Revised Guidance on the Strategic Report
Mala Shah-Coulon, EY explores the FRC's revised Guidance on the Strategic Report.
In July 2018 the Financial Reporting Council (FRC) published revised Guidance on the Strategic Report (the 2018 Guidance), updating the 2014 edition. A greater consideration of wider stakeholders and non-financial matters forms the backdrop for this update. This article provides an understanding of the key changes to help preparers consider how to evolve their next strategic report.
As with the previous version, the 2018 Guidance is persuasive rather than mandatory and has immediate effect other than Section 8 (covered below).
Why has it been updated?
The short answer is primarily to reflect recent legislative changes. It has also been refreshed for more general developments in narrative reporting.
The legislative changes are:
- The EU Non-Financial Reporting Directive (NFRD) – implemented in the UK through The Companies, Partnerships and Groups (Accounts and Non-Financial Reporting) Regulations 2016 and a revision to the Disclosure Guidance and Transparency Rules 7; and
- The Companies (Miscellaneous Reporting) Regulations 2018 which requires large companies to provide a s172 directors’ duties statement. While the purpose of the strategic report has always been to inform members of the company and help them assess how the directors have performed their s172 duty, the 2018 Guidance seeks to strengthen the link.
What are the key changes?
Three objectives have been brought forward from the 2014 Guidance:
- provide insight into the entity’s business model, strategy and objectives;
- describe the principal risks the entity faces and how they might affect future prospects; and
- provide analysis of the entity’s past performance.
Two new objectives have been added in light of the legislative changes:
- provide information to enable shareholders to assess how directors have had regard to stakeholders and other matters when performing their duty under s172; and
- provide relevant non-financial information.
1. S172 statement
While directors’ s172 duties are not new, this new statement (covered in Section 8 of the 2018 Guidance and applicable for financial periods commencing on or after 1 January 2019), is intended to show how company directors have discharged them.
The 2018 Guidance highlights that boards may wish to consider the following in making the statement:
- Long term – how the long-term success of the company has been considered in making strategic decisions and the consequences of those decisions.
- Stakeholders – boards should identify important stakeholder relationships and their significance to long-term value generation and preservation. Disclosure on how a company engages with these stakeholders and the outcomes should provide insight into the prioritisation of stakeholder relationships.
- Principal decisions – how boards considered the matters in s172 when making decisions and the outcome.
- Capital allocation and dividend policy – the statement could explain how directors have considered the long term and the interests of stakeholders in making capital allocation decisions (eg, to invest in research and development, funding pension schemes, dividends etc), which is a principal decision made by boards.
- Culture – disclosing information on the culture the board has set to help ensure that decisions are aligned to values and objectives, and the factors that are important to maintain the company’s reputation.
2. Non-financial information statement
To comply with the NFRD, qualifying public interest entities (PIEs) need to include a non-financial information statement in their strategic report. This applies to years commencing on or after 1 January 2017.
While there are some new disclosure elements introduced by the NFRD, there is significant overlap with pre-existing quoted company reporting requirements in UK company law. The FRC has therefore split the content as follows:
- Section 7A covers entities that are not qualifying PIEs and therefore not subject to the NFRD. The content elements are therefore substantially unchanged from the 2014 Guidance;
- Section 7B covers entities that are qualifying PIEs and therefore within the scope of the NFRD.
Recognising the overlap noted above, the key new elements are:
- information that enables an understanding of the impact of a company’s activity;
- disclosure of anti-corruption and anti-bribery matters;
- description of due diligence processes implemented in pursuance, and outcomes, of those policies related to non-financial matters (environment, employees, social, human rights, anti-corruption and anti-bribery); and
- description of principal risks in relation to these non-financial matters, the likelihood and management of those risks.
A recent EY review of FTSE 350 annual reports, Annual reporting in 2017/18: demonstrating purpose, creating value, found that the NFRD had limited impact on the disclosures in the first year of implementation. Only 8% of companies included a statement referencing NFRD and where disclosures had been incorporated, they were at a high level.
It will be interesting to see whether these disclosures evolve as companies, alongside adopting the 2018 Guidance, improve their reporting by leveraging increased stakeholder engagement and wider changes to corporate governance.
Not driven by legislative requirements per se, the 2018 Guidance places an emphasis on long-term value creation and encourages disclosure on the key drivers of this value in their business – whether recognised on the balance sheet (eg, physical assets) or not (eg, skills of their workforce, brands, etc). The concept of an entity’s purpose (ie, why it exists) is also drawn out to help put the objectives, business model and strategy in context.
Long-term value is a topic that EY is deeply engaged in. Over the last two years we have developed a framework to help companies better measure and report the long-term value they create for their stakeholders, recognising that many sources of this value are intangible. Our framework has been tested by over 30 major global organisations as part of the Embankment Project on Inclusive Capitalism. This project has taken a significant step forward, resulting in an open source framework and an initial set of metrics. The findings offer well researched yet practical ways to measure factors that participants agreed contribute to a company’s long-term value.
There is also extended guidance on principal risk reporting, especially for non-financial matters including examples on the interaction with the viability statement, climate change risks, risks arising from business relationships, products and services.
Familiarise yourself with the new legislative requirements
This is important as the scope and applicability criteria vary. While the flow chart in para 2.7 of Section 2 and the revised Section 7 of the 2018 Guidance (which provides an overview of the content elements applying to different types of entity) are useful, preparers should refer directly to the legislative sources.
Tell your story
With yet more new disclosures, preparers need to ensure that these are framed in the context of the annual report as a whole, rather than as ‘bolt ons’. The overall annual report must remain cohesive and provide information to help shareholders make capital allocation decisions and help them understand how the directors are discharging their s172 duty.
Keep it relevant
Boards need to judge what information is material for shareholders in the context of the entity’s specific business model, strategy and principal risks. Boards will need to decide who their most important stakeholders are, what issues really matter to them and then ensure the disclosures provide relevant information.
See the woods from the trees
Companies must remember the overall backdrop, ie, a better articulation by boards of how the interests of wider stakeholders have been considered in making decisions for the long-term success of the company.
This section relates to a director’s duty to promote the success of the company and states: a director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members, and in doing so have regard (amongst other matters) to –
a. The likely consequences of any decision in the long term;
b. The interests of the company’s employees;
c. The need to foster the company’s business relationships with suppliers, customers and others;
d. The impact of the company’s operations on the community and the environment;
e. The desirability of the company maintaining a reputation for high standards of business conduct; and
f. The need to act fairly as between members of the company.
About the author
Mala Shah-Coulon is an associate partner and runs EY’s corporate governance team.