Contents
THE DETAIL OF THE BUSINESS REVIEW
Section 423, Contents of Business review
The strategic purpose of the EBR
The EBR must be “balanced and comprehensive”
THE IMPACT ON APPLICATIONS AND PROCESSESS
Planning, budgeting and forecasting
Scorecarding and dash-boarding
The UK 's system of company law and corporate governance, setting out the legal basis on which companies are formed and run, is a vital part of the legal framework within which business is conducted. But over time, the Companies Acts 1985 and 1989 have become convoluted and unwieldy to understand as successive amendments were made and changes emanating from Europe impacted on our domestic law.
So the Companies Act 2006 is a consolidating piece of legislation which will codify and re-arrange existing regulation into a more readily understandable and comprehensive source of law whilst giving effect to new aspects of regulation as part of the government's reform agenda.
In broad terms, the Act is designed to promote shareholder engagement and a long-term investment culture as well as introduce new provisions for small companies, for example, making it easier to set up and run a company. But it also introduces new requirements around narrative and performance reporting for all but the smallest of companies 1 – the subject of this review.
Helpfully, in addition to codifying the requirements of the EU Accounts Modernisation Directive the Act ends much of the uncertainty following the withdrawal of the ‘Operating and Financial Review' (OFR) which was abruptly abandoned by the government in November 2005. After the demise of the OFR, the government has re-affirmed its commitment to “encouraging meaningful strategic, forward-looking information to assist shareholder engagement”, but there are some notable differences between the narrative reporting provisions of the Act and the OFR it replaces.
For instance, although auditors will continue to be required to report on the consistency of the Directors' Report with the annual accounts (as is required by the Accounts Modernisation Directive) there will not be any additional requirement to check for other inconsistencies. Furthermore, all companies will be exempted from disclosing in the Business Review information which is seriously prejudicial to the company's interests. This exemption was previously only provided for companies that had to produce an OFR; and finally, there will be no statutory reporting standards for the Business Review. The former Accounting Standards Board (ASB) Standard (RS1) has been relegated to the status of a statement of best practice. So, for example, the Act is much less prescriptive than RS1 about the information to be disclosed when reporting KPIs.
One important change that may have gone unnoticed by many is that the requirements for narrative reporting have been streamlined so that the obligations for quoted companies are now more closely aligned to those for unquoted companies. The effect is that all companies (other than small companies) and not just quoted companies, will need to produce a Business Review as required by the EU Accounts Modernisation Directive, with the primary purpose of helping shareholders to assess how the directors have performed their duty to “promote the success of the company”.
This white paper reviews the main provisions of the Business Review and explains the implications for performance systems and processes.
Note 1 Companies normally fall into a size category if they meet two out of the three criteria
|
Category |
Turnover |
Balance sheet total |
Number of employees |
|
Small company |
£5.6 million |
£2.8 million |
50 |
|
Medium company |
£22.8 million |
£11.4 million |
250 |
The Bill was introduced to the House of Lords on 1 November 2005 and brought forward to the House of Commons on 24 May 2006. The Bill completed the Commons Committee stage on 20 July 2006 and received the Royal Assent this Autumn.
However, the requirement to produce a Business Review is a current legal obligation introduced into the Companies Act 1985 to implement the EU Accounts Modernisation Directive. So in practice, companies must continue to prepare and publish a directors' report containing a business review for all financial years beginning on or after 1 April 2005.
THE DETAIL OF THE BUSINESS REVIEW
Unless a company is subject to the small companies' regime, the directors' report must contain a Business Review. The purpose of the Business Review is to inform the members of the company and help them assess how the directors have performed their duty to promote the success of the company (section 173).
s.423 Contents of Business review
Section 423 says that the Business Review must contain–
(a) a fair review of the company's business, and
(b) a description of the principal risks and uncertainties facing the company
It is also required to be a balanced and comprehensive analysis of –
(a) the development and performance of the company's business during the financial year, and
(b) the position of the company's business at the end of that year, consistent with the size and complexity of the business.
In the case of a quoted company the Business Review must, to the extent necessary for an understanding of the development, performance or position of the company's business, include –
(a) the main trends and factors likely to affect the future development, performance and position of the company's business; and
(b) information about –
(i) environmental matters (including the impact of the company's business on the environment),
(ii) the company's employees, and
(iii) social and community issues,
including information about any policies of the company in relation to those matters and the effectiveness of those policies.
If the review does not contain information of each kind mentioned in paragraph (b)(i), (ii) and (iii), it must state which of those kinds of information it does not contain.
