related documents

top stories

Share

ACCA Research Report No. 80

Rutherford, 2003

Executive summary

This report:

• reviews the progress made so far in the development of the Operating and Financial Review (OFR) in practice within the UK
• examines the implications of current practice for proposals for reform in the UK, including the Accounting Standards Board's (ASB's) draft revisions to its existing guidance and the recently published draft Companies Bill provisions covering a statutory OFR
  and
• examines the implications of current practice for preparers seeking to improve their narrative reporting.

Narrative disclosure has increased rapidly in recent years but individual company reports can be incoherent, confused and repetitive and users of multiple reports will be faced with difficulties in processing efficiently the information they contain because of the range of approaches in use. A sensible way to improve the coherence and consistency of reporting would be for companies to make the OFR their main source of information about operational and financial performance.

Very large companies provide OFRs, addressing many of the areas specified in the current ASB guidance, but others are less likely to provide a full range of material and less likely to gather material together in a recognisable OFR. There are often significant departures from the ASB guidance in the presentation and structure of the OFR.

The more innovative disclosures in the ASB guidance, such as the dynamics of the business, forward-looking disclosures, revenue investment and soft assets, are being resisted by companies generally, including some of the largest. Some preparers are tending towards lightly re-engineering traditional narratives rather than fully complying with the ASB guidance. Disclosures relating to changes in capacity and business activities tend to be focused on corporate form and asset type rather than strategically. There is sometimes very poor disclosure of compliance with ASB guidance.

There is a need for better and firmer guidance to improve the quality of reporting, although it is not clear that the complex approach adopted by the proposed legislation is the best way forward. However, the value of full-scale OFR reporting by smaller entities is unproven and more research is needed before such reporting is mandated. Regulatory bodies remain unclear about the target audience for the OFR.

Very few companies adopt an overall theme for their narrative, although there are advantages in doing so. The business model can provide such a theme, whether the model is applied corporation-wide or differentiated, and whether it embodies a strategy of change or stability.

In some technical areas of disclosure, material can be very complex, inconsistent between preparers, and obscure. There is also a tendency towards 'boilerplate' (formulaic and technical) language. Preparers are having difficulties in providing methodological explanation within the narrative. New requirements will have to be framed very carefully if these problems are to be overcome. The draft Companies Bill requirement that corporate governance disclosures should be included in the OFR seems undesirable, since these are typically in boilerplated language.

The report includes a detailed comparison of ASB's proposed revisions to its guidance and the draft Companies Bill requirements.

The most significant areas in which more guidance from ASB would be desirable are:

• The review of the position of the company at the year end
• Employment, environmental, social and community policies and performance
• Reputational issues
• General advice on determining what other matters might be relevant to the general objective of the statement
  and
• The adoption of a strategic focus in discussion of topics such as changes in capacity and business activities.

There is a danger that the level of attention being devoted to the Operating section of the OFR could lead to the Financial section becoming stale.

In due course it is likely that the International Accounting Standards Board (IASB) will place OFR reporting on its agenda. When it does, it will find itself having to cope, here as elsewhere, with the dichotomy between the principle-based, generalised approach adopted by the UK (and by recent draft guidance issued in Canada) and the more detailed and prescriptive model employed in the US. The prescriptiveness of the US Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) regime looks set to increase in the wake of Enron and other accounting scandals, notwithstanding the objective of the US Securities and Exchange Commission (SEC) to encourage a flexible approach.

RECOMMENDATIONS

The following is a summary of the recommendations, which are set out in full in Chapter 7. Numbering corresponds to the full text in that chapter.

Mandatory OFR reporting

1. There is a need for careful trialling of mandatory OFR reporting, especially among smaller and medium-sized entities. This should include empirical investigation of size limits for exemption from the scope of the requirement.

2. There is an argument for exposure of the proposed standards, intended to provide the infrastructure of regulation and guidance called for by the Company Law Review Steering Group (CLRSG) and the Government, before legislation is finalised. Among issues that will need to be examined in relation to this infrastructure are: (a) whether the regime adequately addresses concerns about materiality and proper presentation; (b) whether the regime establishes an appropriate balance between prescriptiveness and flexibility; and (c) whether the regime permits a sensible approach to the relationship between the OFR and other narrative disclosures the company wishes to make.

