The Operational and Financial Review

Is Regulatory Enforcement of operational issues the way forward?

Analyst Note

By David Harvey; Business Intelligence
Nick Hewson: Hewson Group


In May 2004 the DTI announced a short consultation period (until August 6 th ) on the shape and substance of an OFR which will then enter company law early in 2005. This followed the publication of a government White Paper in 2002 and an updated Statement in January 2003. Patricia Hewitt in announcing the Review offered her opinion that: "The OFR will improve the quality of the reporting and complete the corporate jigsaw to give investors a clearer picture. Shareholder engagement is a success where there is informed, healthy, open dialogue between investors and business".

Rather amazingly, this extremely important piece of legislation does not appear to have fully entered the consciousness of UK business. This is a far-reaching measure that goes well beyond its guidance-only-status predecessor from 1993. The chief executive of the Chartered Institute of Management Accountants certainly believes that " .the OFR in a mandatory form for listed companies is probably the most important development in company reporting in recent years".

Hewson Group and Business Intelligence agree with CIMA as far as the impact of the OFR is concerned. For the very first time legislation will take reporting beyond the financial area into operations, expose that reporting to external audit and will be accompanied by penalty-carrying obligations on all directors to ensure that the information in the OFR is presented after "due and careful enquiry".

Having said that the OFR is very important and also mandatory it is necessary to understand that it is also very interpretive and open to a great deal of subjectivity in its likely output. Operational reporting is quite unlike financial reporting which has applicability across almost all sectors and a highly defined set of rules. With operational reporting there may be very large differences in terms of methodologies and trading conventions between commercial sectors and even subsectors. For this reason, the Regulations will establish a framework with stated objectives but within this framework it will be up to the directors of any given company to decide what will be included in their OFR in order to meet those objectives.

In the draft Regulations published on 5 th May 2004 the Government sets out the general requirements of the OFR. Some of the key passages are:

An operating and financial review shall be a balanced and comprehensive analysis of -

The development and performance of the business of the company and its subsidiary undertakings during the financial year

The main trends and factors underlying the development, performance and position of the company.

The main trends and factors which are likely to affect their future development, performance and position

 ..prepared so as to enable the members of the company to assess the strategies adopted by the company and its subsidiary undertakings and the potential for those strategies to succeed .

The review shall include -

A statement of the business, objectives and strategies of the company and its subsidiary undertakings

A description of the resources available to the company..

A description of the principal risks facing the company.

A description of the capital structure, treasury policies and objectives and liquidity of the company.

The review shall include information about -

The employees of the company.

Environmental matters and social and community matters

The review shall include analysis using financial and other key performance indicators, including information relating to environmental matters and employee matters

The review shall, where appropriate include references to, and additional explanations of, amounts included in the company's annual accounts .

CEOs and Finance Directors of the 1300 or so UK listed companies affected by the OFR legislation will look at the requirements with considerable misgivings for a number of very good reasons. The first reason is that, in fact, they are going to have to provide information that is way beyond the scope of anything they have provided before - in some cases not even to themselves. When Hewson Group carried out some research in early 2003 on non-financial reporting within the FTSE 100 we found that less than 16% of companies reported on anything that could be interpreted as a material operational issue. The exception to this was on Corporate and Social Responsibility issues where there was a more widespread and presentation rich approach. What was particularly notable by its absence was the lack of explanation about strategy and how it would be executed.

With such an indifferent history of public reporting on issues targeted by the OFR something of a quantum leap is going to be required to adequately meet the government's expectations. The DTI in estimating the cost of the OFR to British business calculates the bill at between 6.5m pounds and 19m pounds. On our interpretation of these figures a per-company cost of no more than 20,000 per annum is involved. This seems wildly optimistic and we believe that both the set up and the ongoing annual cost will be significantly more than that - particularly when the need for external audit is taken into consideration. Other issues concern the existence of adequate processes for collecting and reporting relevant non-financial information. Some companies may be ahead of the game here. But many more are likely to find that they have to foot a significant bill to put in place the processes and systems that will generate the information required. We will return to the cost implications in a later paper in this series.