In addition, the review must, to the extent necessary for an understanding of the development, performance or position of the company's business, include –
(a) analysis using financial key performance indicators, and
(b) where appropriate, analysis using other key performance indicators, including information relating to environmental matters and employee matters.
[“Key performance indicators” means factors by reference to which the development, performance or position of the company's business can be measured effectively.]
Where a company qualifies as small or medium-sized it does not have to produce key performance indicators in so far as they relate to non- financial information. (The precise rules governing what qualifies as a medium sized company are contained in s474 but in general, a company is medium sized if it meets two of the following three criteria; turnover not more than £22.8m, balance sheet total not more than £11.4m and number of employees not more than 250).
A significant change is that the Act gives directors a safe harbour from civil liability in respect of statements or omissions made in the Business Review. Liability will only attach to directors if such statements are untrue or misleading and are made in bad faith or recklessly or, in the case of an omission, there is dishonest concealment of material facts.
So the Business Review, sometimes referred to as the Enhanced Business Review or EBR deals principally with mid-sized companies, large companies and listed entities registered in the UK . However it is worth noting that countries right across the European Community will be seeking to embody the requirements of the EU Accounts Modernisation Directive in similar domestic legislation.
At first sight, the requirements of the EBR seem fairly innocuous and undemanding. Afterall, most companies should be able to produce a fair review of the company's business, and its trading position at the end of that year. However, there are a number of matters of emphasis and disclosure that need to be considered carefully and could present significant systems and process challenges for companies that are ill-prepared.
By and large, quoted companies should be in better shape to comply with the new legislation because the now defunct OFR acted as a ‘dry run'. Although the last minute withdrawal of the OFR was frustrating for some, its likely implementation forced listed companies to launch OFR projects to plan for appropriate systems and processes to be put in place. But an unfortunate side effect of the sudden demise of the OFR is that the ensuing debate masked the fact that all companies were going to have to produce a Business Review and as such, many non-listed companies are poorly prepared.
Leading up to the new millennium, many organisations lavished spending on ERP and other transaction systems rather than management information systems which have a pivotal role to play in support of narrative reporting. As a result, management information processes and enabling technologies are fractured and information of the sort envisaged by the EBR is not uniformly easy to gather. Over reliance on spreadsheets, coupled with separate processes and systems, including but not limited to, statutory and management reporting, strategy setting, budgeting, forecasting and performance measurement means that data is duplicated and scattered widely throughout most organisations. As a result many companies will find aspects of the Act more challenging than perhaps legislators anticipated.
An unhelpful aspect of the EBR is that commentators, the press and government refer to it as ‘narrative reporting', which implies that it is a vague essay about performance. But as is so often the case, the devil is in the detail and close inspection of the Act's requirement's reveal that the areas covered are far reaching and extend into novel and unfamiliar territory such as environmental KPIs and forward looking statements.
Furthermore, directors need to be mindful that there are penalties for reckless statements and although there are ‘safe harbour' provisions, it is important that the EBR is grounded in reliable and robust systems and processes so that directors can fulfil their obligations to report and, just as importantly, demonstrate that they have acted in good faith.
The main challenges for companies in relation to performance systems and processes lie in the;
• need to satisfy the strategic purpose of the EBR
• obligation to produce a “balanced and comprehensive” commentary
• requirement to make forward looking statements
• possible requirement to disclose KPIs, especially non-financial KPIs
The strategic purpose of the EBR
The main thrust of the EBR is to allow the ‘members' of the company to assess whether the directors have been successful in their legal duty to “promote the success of the company” – in essence, whether the company has satisfactorily carried out its strategy. “Success” is very broadly defined and, amongst other matters, the directors must have regard for the interests of the company's employees and the impact of the company's operations on the community and the environment.
The EBR must be “balanced and comprehensive”
A balanced and comprehensive review suggests that underlying management information systems and processes should be capable of drawing together a wide range of information, gathered from multiple sources and that performance monitoring, measurement and reporting should capture good and bad performance i.e. balanced, throughout the reporting period, which now extends into the future (see below).
The need for forward looking statements about likely performance in the future based on an analysis of “trends and factors” is a significant departure from existing company law which merely requires a review of historic performance. It will certainly require investment in appropriate planning, budgeting and forecasting systems.
Most companies should have little difficulty preparing financial KPIs though management will need to judge which KPIs to disclose and ensure that they are consistently measured across the enterprise, since an EBR has to be produced for every company (apart from small companies) in the group. However, the requirement to produce non- financial KPIs, such as environmental or employee KPIs could be more stretching because of the need to decide the appropriate measures and draw on wider sources of information.