3. Further consideration should be given to whether it is necessary to incorporate a complex, three-tiered disclosure protocol into the legislation.

4. Further consideration should be given to whether items in the CLRSG's lists of required disclosures, omitted from the draft Companies Bill, should be restored.

5. The possibility of making corporate governance disclosures the subject of a different statement should be explored further.

7. The specification of the target audience for the OFR would be worth revisiting.

8. Further consideration should be given to integrating Financial Review material into the main body of the OFR and signalling this by including more extensive references in the Companies Bill.

9. The possibility of 'safe-harbouring' (that is, explicitly giving preparers protection against liability for some of the content of the OFR, so long as they take reasonable care in producing it) and some way of responding to legitimate concerns about commercially sensitive information should be revisited.

10. Further trialling of the process of audit review may be necessary.

Non-mandatory OFR reporting

11. More extensive coverage of material reviewing the position of the company at the year end would assist in bringing the guidance into line with the proposed statutory OFR.

12. Discussion of monetary returns to shareholders could be eliminated from the OFR and requirements relating to Earnings Per Share (EPS) moved to the section on performance.

13. It would be helpful in preparing companies for the introduction of the statutory OFR if the guidance covered employment, environmental, social and community policies and performance, and reputational issues and general advice on determining what other matters might be relevant to the general objective of the OFR.

14. ASB should give consideration to introducing a principle requiring information generally to be provided within the framework of the company's strategic objectives, performance, change and impact rather than, for example, focusing on organisational structure or legal considerations.

15. Although it may not be essential to do so as part of the current revision, ASB needs to keep in mind the importance of refreshing the guidance relating to the Financial Review.

16. ASB should give consideration to encouraging the exclusion from the OFR of matters which are likely to foster boilerplating.

17. The statutory OFR will require a sharp boundary to be established between the OFR and other material and ASB might consider preparing companies for this necessity by providing guidance at this stage.

18. ASB might consider giving guidance on the naming of nominal authors of the OFR.

19. ASB should consider adding more weight to its encouragement of disclosure of compliance with its guidance.

20. ASB might consider giving more guidance in the areas of: (a) reconstructing data from the financial statements; (b) dividend policy; (c) explanation of methodological issues; (d) human resources; and (e) debt covenants.

21. ASB should consider amending its guidance to encourage companies actually to publish a single integrated OFR and should consider providing a stronger signal that discussion of aggregate performance be preferably located in the Operating rather than the Financial Review.

22. ASB might consider making it explicitly clear that the proposed guidance does not inhibit the composition of a single coherent narrative.

23. Although ASB's approach to target audience is consistent with the statutory OFR, it should undertake more work on: (a) issues relating to the investor audience; and (b) widening the audience for the OFR.

Preparers

24. Preparers should consider whether a greater degree of integration and coherence in their overall narrative reporting would improve communication to stakeholders.

25. Preparers may find it helpful to give more explicit attention to identifying the intended audience for their OFR, within the limits imposed by whatever requirements and guidance are in place at the time.

26. Preparers might wish to consider gathering all the information within the scope of the OFR into one systematic narrative, to improve the communication process.

Accountancy bodies

27. Professional accountancy bodies should consider making available technical support beyond that provided by the standard-setting bodies, including specimen annotated OFRs, published examples of good practice and sources of expert advice, perhaps focused on specific sectors such as smaller entities.

28. Accountancy bodies might consider commissioning further research on the issues raised in this report.

CHAPTER OUTLINES

Chapter 1 describes how the OFR has returned to the reform agenda of financial reporting. A 'new', statutorily-backed OFR has a pivotal role in proposed reform of company law and is seen as a key move to improve corporate governance, open up accountability for soft assets and risk management, and respond to recent US accounting scandals. The evolution of proposals for a new OFR is described and the main features of the proposal, as included in the Final Report of CLRSG and the Government's draft clauses for a Companies Bill, are explained. These include: (a) a statement of the objective of the OFR and a requirement for all disclosure necessary to meet that objective; (b) a three-tier protocol defining items to be included in the OFR; (c) further prescription and guidance to be supplied by the standard-setting body; (d) exemptions for small entities; and (e) audit review. The results of a study trialling the proposal are explained. ASB's proposed revisions to its own guidance are described, together with recent developments in the US and Canada. Finally, the question of how the OFR might be designed is briefly examined.

Chapter 2 examines the structure of narrative reporting generally and the role of the OFR within this structure. The development of mandatory requirements and authoritative guidance, combined with companies' own keenness to increase text-based disclosure, discussion and analysis in annual reports has resulted in a considerable degree of variety in the structure of narrative reporting. This runs the risk of presenting an incoherent picture to users, making it more difficult for them to grasp the message preparers are trying to convey. Users of multiple reports will be faced with difficulties in processing efficiently the information they contain. Although no single company can secure commonality across the sector, preparers need to review their own arrangements to ensure that their narrative reports form a coherent structure. A useful approach would be to make the OFR the main or sole source of information about operational and financial performance: if this approach were followed by all preparers a degree of coherence across the sector would be achieved. Many companies appear to have seen the OFR as an additional statement, adding to, rather than replacing, reports from the chairman and/or chief executive. This yields a confusing and incoherent picture.

Chapter 3 investigates the incidence and overall design of OFRs. Publication of OFR material was apparent in some 80% of the largest quoted companies in the UK, with companies at the smaller end of the range being less likely to publish a full range of material and less likely to publish it in the form of a single integrated OFR. A variety ofthematic structures was observed among the integrated OFRs but only a small number adopted a single major theme for their Operating Review and none carried this through to the Financial Review. The theme adopted was, in all cases, the corporate strategy of the business. A substantial majority of companies located their discussion of aggregate financial performance in the Financial Review, although the ASB guidance regards this as falling within the scope of the Operating Review, perhaps indicating how preparers see this aspect of the OFR. The ordering of material was not always consistent with ASB's preferred 'top-down' approach. There is some blurring of the boundary between the OFR and the rest of the annual report, both physically (for example, are interwoven tables and graphics part of the OFR?) and logically (via cross-references): this may confuse users and have implications if OFR material has to be reviewed, for example by auditors. Practices varied in relation to naming a nominal author of the material.

Chapter 4 looks more closely at the contents of OFRs. The evidence suggests that the more innovative proposals included in the ASB's guidance including, for example, the dynamics of the business, forward-looking disclosures, revenue investment and soft assets, are being resisted by companies generally, including some of the largest. The proportion of the statement devoted specifically to discussing operating performance for the period, and the level of replication of material found in the rest of the annual report, suggest that some preparers of OFRs are tending more towards lightly re-engineering traditional narratives than seizing the opportunity for innovative practice, fully complying with the ASB guidance.

Chapter 5 explores possible approaches to providing a single overall theme for the OFR, to yield a coherent and integrated narrative. Using examples of good practice it suggests that the business model can provide such a theme, whether the model is applied corporation-wide or differentiated, and whether it embodies a strategy of change or stability.

Chapter 6 examines a number of specific topics within the OFR. It provides evidence that:

• companies are making only limited disclosures in innovative areas
• in some technical areas of disclosure, material can be very complex, inconsistent between preparers, and obscure
• narratives and disclosures appear to be strongly influenced by the traditional financial reporting focus in some areas
• disclosures relating to changes in capacity and business activities tend to be focused on corporate form and asset type rather than strategically
• preparers see issues relating to the discussion of financial performance as a matter for the Financial Review rather than, as envisaged by the ASB guidance, the Operating Review
• there is a tendency towards boilerplate language
• there is very poor disclosure of compliance with ASB guidance and
• preparers are having difficulties in providing methodological explanation within the narrative.

Chapter 7 sets out the report's conclusions and recommendations. The recommendations are summarised in the previous section of this report.

Back to top