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The weight of non-financial rules

Will the new EU non-financial information rules be a burden? asks Professor Krish Bhaskar

FOR THE EUROPEAN COMMISSION the final outcome of its less-than-catchy titled directive, The disclosure of non-financial and diversity information by certain large companies and groups, must be a disappointment. While not being a damp squib, the directive in its current form is broad, fuzzy and more than imprecise.

There is some controversy as to how it will be interpreted and its effect on the UK. Under the rules, certain public interest organisations will include a statement in their annual accounts about environmental, social and employee-related matters. This is in addition to human rights, anti-corruption and bribery issues and boardroom diversity.

The agreement, endorsed by the EU council of permanent representatives earlier this year, applies to large public interest entities (PIEs) (mainly listed companies and financial institutions) with more than 500 employees, affecting around 6,000 companies.

The intention is that the directive will help not just shareholders but a wider set of stakeholders such as the media, politicians and special interest/pressure groups. Nevertheless, global investors, representing more than £13tn of assets under management, may also be interested. Indeed, the Eurosif/ACCA survey of global investors in 2011 found that over 90% of investors were interested in such information, while 93% disagreed that current levels of non-financial disclosure were sufficient to assess materiality.

Disclosure politics
As is often the case, the politics of such disclosure has had a split response. This directive has its roots as a reaction to the global financial crisis; the diversity clause is directly intended to broaden directors to prevent ‘group-think’ that may have contributed to the global financial crisis. It is the EC’s attempt to make a set of conditions which might prevent another such crisis, though social justice has inevitably been included by a politically left-leaning European Parliament.

This directive can be traced back to 2011 and it has undergone several revisions, compromises and drafts. Michel Barnier, EC commissioner for the internal market and services, has voiced disappointment that these rules are less strict than the original spirit.

There was considerable discussion and compromises both by the EC and MEPs. The final draft directive was agreed on 15 April and will be adopted by the European Council shortly, though there is still some room for manoeuvre and opportunity to persuade the current government to make this less arduous than perhaps the EC intended.

The directive applies to all large companies: most, if not all, quoted companies, defined by the EU as the parent companies of PIEs and where the average number of employees during the financial year exceeds 500. This is greater than the previous UK benchmark of 250. For the UK, it will probably apply to most, if not all, FTSE 350 companies, some of the AIM companies, over 100 privately-owned companies, some unlisted financial institutions and a few other organisations.

The EC target of 6,000 companies may in effect be an underestimate. The intention was that SMEs should be exempted (under the so called ‘Think small first’ initiative). Exactly what these criteria mean will be determined by each member state. So the FRC and the directive as enacted in UK law will be of paramount importance.

The scope of this directive is a little fuzzy, though not everyone agrees. Further guidelines and clarifications will likely be forthcoming from the FRC and UK policymakers

Reporting commentators have suggested that the requirements will create a level playing field in corporate disclosure throughout the EU, yet some European politicians believe the directive leaves “significant flexibility” for companies and member states to disclose relevant information in the way that they consider most useful in their reports.

Since this EU directive is also capable of substantial country amendments and tailoring, it is unlikely that this objective will be achieved in full. Each company has a degree of flexibility as well.

Indeed, a Deloitte survey of FTSE 350 reporting practice shows that many the top 50 companies have complied with the new UK narrative rules, and that many companies have had a reasonable stab at providing non-financial information. In this respect the UK is ahead of other EU countries.

In addition, the new requirement for boards to state that the annual report, taken as a whole, is “fair, balanced and understandable” will most often fall upon the audit committee in the first instance. All in all, audit committees are under greater scrutiny than they ever have been and that trend is only likely to continue. In this context, BDO released its third annual review of audit committee reporting, which found that as there is flexibility in the directive and no non-compliance sanctions at the moment. This may mean that this directive is less effective.

Of course, there is the ultimate sanction. The FRC can and has taken action against the preparers of reports. In response to a complaint on narrative reporting of Rio Tinto in 2011, the FRC asked the company to include additional information.

Nevertheless, the lack of detail on any penalty for non-compliance is worrying as some companies may see this as a reason not to follow the rules.

What is to be reported?
This is where the directive is not at all clear. The EC will prepare non-binding guidelines, though the FRC may provide further UK guidelines to clarify some of the definitions and reporting criteria. What is important for the UK is the exact provision as enacted in the UK, which will almost certainly be tighter than the directive and the FRC will, I suspect, further clarify.

