The Financial Reporting Council (FRC), the U.K.’s corporate governance regulator, has published the final revised Guidance on the Strategic Report, a set of high-level principles intended to help companies improve the relevance of their strategic reports to shareholders.
The FRC in June 2014 issued the draft Guidance on the Strategic Report in response to the Companies Act 2006, which established the requirement that companies produce a strategic report. Since that time, however, the regulatory focus on narrative reporting, and the expectations of shareholders using such reporting, has significantly increased, prompting the FRC to publish final guidance.
“The FRC believes the strategic report should be clear and concise and result in fair, balanced, and understandable reporting,” the regulator said. “The guidance is, therefore, intended to encourage preparers to consider how the strategic report fits within the annual report as a whole, with a view to improving the overall quality of corporate reporting.”
The final Guidance incorporates new regulations amending the Companies Act under the Non-Financial Reporting Directive (2014/95/EU), as well as the proposed Companies Regulations 2018. The Non-Financial Reporting Directive implemented the European Union Directive on disclosure of non-financial and diversity information. It applies to large (more than 500 employees) Public Interest Entities (PIEs) for financial periods that began on or after Jan. 1, 2017.
Under the proposed Companies Regulations, large companies would be required to include a “Section 172(1) statement” in their strategic report, describing how their directors “have regard” to non-financial matters, the long-term impact of corporate decision making, and the interests of stakeholders—shareholders, employees, suppliers, customers, and others—when performing their duties. This new legislation would apply to large companies for financial years beginning on or after Jan. 1, 2019.
In response to the draft Guidance on the Strategic Report, the FRC said it received 58 comments from a range of stakeholders. Respondents were “broadly supportive” of the direction the Guidance, “but encouraged the FRC to review its approach in certain areas,” the regulator said. For example, respondents supported the principle of all companies providing non-financial information in their strategic reports and focusing on long-term value creation.
Following public comments received and the legislative developments mentioned above, the final guidance issued on July 31, 2018, included a few important clarifications and changes from the exposure draft issued in 2014.
First, many respondents commented that the references to “stakeholders” in the draft amendments was confusing as to the audience of the strategic report. In response, the FRC amended the final guidance throughout to make clear that the primary audience of the strategic report, in line with the legislation, remains the shareholders. The FRC said, however, that it encourages companies “to consider the interests of wider stakeholders when running the business” and added that: “in meeting the needs of shareholders, information in the annual report may also be of interest to other stakeholders.”
“Businesses that operate in silos, teams that don’t communicate and cooperate, will run the risk of omitting or misreporting what they are doing at an operational level, which is really where the new requirements are focussing.”
Matthew White, Audit Partner, BDO London
Secondly, noting that the new non-financial reporting regulations apply only to a subset of entities that are required to prepare a strategic report, some respondents felt that greater clarity on the scope of affected entities was needed. Thus, the FRC has amended the “scope” and “content elements” sections of the Guidance to make clear that the non-financial reporting regulations apply only to PIEs with more than 500 employees. “Quoted companies that are not PIEs will continue to apply the pre-existing non-financial reporting requirements in the strategic report,” the regulator clarified.
The FRC also stressed that, “the Guidance on the Strategic Report serves as a best practice statement and, as such, has persuasive rather than mandatory force.” Additionally, the FRC noted, “the Guidance is for directors and is intended to serve as best practice for all entities preparing strategic reports.”
Complementing the proposed Companies Regulations, one of the key objectives of the final guidance was to strengthen the linkage between a director’s duty under Section 172 of the Companies Act and the purpose of the strategic report. Thus, the final guidance includes a section on how directors should approach the Section 172 statement.
“The revised guidance underpinned by legislation will improve the effectiveness of Section 172 and stimulate board discussions on how companies are considering various factors to ensure their business is sustainable over the long-term, including the impacts on the company’s key stakeholders,” said Paul George, the FRC’s executive director of corporate governance and reporting.
George added that the revisions to the Guidance complement recent changes to the FRC’s Corporate Governance Code, which are to take effect from Jan. 1, 2019, “and as a package will contribute to enhancing trust and transparency in business.” The Corporate Governance Code sets standards of good practice in relation to board leadership and effectiveness, remuneration, accountability, and relations with shareholders.
“The new FRC Guidance on Strategic Reporting that links director’s duties with the long-term focus of the business is a positive step,” says Nick Topazio, associate technical director – management accounting at the Charted Institute of Management Accountants (CIMA), the world's largest professional body of management accountants. “CIMA has long promoted the importance of sustainable business models and being able tell a holistic corporate story through integrated reporting. This new guidance will help companies explain how they generate value for the long term.”