THE IMPACT ON APPLICATIONS AND PROCESSESS
Taking these matters together, it can be seen that the EBR draws on a very wide set of interrelated business applications and processes. Collectively, these related processes are referred to as “Business Performance Management” (BPM). BPM is a ‘closed loop' process that commences with the preparation of a business strategy, the development of budgets and operational plans and then provides the means by which actual performance against plan can be measured, monitored and reported. In the fullness of time, the experience and insights gained from an analysis of performance and an understanding of the key trends and factors affecting it can be used to refine the strategy before the cycle starts all over again – the closed loop.
A typical performance management process
Whilst the theory of BPM is well articulated in many organisations, there are often significant barriers to its implementation, such as an over-dependency on spreadsheets, the lack of suitable applications, enabling technologies and processes that bind them together.
Perhaps the most under-served part of the BPM process is in the area of strategy setting and development. Given the pivotal role of strategy development for the conduct of the whole performance management cycle it is perhaps surprising that it is such a neglected process in so many organisations. Yet, it is often characterised by an un-auditable collection of standalone spreadsheets and documents which are not conducive to a strategically aligned organisation. The absence of suitable systems and process support in this vital area poses significant business risk to boards of directors seeking to demonstrate that they have “promoted the success of the company”.
Clearly, it is management's responsibility to develop a practical and realistic strategy for the organisation. However, technology has a vital role to play in ensuring that, the strategy is communicated throughout the organisation, that operational plans and performance measures are strategically aligned with it and that monitoring systems highlight management actions that need to be taken to keep the strategy on course.
Therefore, in fulfilling the obligations of the EBR, there is a strong requirement for software tools which support the iterative process of strategy development and allow the outcome to be documented and revisited as appropriate.
Planning, budgeting and forecasting
Once developed, it is crucial that performance objectives are built into the operational plans and forecasts of the organisation. The forward looking orientation of the EBR makes it essential that boards consider the effect of current trends and factors on performance in the future. In order to meet this objective organisations require a budgeting and forecasting application that allows for frequent re-forecasting and can improve the analysis and business insights that can be obtained from the process.
Modern web based planning applications encourage collaboration between budget holders, accelerate the re-forecasting process and through higher levels of participation can improve data quality and the frequency of re-forecasting. This latter point is important as the EBR requires directors to report in a “balanced and comprehensive” way throughout the period. The more frequently that organisations can re-forecast, the more likely it is that directors are acquainted with the trends and factors affecting performance.
Scorecarding and dash-boarding
However, if directors are to deliver success, it is vital that the strategy is communicated and understood throughout the organisation and that operational objectives and performance measures, which guide organisational behaviour, are strategically aligned.
This is where scorecarding and dash-boarding applications come into play. They are designed to help companies articulate their strategy using KPIs, communicate strategy across the enterprise and link it to operational objectives and initiatives. Leveraging this technology, individual and departmental goals can be aligned with corporate goals and objectives thus ensuring accountability for delivering results throughout the organisation.
The EBR requires all of the strands of performance management to be brought together in a way that permits “balanced and comprehensive” reporting across the enterprise for all periods under review. In this context consolidation applications used for management and statutory reporting form a very necessary part of the drive to capture information reliably from a variety of underlying data sources at the end of each accounting period.
Given the broadly based requirements of the EBR and in particular the possible need to report more widely on non-financial matters and related KPIs, consolidation systems become even more central to the solution. The ability to easily adapt data entry forms, collect statistical or memorandum information directly from the underlying transactions systems (ERP) and develop business logic as appropriate are essential to responding to the detail of the EBR.
Web based data entry bolstered by vendor certified adapters that allow integration with third party transaction systems are becoming essential features for modern performance management systems. They can significantly reduce reporting cycles leaving management with more time to analyse performance and take remedial action as necessary.
In recent years the advent of cost effective, web deployable reporting has opened up performance management applications to a much larger population of end users. Increasingly, this extended population has grown to include individuals from all levels of an organisation and most functional areas. Indeed, the EBR, with its diverse reporting requirements, underlines the need to engage with more individuals from across different functional areas in the organisation. With environmental, employee and social reporting firmly on the agenda, it is important that, say, finance directors, HR directors, Production directors and Investor Relations professionals are bound into a joined up process and equally comfortable with reporting from the performance management system regardless of their skills and background.
So it is crucial too, that a performance management environment permits a variety of analytical tools to be deployed allowing users from different functional areas to select tools for the creation of regular production reporting, ad-hoc and interactive reports according to their personal preferences. As such, in addition to ‘normal' reporting, a performance management platform should ideally provide choices around, dashboards, scorecards, dynamic spreadsheets and portals as well as making use of the latest techniques in alerting, customisable displays (colour coded meters, gauges and dials), animated pin-boards and “traffic lighting” to highlight under or over performance in a visually striking way.
