OFR update: the devil is in the lack of detail

At the end of November Gordon Brown announced that the government was
abandoning the mandatory Operating and Financial Review, replacing it with a
simpler business review in line with the minimum requirements of the European
Union Accounts Modernisation Directive.

The news was a surprise, not least because regulations were already in place,
requiring quoted companies to prepare a statutory OFR for financial years
beginning on or after 1 April 2005.

DTI plans

As stated in the Department of Trade and Industry’s Better Regulation:
Draft Simplification Plan, issued the day after Brown’s announcement, the
government expects that the key improvements in narrative reporting from the OFR
will be retained in the business review, but in a “less prescriptive and more
flexible form”. For example, the business review would include:

• information relating to employee, social and environmental matters where it
is material;

• a description of principal risks and uncertainties facing the company; and

• balanced and comprehensive analysis of the development, performance and
position of the business.

The DTI has estimated that removing the requirement for quoted companies to
produce an OFR and have it audited would reduce business costs by up to £33m per
year.

At the time of going to press in mid-December, the DTI was talking to
stakeholders about the business review, and hoping to make a parliamentary
announcement on the next steps before Christmas.

Current regulations

Statutory instrument number 1011/2005 introduced the OFR regulations for
quoted companies. It also set out the requirements for other companies for a
business review in the directors’ report. It says such reports must contain:

• a fair review of the business of the company; and

• a description of the principal risks and uncertainties facing the company.

It requires that the review should be “a balanced and comprehensive analysis”
of:

• the development and performance of the business of the company during the
financial year; and

• the position of the company at the end of that year, consistent with the
size and complexity of the business.

It also states: “The review must, to the extent necessary for an
understanding of the development, performance or position of the business of the
company, 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.”

What has been lost from the OFR

The OFR regulations, and the accompanying Reporting Standard 1 produced by
the Accounting Standards Board, would have required detailed reporting. Until
further guidance is provided, the level of detail needed in the Business Review
is uncertain, although it will inevitably be less than would have been required
in the mandatory OFR.

“The business review differs in that the OFR is more forward looking,
requiring more information on trends, policies and strategies over the long
term,” says Richard Slynn, partner at Allen & Overy. “The business review
refers to the financial year in question, although it does refer to risks facing
the company and that has an element of foresight in it.” The Companies Act has
also required the directors’ report to contain an indication of the likely
future development of the company and its subsidiaries. “Therefore, there are
some elements of forward-looking review [in the business review], though it’s
much less prominent than in the OFR,” Slynn says.

“RS1 was very specific about the things that would be required,” says Isobel
Sharp, audit partner at Deloitte. With the abolition of the statutory OFR,
directors will not necessarily have to report on community issues, the
regulatory environment, technological change, competitor or product information.

“The requirement to set out your objective and strategy ­ that is not as
clear as it was [under the OFR],” Sharp adds. The KPI requirement is also
softer, she believes, only requiring that non-financial KPIs are given where
appropriate to help understanding of the company. The overall effect on
narrative reporting could be dramatic. “We are talking potentially about having
just four paragraphs, and one or two KPIs,” Sharp says.

FRC’s response

The Financial Reporting Council said that once the government’s detailed
plans become clearer it will consider the implications and consult as
appropriate. The DTI has indicated that “voluntary guidance” will be developed.

The FRC’s statement following Brown’s announcement said: “The FRC has long
believed that the publication of a narrative explanation of a company’s
development, performance, position and prospects should be encouraged as an
important element of best practice in corporate reporting.”

It noted that the ASB first produced a statement of best practice in 1993
(updated in 2003) and that a significant number of FTSE-100 companies already
publish an OFR. It concluded: “Regardless of whether or not an OFR is a
statutory requirement, the FRC’s view of best practice remains unchanged. RS1 is
the most up-to-date and authoritative good source of best practice guidance for
companies to follow.”

Companies that have already put effort into preparing for their first
statutory OFR may still decide they can gain market benefits by reporting more
fully than they would need to under the Business Review requirements.

Furthermore, given the uproar from many investor groups following Brown’s
announcement, quoted companies may find themselves under pressure to report in
the spirit of the OFR, even if they are no longer legally required to do so.