Others are less sceptical in part because much of the directive is already enshrined within the UK rules – for instance, in the FRC’s guidance on the strategic report.

Nevertheless, the directive states that either in the annual report or in a separate report a “non-financial statement containing information to the extent necessary for an understanding of the undertaking’s development, performance and position and of the impact of its activity, relating to, as a minimum, environmental, social and employee matters, respect for human rights, anti-corruption and bribery matters” must be included.

Sounds fierce, but actually a company can opt out by providing “a clear and reasoned explanation” for not reporting, or where such disclosure would be “seriously prejudicial”. There is disagreement about how far these escape clauses will be used. Investors may very well react negatively. The clause about essential contractual relationships was adhered to with few using the seriously prejudicial exclusion clause (this clause has since been repealed). So it remains to be seen whether people will comply with the spirit.

Veronica Poole, IFRS leader at Deloitte, has previously said that although the new directive will need to be transposed into UK law, there should be little to worry about because the current UK requirements apply to all companies rather than just those that are of public interest.

While the new narrative/strategy reporting regulations covers much of the EU requirements, I believe that this directive goes significantly further. For some UK larger private companies this may be burdensome – they may not be currently required to produce narrative/strategy reports and may have to do significantly more drafting work.

Disclosure rationale 
Like disclosures around a company’s business model, environmental disclosures are probably covered by the UK narrative rules, but it may go further. The directive specifies a non-financial statement containing details of the current and foreseeable impacts of the undertaking’s operations on the environment, and, as appropriate, health and safety, the use of renewable and/or non-renewable energy, greenhouse gas emissions, water use and air pollution.

Information around social and employee matters may be provided to ensure gender equality; the implementation of conventions on working conditions, social dialogue, respect for the right of workers, respect for trade union rights, health and safety at work and the dialogue with local communities.

With regard to human rights, anti-corruption and bribery, the non-financial statement could include information on the prevention of human rights abuses and/or on instruments in place to fight corruption and bribery.

Human rights and gender equality are already a UK requirement as detailed in the FRC exposure draft. However, working conditions, social dialogue, trade union rights, health and safety, and dialogue with local communities may be hinted at, but are not part of current UK requirements.

Board diversity remains a major concern of the EC. Its rationale is that board members from similar educational, professional and geographical backgrounds, who are of the same gender and are close in age, could fall prey to ‘group think’. This could mean management decisions are not effectively challenged or debated, as the lack of diverse views and skills generates fewer ideas and alternative perspectives.

The diversity information required is a description and the objectives of the company’s diversity policy for administrative, management and supervisory bodies (but not the whole workforce) with regard to aspects such as age, gender, and educational and professional backgrounds. The report must include how this has been implemented and the results of its adoption in the reporting period. But again there is a cop-out clause: “If no such policy is applied, the statement shall contain an explanation as to why this is the case.”

UK companies are much better at diversity than they used to be. FRC guidance does lay down reporting requirements for the number of persons of each gender who were directors of the company and number of persons of each gender who were senior managers. However, UK companies have in general gone beyond this requirement. Call it peer group pressure; particularly after the Lord Davies Review, few companies say they have no policy.

A game-changer
Supply and subcontracting chains is one area which may prove more irksome for UK companies.

The EC probably had in mind the tragedy of the Rana Plaza collapse in Bangladesh in April 2013, with a reported death toll of 1,129 and a further 2,515 injured. Prominent global retailers whose merchandise was produced in the complex were reported as failing to sign new safety agreements, or compensation claims, or were found to make it difficult to claim compensation.

According to Vincent Neate, head KPMG’s UK climate change & sustainability practice, firms think of a boundary to their business. This regulation expands that boundary. Hence, the non-financial statement should also include information on the supply and subcontracting chains, in order to identify, prevent and mitigate existing and potential adverse impacts, but only where it is “relevant and proportionate”. Again, the FRC or UK law may provide some clarity.

Neate has pointed out that although companies (especially financial services) feel there is no direct link, they may have to think more laterally because “they may be facilitating such abuses by using organisations associated with these practices in their supply chain, or holding bank accounts for them and so on”.

“Companies will therefore need to report on the importance of regular monitoring to ensure that they are honouring best corporate practices, and disclose whether they are considering such risks, and the actions they are taking to mitigate them,” he added.

This expanding boundary will make companies more aware of the supply chain and their commitments. I would even go as far as saying over time it is a game-changer.

Professor Krish Bhaskar is writing a series of works on The Future of Financial Reporting, including non-financial and integrated reporting. These will be published by Routledge.

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