The performance management cycle as a business process draws on numerous specialised applications and potentially hundreds of underlying data sources to provide management insights. Traditional ETL (Extract, Transform and Load) tools, designed for bulk data transfers with no specific applications in mind are likely to prove lacking in a more challenging performance management environment. Newly emerging FDQM (Financial Data Quality Management) solutions created for complex performance management applications where interfaces are intricate and precision is vital will be more suitable. Specially designed to leverage the skills of the finance community to maintain financially oriented interfaces, they provide a bridge between source and target applications in a similar way to ETL but crucially provide visibility into the processes on either side, with full traceability of transactions backwards or forwards through the interfaces.
Once the data is captured from the source systems it is vital that performance management processes, applications and data are fully integrated so that the integrity of data is assured right across the performance management environment and that all users share the same information.
It is metadata that defines structural information, such as organisational hierarchies, account codes, time periods and product group dimensions that form the backbone of most performance management applications. Differences in metadata prevent reporting across applications and whilst it can be temporarily forced into alignment with clever mapping tools and technology it quickly slips out of alignment as changes are made to different business areas and applications. In theses circumstances, MDM (Master Data Management) style solutions that allows master data and data definitions to be staged in one repository so that the interrelationships between applications are defined and their metadata is synchronised throughout the performance management suite are crucial. MDM solutions ensure that amendments made to data structures by end users in any application are automatically reflected elsewhere so that any of the other applications working off the same data platform are automatically made ‘aware' of the change. Using this technique, structures are brought automatically into alignment, reporting maintains its integrity and consistency of reporting is assured.
Unfortunately, many organisations have grown their performance applications and processes in isolation, often using different software vendor's tools and spreadsheets which accentuate the differences. In these circumstances, each application is governed by its own business rules and data structures rendering comparisons of data held in different application areas unworkable. Making sense of all of this data presents significant management and IT challenges, particularly as the reporting landscape is constantly changing in the face of new reporting requirements. In addition a possible lack of consistency in reporting seriously jeopardises the reliability of reporting. In the context of the EBR, independent auditors have to attest that the claims made in the Business Review are consistent with the financial statements. Therefore, both management and auditors need certainty that, for example, a financial KPI reported in the EBR, such as Return on Capital Employed (ROCE) is completely consistent with the same values derived from a scorecard, the monthly board pack and the current forecast.
So integration is at the heart of performance reporting and compliance with the EBR. It is only through integrated applications that management can be sure that the information it is using to analyse trends and factors affecting current and future performance is reliable and comparable over time.
The narrative reporting requirements of the Companies Act 2006 are part of a growing trend in company reporting towards the convergence of external and internal management reporting combined with a surge of interest in non-financial reporting, most notably; factors that affect employees, the environment and wider community. In effect, most of the provisions of the obsolete OFR have been re-introduced in the Act and apply equally to quoted and unquoted companies.
The breadth of disclosure requirements coupled with formidable obligation to make forward looking statements means that management has to have its ‘finger on the pulse' of the company continually, analysing any trends and factors affecting performance right across the enterprise. Such demands mean that it is no longer viable for businesses to manage performance in functional silos or to use a series of unconnected applications and processes from different vendors which jeopardise data integrity. The need for constant appraisal of performance coupled the speed of reporting leaves no choice but for companies to standardise on an integrated performance management platform that can support robust and dependable processes from strategy setting right through to performance monitoring, analysis and reporting.
But the needs of narrative reporting in the Business Review now extend beyond the pure technical requirement to unify metadata, applications and technology. Potentially, the construction of a comprehensive and balanced EBR requires the involvement of different functional specialists from across the organisation which means that systems have to address a wide range of competencies. The winners in performance management will be those BPM vendors that can provide an adaptable and rewarding ‘user experience' as well as an outstanding technical solution.
About FSN Publishing Limited
FSN Publishing Limited is an independent research, news and publishing Organisation catering for the needs of the finance function. The report is written by Gary Simon, Group Publisher of FSN and Managing Editor of FSN Newswire. He is a graduate of London University , a Chartered Accountant and a Fellow of the British Computer Society with more than 23 years experience of implementing management and financial reporting systems. Formerly a partner in Deloitte for more than 16 years, he has led some of the most complex information management assignments for global enterprises in the private and public sector.
Whilst every attempt has been made to ensure that the information in this document is accurate and complete some typographical errors or technical inaccuracies may exist. This report is of a general nature and not intended to be specific to a particular set of circumstances. FSN Publishing Limited and the author do not accept responsibility for any kind of loss resulting from the use of information contained in this document.
