Draft OFR Regulations published

United Kingdom

On 5 May the DTI published the long-awaited draft regulations that will require certain companies to produce an Operating and Financial Review (OFR) as part of their annual report and accounts. The Regulations will amend the Companies Act 1985 (Act) and are expected to receive Royal Assent in the summer or autumn of this year. Although the DTI is consulting until 6 August on a number of the issues covered by the Regulations, few significant changes are expected to be made.

Amendments to the Act are proposed in two main respects:

1. OFR for quoted companies

Quoted companies will have to produce an OFR in respect of financial periods beginning on or after 1 January 2005. The definition of quoted company is the same as that used for the directors' remuneration report and means companies with shares listed on the Official List of the UKLA, on the official list of another EEA state, or on the NYSE or NASDAQ. The DTI estimates that 1,290 companies will be affected, of which 1,260 are on the Official List.

But companies whose shares are listed on secondary markets such as AIM or OFEX, and companies with listed debt securities only, will not be caught. Despite the Government having previously indicated otherwise, large companies whose shares are not quoted will not after all have to produce an OFR, but they will have to include a 'business review' in the directors' report that will have to contain some of the same information as that in an OFR (see section 2 below).

Like the remuneration report, the OFR will be a separate report that will have to be laid before the company in general meeting, along with the directors' report and accounts. But, unlike the remuneration report, companies will not be required by the Act to put the OFR to shareholders for approval – although companies may do so voluntarily.

Contents of the OFR

The OFR will be addressed to the company's shareholders and have to include:

  • a "balanced and comprehensive analysis" of:
  • the development and performance of the business of the company and its subsidiaries (group) during the financial year, and their position at the end of the year, and the main trends and factors underlying these things. For example, changes in market conditions; the introduction or announcement of new products and services; changes in exchange rates and inflation rates; new and discontinued activities; and any acquisitions and disposals.
  • the main trends and factors which are likely to affect the group's development, performance and position in the future. This is intended to include forward-looking information. Companies that do include forward-looking information will need to bear in mind the rules relating to, amongst other things, market abuse, announcements of price-sensitive information and profit forecasts. Believing it to be "impracticable and inappropriate", the Government has decided not to include in the Regulations any 'safe harbours' from these rules. Directors of quoted companies may find it helpful to refer to the guidance on the relevant rules, and how to publish forward-looking financial information safely, published by the ICAEW in July 2002, entitled 'Guidance for directors on publishing prospective financial information'.
  • a description of the group's:
  • business, objectives and strategies. For example, the industries in which the business operates; its main products and services, business processes and distribution methods; its major markets and competitive position within those markets; the structure of the business and an overview of the main operating facilities and their location; and the significant features of the legal and regulatory environment that influence the business. Objectives might include total shareholder return, market position, or net cash flow; or non-financial achievements such as levels of customer satisfaction, productivity or emissions.
  • available resources, including business opportunities presented by market conditions and advances in technology; resources comprised in intellectual property, training and R & D programmes; and strengths represented by corporate reputation and market position.
  • principal risks and uncertainties. For example, scarcity of raw materials; skill shortages and expertise of uncertain supply; technological change; dependence on major suppliers or customers; risks related to environmental issues; access to markets; product liability; regulatory issues; and changes in demographic, political or macro-economic conditions, such as exchange rate fluctuations. The OFR will probably have to include an explanation of the directors' approach to managing such risks.
  • capital structure, treasury and dividend policies and objectives and liquidity. For example, the management of interest rate and currency risk; the maturity profile of borrowings; how treasury activities are controlled; the currencies in which borrowings are made and in which cash and cash equivalents are held; the extent to which borrowings are at fixed interest rates; funding requirements for investment commitments, and any impending breaches of covenants; the use of financial instruments, for hedging purposes and otherwise; the extent to which foreign currency net investments are hedged by currency borrowings and other hedging instruments; the principal sources and destinations of cashflows; internal sources of liquidity and any restrictions on transferring funds around the group; the effect of interest costs on profits; and the purpose and effect of major financing transactions.