The final Guidance incorporates several changes to Sections 4 (The strategic report: purpose ) and Section 7 (content elements) to reflect comments received. For example, Section 4 was amended to refer to Section 172 and to recognize that disclosure of information additional to that prescribed by the Companies Act may be necessary to ensure that the strategic report meets its overall purpose.
FRC outlines strategic report goals
(x) The purpose of the strategic report is to provide information for shareholders and help them to assess how the directors have performed their duty, under section 172, to promote the success of the company and, in doing so, had regard to the matters set out in that section. This includes considering the interests of other stakeholders which will have an impact on the long-term success of the entity.
(xi) The strategic report should reflect the board’s view of the company and provide context for the related financial statements.
(xii) The guidance recommends that information that is material to shareholders should be included in the strategic report. Immaterial information should be excluded as it can obscure the key messages and impair understandability.
(xiii) The communication principles suggest that the strategic report should have the following characteristics – be fair, balanced and understandable; be concise; have forward-looking orientation; include entity-specific information; and link related information in different parts of the annual report. There are also principles which recommend that the structure, presentation and content of the strategic report be reviewed to ensure that information remains relevant to the current period. The communication principles are intended to emphasise that the strategic report is a medium of communication between a company’s board and its shareholders.
(xiv) The content elements for the strategic report set out in the guidance are derived from the Companies Act 2006, and include a description of the entity’s strategy, objectives and business model. In addition, the strategic report must include an explanation of the main trends and factors affecting the entity; a description of its principal risks and uncertainties; and an analysis of the development and performance of the business, including key performance indicators. Entities must disclose information about the environment, employees, social, community, human rights, and anti-corruption and anti-bribery matters when material. There is also a requirement to include disclosures on gender diversity.
Source: Financial Reporting Council
“In recent years there has been growing concern that companies are focused too much on short-term profits, to the potential detriment of long-term success,” the FRC said. “The amendments to the Guidance are to encourage entities to focus on and disclose the factors which are important to long-term value generation and to recognize the importance of considering the interests of and maintaining relationships with key stakeholders as part of this.”
Relative to Section 7, the “content elements” of the Guidance are structured into the following three sections to ease navigation:
Section 7A sets out the content elements for companies that are not PIEs and, therefore, not subject to the NFR Regulations;
Section 7B sets out the content elements for companies that are PIEs and, therefore, within the scope of the NFR Regulations; and
New Section 8 sets out the content elements for large companies that are required to provide a section 172(1) statement.
Companies should use either Section 7A or 7B, plus Section 8 if they are a large company, the FRC explained in the final Guidance.
Implementing the guidance
Given that the legislative and regulatory focus on narrative reporting is becoming ever more complex, “this brings with it a big danger that companies starting the drafting process late in the reporting cycle and/or taking a ‘tick-box approach’ to addressing the requirements will find the length of their annual reports continuing to spiral out of control as they swell with disclosures that are of limited use or relevance to anyone,” says Matthew White, an audit partner in the professional services group at BDO London.
“My advice to directors is to think about what they want to say—and how they want to say it—early and to work out how that fits into the legislative framework,” White adds. “Legal compliance is obviously very important, but so is the need to tell the company’s story in a way that is clear, concise, and relevant to investor and wider stakeholder needs.”
Topazio of the CIMA says, “Boards of directors should ask themselves whether they have a firm understanding of the organization’s current business model and the operating environment in which it seeks to create value.”
“Risk mitigation is another important consideration that boards need to be fully aware of, as this helps to promote long-term business success by considering future-focused questions,” Topazio adds. The CGMA’s guide, “Connecting value generation for the long-term,” contains several key resources that can help, including two sets of questions that boards can ask themselves to understand their business model and also consider risk in the light of long-term value creation, he says.
White notes that the FRC Guidance also highlights the importance of communication within the business, given that the guidance focuses on what companies do at an operation level and how they disclose that in the annual report. “This will require operational teams to become much more integrated with the finance and investor relations teams who have traditionally been the most involved in the drafting of the annual report,” he says.
“Businesses that operate in silos, teams that don’t communicate and cooperate, will run the risk of omitting or misreporting what they are doing at an operational level, which is really where the new requirements are focussing,” White adds. “As a best case, organizations that do not take an integrated team approach are likely to be producing very long and disjointed narrative disclosures.”