From great expectations to ..?

What the Dickens happened to the OFR? asks Tim Hopkirk

Christmas past

You would have had to have been on a sabbatical, gardening leave or partaking of an obscenely long Christmas break to have missed the furore over UK Chancellor of the Exchequer Gordon Brown's announcement in a speech to the Confederation of British Industry on 28 November 2005, that the requirement on quoted companies to prepare Operating and Financial Reviews (OFRs) would be abolished.

This was nearly 15 years after its conception and a mere eight months after its introduction.

Christmas present?

Once relieved of its red tape and tissue paper however, this totally unexpected gift contained no instructions, no batteries and apparently no receipt for return. Gordon Brown's seemingly impulsive and seasonally-spirited generosity shocked rather than pleased.

Through the eyes of Gordon Brown, the OFR might have appeared to be the unnecessary gold-plating on the EU's Accounts Modernisation Directive, but this was not a view shared in many informed quarters, where his largesse went down like a lead-plated balloon.

Great expectations

It is worth remembering of course that the primary intention of the OFR was to provide shareholders with a deeper understanding and a greater knowledge of the current and future prospects of the business in which they were investing.

This was to have been produced in a non-fictional, 'through the eyes of the board,' narrative, which advised its readers of the potential rewards, opportunities, risks and uncertainties that might affect the strategy underpinning the business model. This narrative would also have been supplemented by a set of key performance indicators that would have remained consistent over time.

Embedded within all of this was a requirement to report fully on key intangible assets, such as reputation, brand and customer-supplier-employee relationships, - assets which rarely appear in a balance sheet, despite accounting for the majority of most quoted companies' value.

So, by fully understanding the potential upside and downside of what they were investing in, it could reasonably be expected that shareholders' aspirations would be aligned with realistic expectations, creating in essence an open, transparent, surprise-free and litigation-free environment.

Indeed, Warren Buffet, probably the greatest investor of modern time, and a man who was never 'dot conned,' repeatedly says that he will only invest in a company whose business he fully understands.

Back to Christmas past

The Government's proposed alternative is a 'Business Review' under the aegis of the Accounts Modernisation Directive. Predictably, therefore, a much-publicised debate and analysis of the theoretical and practical implications of the OFR's demise was conducted prior to the Christmas break.

Three key messages that came out of this early, non-festive and often feisty debate were that:

- Guidance and instruction on the implementation of the Business Review provisions would be provided by the DTI and would be made available for consultation, with an anticipated implementation date of 1 April 2006

- Much of the work undertaken by companies in preparing their OFRs will not be wasted. Obligations for large companies under the Accounts Modernisation Directive currently require:

(1) The directors' report for a financial year must contain:

(a) a fair review of the business of the company; and

(b) a description of the principal risks and uncertainties facing the company.

(2) The review required is a balanced and comprehensive analysis, consistent with the size and complexity of the business, of:

(a) the development and performance of the business of the company during the financial year; and

(b) the position of the company at the end of that year

(3) The review must, to the extent necessary for an understanding of the development, performance or position of the business of the company, include:

(a) analysis using key performance indicators; and

(b) where appropriate, analysis using other key performance indicators, including information relating to environmental and employee matters."

- Many companies outside the original 1290 quoted companies that were to have mandatorily produced OFRs are not prepared for the new reporting requirements under the Accounts Modernisation Directive. These are required in respect of financial years beginning on or after 1 April, 2006. The implications for medium sized companies are not as great as those for large companies. (See panel below)

Christmas future?

So then, the reporting genie is now very much out of the bottle. Gordon Brown has very successfully raised the level of interest in, and the standard of debate about, the importance of narrative reporting. This debate nearly reached the courts. Friends of the Earth, supported by evidence from other NGOs and some investment bodies, launched judicial review proceedings.

They were seeking to persuade the High Court that the mandatory OFR had been illegally dumped.

This, combined with other adverse reactions from key stakeholders, obviously triggered major concerns, and, on 2 February, the Government changed direction again and announced a full consultation on their decision.

This will last until March 24. Any resultant changes would not come into force for another year.

Whatever the outcome, a significant number of quoted companies already prepare 'old style' OFRs on a voluntary basis, and investors have made it clear the trend is towards increased use of OFR-type disclosures to inform their decision-making.

As with the OFR, competitive pressures, the risk of adverse business media comment, and the possibility of regulatory intervention from the Financial Reporting Review Panel, (FRRP) will inform companies' decisions on how they decide to respond to the Business Review regime.