To the extent that the directors consider it necessary to enable shareholders to assess the company's strategies and the likelihood of their succeeding, and to assess the group's business, resources, risks and capital structure and so on, information about the following will also have to be included:

  • the group's employees, and environmental, social and community issues relating to the group (sometimes called SEE issues)
  • customers, suppliers, lenders and other parties whose relationship is essential to the group
  • money raised through equity issues and funds returned to shareholders through dividends, share buy-backs, bonus issues etc
  • analysis using financial and other key performance indicators relevant to the group
  • explanations of amounts included in the accounts (to the extent not already covered in the notes to the accounts).

Current practice

For some time companies have been able voluntarily to publish an OFR. Many listed companies do so as a matter of best practice or to enhance their reputation and profile in particular areas, such as the environmental impact of their business. The Accounting Standards Board (ASB) first issued a statement of best practice for the OFR in 1993 and this was revised last year. The statement is not an accounting standard and is not mandatory, but its use is commended by the Financial Reporting Council, the Hundred Group of Finance Directors and the London Stock Exchange.

As well as specifying many of the areas for discussion in the OFR (some of which are reflected in the 'examples' given above), the ASB statement recommends that:

  • The discussion should comment on the impact on future operations of significant post-balance sheet events. The OFR should also discuss predictive comments made in previous statements where these have not been borne out by events
  • Information and analysis contained in the OFR should be "neutral, free from bias and complete, dealing even-handedly with both good and bad aspects"
  • Disclosure should be sufficient for the user to be able to compare the information presented with similar information about the entity for previous periods and with information about other entities in the same industry or sector
  • Measures should be defined and calculation methods explained, with any sources and assumptions disclosed.

Last year a survey by Deloitte & Touche reported that over 60% of listed companies prepare an OFR or adopt the broad approach set out in the ASB statement, and a further 30% include some recognition of the OFR in their reporting. But the Company Law Review (CLR) found that the content and rigour of reporting varies widely, and that a significant proportion of large companies fall well short of meeting the ASB's recommended practice.

The CLR also found that company accounting and reporting is essentially backward-looking and based on financial indicators, and that companies do not disclose enough information about the main qualitative factors which underlie their past and future performance – particularly their strategy, prospects, opportunities and risks; their intangible assets; and their key business and wider relationships. As a result, the CLR recommended in July 2001 that public and certain large private companies should be required to prepare and publish an OFR as part of their annual report and accounts. This recommendation was reflected in the company law White Paper published in 2002.

What will the changes mean for quoted companies?

As part of the new regime, the ASB will issue an exposure draft of the new OFR accounting standard in the second half of this year, to be finalised in the first half of 2005. The new standard can probably be expected to draw heavily on the existing ASB statement. In order to ensure that their accounts give a true and fair view, all quoted companies that prepare an OFR will generally have to comply with the new standard.

Guidance for Directors on preparing an OFR

Directors of quoted companies will be able to draw upon guidance published by the OFR working group at the same time as the draft Regulations were released. The guidance is described as being in 'final' form but it will be updated once the Regulations are approved by Parliament and the ASB has published its accounting standard on the OFR.

The guidance is designed to help directors determine the principles to be applied in deciding what should be included in the OFR. In particular, it recommends that companies should establish a planned, orderly process for compiling the report and should consult with shareholders and other key groups whose decisions could affect the company's performance.

Materiality

Whilst the Regulations specify a number of topics that must be covered in the OFR, they do not prescribe the exact contents or the way it must be presented. What is included and left out will be a matter for the directors' judgement. Certain topics must always be covered (see above). But information about SEE issues, customers and suppliers and equity issues and dividends, and the analysis of key performance indicators, must only be included "to the extent necessary" to understand the company's business and strategy. This formulation reflects the wording in the Modernisation Directive (discussed in the consultation paper) but the DTI states that its meaning is intended to be the same as the accounting concept of "materiality".

Confidential and commercially-sensitive information

Although the CLR recommended that companies should be allowed to leave out of the OFR information that the directors consider to be particularly confidential or commercially sensitive, the Government has not been convinced that there is sufficient argument for doing so, and believes that there are compelling arguments against. The Regulations therefore do not allow companies to withhold information from the OFR on the grounds that it is confidential or commercially sensitive.

Role of auditors

The company's auditors will have to report on whether in their opinion the OFR has been prepared "after due and careful enquiry", whether the contents are consistent with the accounts, and whether in the course of the audit they have become aware of anything that is inconsistent with the OFR. The intention, according to the DTI, is that the auditors should not second-guess the directors' judgements but should examine the process used to compile the review, and its adequacy, and satisfy themselves that each statement in the OFR has been made after due consideration. To support their opinion, auditors may well expect directors to give confirmation to this effect in management representation letters.

