extent necessary to comply with the general
requirements, the review must, where appropriate,
include references to, and additional explanations of,
amounts included in the company's annual accounts.66
The review must, where appropriate, include
references to, and additional explanations of, amounts
included in the company’s annual accounts.67
The review must •
•
state whether it has been prepared in accordance
with relevant reporting standards, and
contain particulars of, and reasons for, any
departure from such standards.68
In relation to a group operating and financial review
this Schedule has effect as if the references to the
company (other than the last such reference in
paragraph 1) were references to the company and its
subsidiary undertakings included in the
consolidation."69
C.2
•
-
In relation to a group directors’ report this section has
effect as if the references to the company were
references to the undertakings included in the
consolidation.70
Audit requirements
The previous OFR Regulations required a higher standard audit of the narrative information
provided in company reports than is required under the Companies Act 2006 (see below).
Previous OFR requirements
If the company is a quoted company, the auditors
must state in their report •
whether in their opinion the information given in
the operating and financial review for the financial
year for which the annual accounts are prepared is
consistent with those accounts; and
•
whether any matters have come to their attention,
in the performance of their functions as auditors of
the company, which in their opinion are
inconsistent with the information given in the
operating and financial review.71
•
Business review requirements under the
Companies Act 2006 (as applicable to
quoted companies)
The auditor must state in his report on the company’s
annual accounts whether in his opinion the information
given in the directors’ report for the financial year for
which the accounts are prepared is consistent with
those accounts.72
Under the Companies Act 2006, the mandatory audit is limited to making a statement of
whether the forward-looking narrative information provided by the company is consistent
with the backward-looking financial information in the company accounts.73 This standard of
audit can provide only extremely limited verification for the accuracy of the narrative
provided in company reports.
25
•
The OFR Regulations required that, as well as making a statement regarding consistency
with the company accounts, auditors had to state whether any information had come to
their attention during the performance of the audit that was inconsistent with the narrative
information given in the operating and financial review.74 This standard of mandatory audit
provides considerably greater scope for scrutiny and meaningful verification of the accuracy
of the information provided in the narrative reports.
26
Notes
1
HMGovernment, 'The Coalition: our programme for government' (May 2010), p. 10
2
Accounting Standards Board Reporting Standard 1: Operating and Financial Review para 4
3
Those companies which are listed on the UK stock exchange, listed in a state in the European Economic Area,
or listed on one of the major New York stock exchanges (Companies Act 2006 s 385).
4
The effectiveness of the OFR framework was therefore never tested in practice.
5
See annex A.1
6
HMGovernment, 'The Coalition: our programme for government' (May 2010), p. 10
7
Companies Act 2006 s 417(2)
8
Accounting Standards Board Reporting Standard 1: Operating and Financial Review para b
9
See, for example, Hansard HC vol 450 col 881 (18 October 2006)
10
Secretary of State for Trade and Industry, ‘Company Law Reform’ (Cm 6456, 2005), p. 5
11
Companies Act 2006 s 417(3)(a)
12
Companies Act 2006 s 417(4)
13
Companies Act 2006 s 174
14
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 9
15
HMGovernment, 'The Coalition: our programme for government' (May 2010), p. 10
16
ClientEarth. Environmental and social transparency under the Companies Act 2006: Digging deeper (2010),
available at <http://www.clientearth.org/reports/environmental-and-social-transparency-under-the-companiesact-2006-digging-deeper.pdf>, or in hard copy directly from ClientEarth.
17
The FRRP is an operating body of the Financial Reporting Council (FRC), “the UK’s independent regulator
responsible for promoting high quality corporate governance and reporting to foster investment” (FRC website,
‘About the FRC’ <http://www.frc.org.uk/about/> accessed June 2010).
18
Companies Act 2006 s 459
19
Companies Act 2006 s 456
20
Statutory powers have been delegated to the FRRP from the Secretary of State for these purposes, by the
Companies (Defective Accounts and Directors’ Reports) (Authorised Person) and Supervision of Accounts and
Reports (Prescribed Body) Order 2008 SI 2008 / 623.
21
Year ending 31 March 2009.