Hewson Group and Business Intelligence should declare an interest here. For the last two years we have been arguing not just for greater transparency in how companies are managed but that the historic principle of investor judgment based on financial information (often out of date in reality) was increasingly invalid. Business Intelligence's work in the field of corporate performance management has tracked the growing understanding among companies that the key to managing future value lies in managing those non-financial dimensions of performance from skills and talent to innovation capacity and market share. The research has also highlighted the challenges that this presents, reflected in Business Intelligence's portfolio of reports on the balanced scorecard and measuring intellectual capital and intangibles.

In a Hewson Group White Paper last year we argued that a whole range of non financial indicators including infrastructure investment, human capital, competitive environment and customer management should be seen and understood by stakeholders and that it was illogical to try and make considered information about a company's prospects unless its ability to execute strategy was clear. We did not propose a mandatory approach because we felt it was a very difficult area to legislate for. Our contention was that market forces would cause companies to report more on leading indicators such as customer satisfaction and retention and that laggards would be forced to follow or face exposure in the face of investor pressure to disclose.

In a sense, this is still our position. The detail of the OFR has yet to be seen but the overall guidelines look good with some discretion about, and responsibility for, content remaining with the companies involved. This suggests that all OFRs will not be created equal as some companies will attempt to meet the requirement by narrow meaningless statements or by spinning irrelevancies while others will meet the expectations of investor groups and provide credible information. In time, the pressure exerted from those with good OFRs will leave others with fewer options for dissimulation. We do not expect that to be the case in 2006 however when a very variable quality can be expected. In principle we are in favour of the OFR. It will change the reporting landscape for the better. However we also have some misgivings about the proposed legislation and right now we consider that there is one big Plus, three Minuses and a Question Mark:

The Big Plus

A mandatory OFR will cause public companies to report on issues of substance that should allow shareholders (and possibly other stakeholders such as employees, customers and suppliers) to better judge the value and direction of the company. Even the DTI and the ASB may be unaware of how bad internal reporting is within many organizations - especially on critical KPIs. Having an external reporting imperative may result in more attention being paid to operational information and how it is reported to the board. As the guidance notes on the OFR suggest:

"The requirements of the OFR in this regard should not diverge markedly from the needs that the board anyway has in order to effectively to oversee the management of the business, although directors may want to review the performance measures currently in place to ensure that, taken together, they are both appropriate and adequate as a basis upon which members can assess the business. Additionally, directors should also consider the approaches adopted by others in the same industry to see whether any consistent approaches might be appropriate in their own case"

The latter point is, of course, in line with our comments about market forces. Overall, while the OFR may also have a secondary anti fraud benefit we think that the bigger enemy facing companies is simply around poor strategy and poor execution. Business failure attributed to these causes over the next few years is likely to outweigh the freak occurrences of Enron or Parmalat and early warning of poor market performance is likely to be more beneficial than the current outbreak of regulatory control to combat fraud.

The Minuses

External audit

Review by external auditors is part of the draft Regulations. The auditors have to affirm that the directors prepared the OFR after "due and careful enquiry" but we believe that this a mistake for a number of reasons:

External auditors failed to pick up salient information in cases such as Enron and Parmalat where domain expertise around financial information was involved.

In respect of strategy and operational issues external auditors have little expertise and may have less than either the reporting company or stakeholders

Auditors may have to review information that the directors present as part of the OFR but which they may feel they cannot accept without considerable scrutiny and drill back to source. How for example, would auditors deal with output based on something like Balanced Scorecard or a company generated customer satisfaction audit? The difficulty here maybe that this potentially valuable information is not presented or if it is, only at considerable cost in audit investigation.

The very fact that auditors are involved will cause a narrowing of the information presented and may result in anodyne statements. This is patronizing to shareholders who may feel that they would rather have more, possibly subjective, data on which to make assessments

There is a cost which simply adds to the regulatory related overhead that companies are having to deal with.