Audit fees are likely to increase by about 5%, according to the DTI's estimate, meaning approximately £19,000 per quoted company (based on an average audit fee of £385,000). To this must be added the internal costs of establishing systems to compile the OFR: the DTI estimates around £5-15,000 per company, depending on its size and complexity and the extent and sophistication of its existing systems.

Sanctions

Where an OFR which does not comply with the statutory requirements is approved by the board, every director will be guilty of a criminal offence punishable by a fine of up to an unlimited amount. For a fine to be imposed, it will have to be demonstrated that a director knew that the review did not comply, or was reckless to whether it did, and that he failed to take all reasonable steps to prevent it from being approved.

In practice, companies will be able voluntarily to revise an OFR that they come to realise is defective; failing this, the Financial Reporting Review Panel (FRRP) will have the power to apply to court for an order that the OFR be revised. Fines are likely to be imposed only in more extreme cases where a company has failed to comply with a revision order.

2. Expanded directors' report for unquoted large and medium-sized companies

For financial periods beginning on or after 1 January 2005, large and medium-sized companies whose shares are not quoted will have to produce an expanded version of the "fair review" that must currently be included in the directors' report. The expanded report will include a "business review", which will have to include much of the same information that quoted companies must include in an OFR, save that no forward-looking information about future trends and developments will be required.

The expanded directors' report will have to contain:

  • A description of the principal risks and uncertainties facing the group
  • A balanced and comprehensive analysis, consistent with the size and complexity of the business, of:
  • the development and performance of the business of the group during the financial year, and
  • the position of the group at the end of that year.

And "to the extent necessary for an understanding of the development, performance or position of the business of the company and its subsidiary undertakings":

  • analysis using financial key performance indicators, and
  • where appropriate, analysis using other key performance indicators, including information relating to environmental and employee matters.

However, non-financial information, such as that relating to environmental and employee issues, will not have to be included by medium-sized companies that do not have to prepare group accounts. A company counts as medium-sized if two or more of the following requirements are met in a year:

Turnover: not more than £22.8 million

Balance sheet total: not more than £11.4 million

Number of employees: not more than 250.

Quoted companies that produce an OFR will automatically be deemed to satisfy the requirements for the expanded directors' report and will not have to duplicate it.

Groups

Where a group contains two or more companies that are large or medium-sized, each of them will have to prepare an expanded directors' report. But for the first time where such a report is prepared by the parent company of a group it may "where appropriate, give greater emphasis to those matters which are significant to the company and its subsidiary undertakings taken as a whole".

Role of auditors

The company's auditors will have to report on whether in their opinion the information given in the directors' report is consistent with the accounts. This represents a change from the current position, in which auditors only have to report where they consider that the directors' report is inconsistent with the accounts.

How much the extra work by auditors is likely to cost is not certain. Estimates given to the DTI ranged from nil to £5,000, depending on the size and circumstances of the company.

Sanctions

Where a directors' report is approved that does not contain the necessary information, as at present every director can be fined up to an unlimited amount. Currently a director has a defence if he can show that he took all reasonable steps to prevent the report from being approved. But once the Regulations come into force the burden of proof will be reversed in favour of the director, so that it will be necessary to show that he failed to take all reasonable steps, and also that he knew that the report was defective or was reckless as to whether it was.

In practice, companies will be able voluntarily to revise a directors' report that they come to realise is defective; failing this, the Financial Reporting Review Panel will have the power (as at present) to apply to court for an order that the directors' report be revised. As with the OFR, fines are likely to be imposed only in more extreme cases where a company has failed to comply with a revision order.

No application to small companies

Small companies will not be affected by the Regulations. The OFR regime for quoted companies will not be relevant, as a public company cannot qualify as "small"; and small private companies are already exempt from the requirement to produce a "fair review" in the directors' report.

Useful links

Click here for the DTI consultation paper, including the draft Regulations, and the Guidance for Directors published by the OFR Working Group.

Click here for the ICAEW Guidance for directors on publishing prospective financial information (July 2002).

Click here for a link to the ASB Statement of Practice on the OFR.