The Accounting Standards Board (ASB) has today published its first review of narrative reporting by UK listed companies, with the aim of keeping the spotlight on narrative reporting and the importance of encouraging continuing improvement in this area.

The review, which also draws on work by other bodies in the field, found that while most companies were good at describing their strategy and current performance, they were weaker on providing forward looking information and identifying their principal risks and how they are managed.

The purpose of this review is to highlight the strengths and weaknesses of current narrative reporting, in the interests of widespread adoption of best practice. The ASB, as part of its role in promoting confidence in corporate reporting, will continue to review progress in the UK and be a leading contributor to any international developments on management commentary.

The report had dual objectives of assessing:

• Best practice - the degree to which companies have adopted the recommendations in the ASB’s Reporting Statement on the Operating and Financial Review (OFR), given that it is the most complete and authoritative source of best practice guidance; and
• Compliance - how UK companies are performing in the light of the requirement under the EU Accounts Modernisation Directive for companies to provide a business review in the Directors report in their 2006 Annual report.

The report’s summary of conclusions is attached. Whilst companies are generally complying with the legal requirements, when measured against the best practice recommendations set out in the ASB’s Reporting Statement, we found the following:

Areas of good reporting

• