FRC consults on strategic report

The U.K.’s corporate governance regulator wants to expand the range of non-financial reporting that companies should make so that “stakeholders as a whole” can gain a better understanding of the key information that underpins corporate strategy and decision making.

The Financial Reporting Council (FRC) also hopes that wider disclosure will help the public—as well as shareholders—understand what steps companies take to uphold ethical behaviour and how boards assess the business’ impact on the environment and human rights.

The FRC’s Draft amendments to Guidance on the Strategic Report seek to improve the effectiveness of section 172 of the Companies Act 2006. This requires executives “to have regard” to the long-term impact of corporate decision making, the interests of stakeholders (and not just shareholders), and non-financial matters while pursuing the long-term success of the company.

The FRC says the proposals reflect the enhanced disclosures that certain large companies are required to make in respect of the environment, employees, social matters, gender diversity, respect for human rights and—from now on—anti-corruption and anti-bribery matters.

The regulator says that the draft amendments aim to strengthen the link between the purpose of the strategic report and the matters directors should concern themselves with under section 172 of the Act.

The Guidance on the Strategic Report was first issued in 2014 following the introduction of the requirement for companies to produce a strategic report. It is being amended now to take account of the EU Directive on disclosure of non-financial and diversity information, which came into effect last December. The rules apply to large companies with more than 500 employees and are effective for financial periods beginning on or after 1 Jan. 2017.

“The proposed amendments to the Guidance on the Strategic Report encourage business to consider the impact of their activities on stakeholders and the factors that contribute to the success of the company over the longer term.”

Paul George, Executive Director of Corporate Governance and Reporting, FRC

In a statement, Paul George, the FRC’s executive director of corporate governance and reporting, said that “high-quality reporting enhances transparency and trust in business. The proposed amendments to the Guidance on the Strategic Report encourage business to consider the impact of their activities on stakeholders and the factors that contribute to the success of the company over the longer term.”

He added that the regulator “encourages all companies to make non-financial reporting an integral part of the annual report and to provide information which helps shareholders and the wider community to understand how directors have had regard to their obligations under Section 172 of the Companies Act 2006. The FRC is committed to improving reporting in this area, since it believes that it provides an important insight into the culture of a company.”

The consultation contains a mix of both new and amended proposals. For example, the guidance has been revised to reflect that entities should start disclosing information about anti-corruption and anti-bribery matters, alongside issues regarding the environment, employees, the wider community, gender diversity, and human rights.

Furthermore, a new paragraph (3.5) has been inserted to make it more explicit that non-financial information provides a fuller understanding of the company, its business model, and its risks. It says that “the annual report cannot provide all of the information that shareholders and other stakeholders may find useful and is only one of the reports that entities might produce. Other forms of corporate reporting, delivered through alternative channels, may also provide a source of information.”

Another new paragraph (3.7) says that external audit must make a recommendation on the strategic report to see whether it is consistent with financial statements, contains any material mis-statements, and complies with what is legally required.

The guidance has also been amended to address the “sources of value” that underpin a company’s success, such as a highly trained workforce, intellectual property, or internally generated intangible assets, as the FRC says that “these are relevant to an understanding of the entity’s development, performance, position, or impact of its activity.” Newly inserted paragraph 4.7 says that the strategic report should contain sufficient information to help members of the company “assess how the directors have performed their duty under section 172,” adding that while “this may require the inclusion of information additional to that prescribed in the Act,” the matters listed “should not be applied as a checklist.”

The guidance and its “encouraged content elements”

Below the FRC describes proposed amendments to the guidance on strategic reporting.
 The FRC’s proposed amended guidance to improve strategic reporting contains three “encouraged content elements” aimed at enhancing proper, meaningful corporate disclosure—even when the Companies Act has no such explicit requirements. All of these examples appear in Section 7 of the guidance, which refers to “content elements”. Compliance professionals may find them of interest to determine how much extra information their organisations should disclose to meet the “spirit” of the proposals.
The encouraged content elements are:
An entity could set out who it considers its major stakeholders to be, how an entity engages with those stakeholders and how the interests of major stakeholder groups and the matters set out in section 172 were taken into account when making significant strategic decisions in the period.
An entity could describe how it develops and maintains its relationships with its key stakeholders. This could include the regular interactions it has with them, how it communicates with them and how regard is had to their interests in key decisions. For instance, there may be a non-executive director who has specific responsibility for considering the interests of employees and other stakeholders.
An entity could describe how its allocation of resources will support the achievement of its strategy, generate and preserve value and will impact on its stakeholders where material to an understanding of the entity’s future prospects. This could include a quantitative and qualitative analysis of allocation decisions made (such as investments) and their impact during the year.
Source: Financial Reporting Council

Paragraph 5.1 is also a new addition. Its purpose is to reinforce the idea that terms such as “principal,” “key,” and “necessary” should inform boards of the amount of information needed to properly inform stakeholders about the main risks to the business and what underpins the company’s objectives—essentially, more important risks or performance indicators require more disclosure.

Subsequent paragraphs also discuss the need for companies to provide more disclosure on principal risks. For example, a new paragraph, 7.24, says that principal risks “should include … those risks that could result in events or circumstances that might threaten the entity’s business model, future performance, solvency, or liquidity.”

Section 7 of the guidance on “content elements” contains the largest number of proposed amendments and additions. The first is paragraph 7.2, which states that entities are encouraged to consider disclosing more details than they are legally bound to. “This guidance provides examples in the form of encouraged content elements which, whilst not required by law, may provide information to ensure that the strategic report achieves its overall purpose,” it says.

Paragraph 7.11—also newly inserted—states that a company’s purpose and strategy “should be reflected in its objectives and KPIs.” It adds that “the discussion of KPIs should allow an assessment of the entity’s progress against its strategy and objectives. Similarly, emphasising the relationship between an entity’s principal risks and its ability to meet its objectives may provide relevant information, particularly in relation to an entity’s risk appetite.”

One of the key parts of the proposed revised guidance in Section 7 is the idea that companies should provide more information on their key business relationships, from the makeup of their workforce to the extent of their supply chains.

“External trends” also need further explanation, says the FRC. For example, companies “should consider the risks and opportunities arising from factors such as climate change and the environment and, where material, discuss the effect of these trends on the entity’s future business model and strategy.”

Another important factor that the FRC wants more disclosure on is the nature of the market in which the entity operates, such as whether the market is growing or contracting, and what proportion of sales/revenue is generated from a particular market (and why).

For example, a pharmaceutical firm might have a ready market for an innovative drug. However, the key to creating value is developing the drug and getting approval from the necessary authorities to market it. As a result, suggests the FRC, the business model description should give due emphasis to the critical drug development and approval processes.

The proposed changes have already met with approval from organisations that champion better corporate governance. The International Integrated Reporting Council (IIRC), a global coalition of regulators, investors, companies, standard setters, the accounting profession, and NGOs that wants to improve corporate reporting, has welcomed the updated guidance on the strategic report.

In a statement, Richard Howitt, CEO of the IIRC, said that “the UK is providing a model for the adoption of integrated reporting,” adding that “the language of long-term value creation is becoming embedded in U.K. corporate reporting practice.”

The FRC consultation is available at www.frc.org.uk. The deadline for comments and feedback is 24 Oct. 2017.