Increased Corporate Responsibility

There is a real danger that the anti fraud and good governance frenzy that has gripped Western governments will cause far more harm than good. Unlimited fines are proposed for breaches of the OFR which will surely cause exactly the opposite of what is intended.

The Regulations require each director to take responsibility for disclosures by all fellow directors and to disclose information which "he ought to know that the auditors are not aware of. As Lord Hodgson, the Conservative Shadow Trade and Industry spokesman points out: "A general objective of this new companies bill must be to improve corporate governance and management by encouraging men and women of quality and experience to serve on company boards. There must be a real danger that the outcome will be either to scare off such people or reduce the OFR to a series of anodyne, legally driven statements that do little to explain and highlight the commercial realities of a particular company"

Timeliness of the OFR

The OFR will be produced annually and associated with the annual report. This is an advance in the sense that forward looking information will be available but the nature of annual reports is that they can be significantly removed in time from the events to which they refer. Business in the 21 st Century is a dynamic and time sensitive affair. We would like to see the availability of operational information on Investor Relations sites on a more regular and current basis.

The Question Mark

When the draft OFR was announced in early May there was a tendency, particularly in the press to see it as charter for those who wish to espouse more corporate and social responsibility (CSR). It is very hard to argue against the laudable aims of improved CSR. However, with exception of companies such as Shell and BAT there is often little link with the actual core business or with operational ability. CSR has become a battle of PR budgets and presentation technique. From an OFR point of view there is little danger to the directors because there is little of substance to prove. There is a real danger that the first round of OFRs will see some companies long on nicely presented irrelevancies and short on strategy. Such apparently responsible and praiseworthy documents will be hard to criticize but the DTI, competitors and shareholders should make sure that they are wise to this.

Finally, it is important not to underestimate the culture shock that the OFR will cause. It is probably fair to say that most Finance Directors subscribe to the view that companies should reveal the minimum rather than the maximum about their organizations' performance, particularly if the maximum includes less than flattering disclosures. Although this might be their preferred policy, the tide of shareholder and public opinion is moving towards transparency and disclosure, which is clearly galvanizing Governments world-wide to act. There are of course commercial risks and downsides in revealing more, but these are balanced by the opportunity of gaining increased market credibility and investor confidence from being seen to be ready, if not keen, to lift more than just the financial veil on performance and corporate policies.

Overall, we like the OFR but we think that less regulation is likely to result in an outcome more to everyone's liking. If the government can tone down some of the more draconian remedies and think through the external audit requirement then so much the better. Transparency is good. Regulations are only desirable to a point. Governments everywhere have a responsibility to think about outcomes and not to predicate legislation on the basis that every director will be a crook given half the chance,

Hewson Group    Business Intelligence   Copyright 2004

About Hewson Group

Through research and publications, Hewson Group became perhaps the best-known CRM analysts in Europe during the nineties. Amongst their publications were The Impact of Computerised Sales and Marketing Systems (1991); Emerging Information Technologies (1993 with Professor Malcolm McDonald and Dr Hugh Wilson); Towards Excellence in Marketing Strategy (with W Hewson , Professor Malcolm McDonald and Dr Hugh Wilson). The Business use of the Internet (1997). Also established were the Sales Productivity Benchmarking Group with PricewaterhouseCoopers and Sistrum - a Europe wide CRM forum.

In the last five years Hewson Group has re-inforced its reputation for accurate market size and trend information and has been involved with some of the worlds largest vendors for both strategic advisory work and for Merger and Acquisitions assignments.

In 2001 Hewson Group became involved in leading edge work in two areas: Public Sector and Corporate Reporting standards. Hewson published CRM in the Public Sector in 2002 followed by Towards a Citizen Centric Authority: Beyond CRM, E Govt and the Modernizing Agenda ( W Hewson , A Meekings; May 2004)

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