True value reporting - the use of better business intelligence to improve operational performance (to the benefit of the company), and levels of disclosure (to the benefit of shareholders and stakeholders) - remains a strategic priority, and a potential source of competitive differentiation.
Non-financials, and particularly intangibles such as reputation and relationships, remain undiminished in importance. The abolition of the mandatory OFR has not affected the reporting obligations in this area.

Indeed, it is worth repeating the view of all of this from the Financial Reporting Council: 'Regardless of whether or not an OFR is a statutory requirement, RS1 is the most up-to-date and authoritative good source of best practice guidance for companies to follow.'

The Business Review will by no means, represent business as usual, and significant parts of the OFR will undoubtedly reappear in the new regime.

Regardless of the format of the new regime, and how long it takes to materialise, various mandatory reporting requirements are currently in place and do require immediate action.

Reputation

One of the most notable features of RS1 was the increased importance attributed to reputational risk. In the original 1993 Guidance, reputational risk did not feature at all. By the time of the interim 2003 guidance, it occupied the equivalent of a footnote. In RS1, by contrast, there was a specific reference to the expectation that reputational risk would be covered in the OFR report, and the document was peppered throughout with references to reputation.

The increased emphasis is justified, as reputational issues are playing an increasingly important role in building a company's value. Not only has reputation become one of a company's most important intangible assets, analysis of how a company builds up its reputation, and how it lets it slip away, provides the key to reporting on other areas of intangible value.

'Reputational equity' is generated primarily by the way in which the company manages the key business relationships which underpin delivery of the business plan. Well-managed relationships generate reputational equity, while poorly managed relationships erode it. Managing reputational risk is achieved by developing a holistic understanding of the importance of business-critical stakeholders to, and their impact on, the main revenue streams and sources of income generation. These in turn determine company performance and, ultimately, investor sentiment.

Reputation becomes both a proxy for the effectiveness of the processes which deliver the business plan, and a lead indicator of the level of success which will be enjoyed by the company in delivering its numbers and hitting its targets. Understanding and anticipating the needs of stakeholders provide insights which can inform the company's strategy, and help it outperform.

Reputation is also an umbrella under which a number of other intangibles - execution capability, intellectual capital, customer service - can be analysed and understood. With intangible assets representing up to 75% of many companies' value (and sometimes more), the ability to manage this area of activity is important - shareholders should have assurance that the company has strong systems in place to safeguard these assets, and has a strategy for developing them to generate additional value.
Managing reputational risk exposure must be seen as a key business process.

Unfortunately, however, despite the indisputable logic, reputational risk, or the consequential adverse impact that other risks have on a reputation, has hitherto been a challenge with which many companies continue to struggle.

Silo or bunker mentality has stifled the good intentions of some of the best risk managers in their efforts to adopt the holistic or enterprise wide approach that this challenge needs.

However, those companies that do devise a methodology which helps the senior management team to manage the key business relationships and to understand the reputational factors, which underpin, or undermine, the process, will be the ultimate winners.

This has to be the most interesting risk management challenge that exists today!

It is a far, far better thing ...

We have a very interesting few months ahead of us, because, regardless of the format of the new reporting regime, and how long it takes to materialise, various mandatory reporting requirements are currently in place and require immediate action. In addition, irrespective of any statutory requirements we are in an environment where overseas competitors and private equity houses alike have already identified the true value of many FTSE 100 and FTSE 250 companies.

It is essential therefore that this true value is recognised by senior management and reported to current shareholders before, rather than after, a takeover bid. Thereafter, any bid would require a realistic premium.

The adoption of RS1 will go a long way to identifying true value and might stop the ever-diminishing number of great British companies being bought on the cheap. We do not want a reputation as being a bargain basement, any more than Gordon Brown wants to encourage further outflows of corporation tax!

Tim Hopkirk is a partner at Glenfern Consulting Ltd, Tel: 0207 399 0444, E-mail: TimH@glenfern.com

Impact Assessment of the Account Modernisation Directive

Implementation of the Modernisation Directive requires all large and medium-sized companies to prepare an enhanced fair review.

The DTI has estimated that the number of companies affected will be as follows:

Category: Total number

Medium: 24,000

Large: 12,000

All quoted*: 1,290

Total: 37,290

*Large Quoted: 100

Mid Cap Quoted: 250

Smaller Quoted: 940