22
Financial Reporting Review Panel, 'Review Findings and Recommendations - 2009' (2009)
23
Financial Reporting Review Panel, 'Review Findings and Recommendations - 2009' (2009), pp. 6-7
24
Financial Reporting Review Panel, 'Review Findings and Recommendations - 2009' (2009), p. 4
25
Financial Reporting Review Panel, 'Review Findings and Recommendations - 2009' (2009), p. 4
26
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 regs 17-18
27
Available at <http://www.clientearth.org/reports/environmental-and-social-transparency-under-the-companiesact-2006-digging-deeper.pdf>, or in hard copy directly from ClientEarth. Alternatively, see ClientEarth,
‘ClientEarth response to the Financial Reporting Council’s Draft Plan and Levy Proposals 2010/11’ (March 2010),
available at <http://www.clientearth.org/reports/environmental-justice-clientearth-response-to-the-financialreporting-councils-draft-plan-and-levy-proposals-2010.pdf> accessed June 2010.
28
As well as access at all times to company books, accounts and vouchers, an auditor may require any
information or explanations that they think necessary for the performance of their duties from a range of persons
currently or formerly related to the company. Auditors also have the right to oblige parent companies to take all
steps that are ‘reasonably open to it’ to secure any information or explanations that are necessary for the
27
purposes of the audit from a subsidiary (or employee of that subsidiary) not subject to UK law (Companies Act
2006 ss 500-502).
29
In 2005, government figures estimated that the enhanced audit would have cost business an extra £29.3
million per annum (EASC, ‘Operating and Financial Review (OFR) Regulations: Proposal to roll-back to EU
minima: Note to Chancellor’ (11 November 2005)).
30
Companies Act 2006 s 496
31
Financial Services Authority & Financial Reporting Council, ‘Discussion Paper 10/3: Enhancing the auditor’s
contribution to prudential regulation’ (June 2010)
32
Stephen Haddrill, 'Should statutory audit be dropped and assurance needs left to the market?' (Speech at the
ICAS Aileen Beattie Memorial Event, 28 April 2010)
<http://www.frc.org.uk/images/uploaded/documents/28%2004%2010%20%20Aileen%20Beattie%20Memorial%20speech%20-%20Stephen%20Haddrill.pdf> accessed June 2010.
33
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 10
34
Companies Act 2006 s 468(2)
35
Companies Act 2006 s 468(3)
36
Companies Act 2006 s 473
37
Companies Act 2006 s 1290
38
Accounting Standards Board Reporting Standard 1: Operating and Financial Review para 4
39
The Accounting Standards Board (ASB) is an operating body of the Financial Reporting Council (FRC), which is
the UK’s independent regulator responsible for promoting high quality corporate governance and reporting to
foster investment. The role of the ASB within the FRC’s mandate is to issue accounting and reporting standards.
40
Accounting Standards Board Reporting Standard 1: Operating and Financial Review Appendix C
41
The effectiveness of the OFR framework was therefore never tested in practice.
42
Companies Act 2006 s 385
43
Accounting Standards Board Reporting Standard 1: Operating and Financial Review (May 2005)
44
A Key Performance Indicator is a quantitative factor by reference to which the development, performance or
position of the business of the company can be measured effectively.
45
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 11
46
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 11
47
Accounting Standards Board Reporting Standard 1: Operating and Financial Review para c
48
Accounting Standards Board Reporting Standard 1: Operating and Financial Review para 27
49
Accounting Standards Board Reporting Standard 1: Operating and Financial Review para 5
50
Accounting Standards Board Reporting Standard 1: Operating and Financial Review para 27
51
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 10
52
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 9
53
Companies Act 2006 s 417(4)
54
Companies Act 2006 s 417(5)(a)
55
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 9
56
Section 417(2) Companies Act 2006. Section 172 Companies Act 2006 provides that “A director of a company
must act in the way he considers, in good faith, would be most likely to promote the success of the company for
the benefit of its members as a whole, and in doing so have regard (amongst other matters) to— (a) the likely
28
consequences of any decision in the long term, (b) the interests of the company’s employees, (c) the need to
foster the company’s business relationships with suppliers, customers and others, (d) the impact of the
company’s operations on the community and the environment, (e) the desirability of the company maintaining a
reputation for high standards of business conduct, and (f) the need to act fairly as between members of the
company”.
57
Companies Act 2006 s 417(3)(a)
58
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 9
59
Companies Act 2006 s 417(3)
60
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 9
61
Companies Act 2006 s 417(5)
62
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 9
63
Companies Act 2006 s 417(5)
64
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 9
65
Companies Act 2006 s 417(6)
66
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 9
67
Companies Act 2006 s 417(8)
68
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 9
69
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 9
70
Companies Act 2006 s 417(9)
71
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 10
72
Companies Act 2006 s 496
73
Companies Act 2006 s 496
74
Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 SI 2005 /
1011 reg 10
29
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June 2010
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30