For the past six months, the UK’s corporate governance debate has centred on the Higgs Review and its proposals for changes in the boardroom. Yet while the attention of boardrooms is focused on Higgs, forthcoming changes to UK companies’ legislation are arguably of greater long-term significance and will have a fundamental impact on how businesses operate.
Last year, the then Competition Minister, Melanie Johnson MP, unveiled the Modernising Company Law White Paper. Following the consultation, the Department of Trade and Industry is now refining its proposals before laying them before Parliament – perhaps as early as the Queen’s Speech in November 2003.
As part of the reforms, the Government has proposed that large companies provide an Operating and Financial Review (OFR) as part of their annual report, containing information on a company’s relationships with stakeholders, its environmental and community impact, corporate governance and risk management. This move to include non-financial elements marks a significant change from traditional financial reporting. The Government has also suggested that guidance requirements for the OFR would be provided by a newly created Standards Board.
Following on from this, in December 2002, Ms Johnson announced the terms of reference and membership of a working group of experts to advise on the OFR. In January this year, the Accounting Standards Board published a revision of its 1993 statement, Operating and Financial Report. This describes itself as “a formulation and development of best practice, intended to have persuasive effect”.
The OFR Working Group on Materiality recently issued a consultation paper on materiality to provide guidance for Directors on how to prepare and organise their company so that they are ready to provide OFRs. The need for OFRs has arisen as the impact of elements of a businesses’ operations, not traditionally thought relevant to the company’s share price, are increasingly seen to be material by investors. It will remain up to the Board to decide what constitutes materiality and, therefore, merits inclusion in the report. The possibilities for confusion and disagreement are obvious. OFRs can be viewed as the first stage towards the institution of formal Corporate Social Responsibility (CSR) reporting.
As Rosemary Radcliff, Chairman of the Working Group on Materiality stated:
“Directors’ judgements as to what is and is not material will be fundamental to the scope coverage of their OFR, so the question of materiality is a real and practical one for business.”
CSR requires a company to demonstrate that it is operating in an ethical way. Business has long been arguing against the introduction of formal CSR rules and procedures. To date, it has been left to companies, on an ad hoc basis, to show how important CSR policies are to them – by issuing reports, by entering into various CSR operations, and by communicating their activity in this area.
The OFR provides an ideal opportunity for such companies to take a liberal interpretation of materiality and include areas, policies and issues which competitors may not, such as employee relations, environmental actions, trade policies, ethical sourcing etc. This could deliver real competitive advantage. Conversely, a failure to report on these aspects could adversely affect their financial position.
Initially, the key audience for OFRs will be the financial community which has, traditionally, focused its attention on financial figures. But this may change. Reports such as that by the Institute of Business Ethics (IBE) showing that companies with a firm commitment to ethical conduct perform better on measures of long term financial matters, will increase the pressure for companies to prove their ethical conduct through OFRs. The IBE report suggests that companies with ethical commitment have 18 per cent higher profits on average. In addition, research from Business in the Community has shown those companies who have a responsible business practice attract, motivate and retain a talented and diverse workforce, and this has a positive impact on their bottom line.
The Associated Chartered Certificated Accountants (ACCA) has already called for high level disclosures of corporate, social and environmental performance and policies by companies in the new OFR. It would take only one company in a sector to widen its interpretation of materiality by providing more details in an OFR than is expected for that to become the benchmark for others to follow. If one company can demonstrate materiality then others will find it difficult to prove otherwise, effectively forcing competitors into greater disclosure. In the long term, this will mean convergence in the information contained in OFRs.
A quick scan of the CSR reports of just a few PLCs reveals that, at present, companies are reporting non-financial information in a myriad of ways. Such reports could include:
- Details of CSR management principles and policies
- Internal review panels
- Stakeholder relationship programmes
- Awards for progress
- Rankings in public benchmarking surveys
- Details of engagements with specific stakeholders
- Community development initiatives
- Employment and labour conditions
- Attitudes to health and safety and human rights policies
- General and site-specific environmental initiatives where relevant
- Strategies for communicating CSR policies, such as the publication of internal and external reports and case studies
As companies seek out the commercial and financial benefits associated with good CSR practice (including staff retention) then OFRs would appear to offer many opportunities. Many may look to move away from “box ticking”, currently favoured by firms (according to a report by Tomorrow’s Company), new ways of reporting and communicating CSR will be sought.
There appears to be increasing pressure for mandatory CSR reporting, as demonstrated by new rules recently introduced in France. But this will present serious challenges for businesses as they pursue a greater level of disclosure. In the US, Nike are currently fighting a court battle against consumer activist, Mark Kasky, on whether statements made by Nike about its labour practices in its Asian factories are covered by the First Amendment of the US Constitution (the right to freedom of speech) or whether they constitute “commercial speech”, which would not be protected by the First Amendment. If the statements are found not to be protected, then the company may be sued if it is believed that their content can be challenged. The whole of the commercial sector in the US is watching the case carefully. If Nike lose, it could mean the end of voluntary CSR reports as they currently exist as they could prove too great a potential liability.
The field of CSR reporting is moving quickly but there are signs that the introduction of OFRs may be the first step towards mandatory CSR reporting in the UK.
This article was co-authored with Sam Hinton-Smith.
Insurance Day, 23 July 2003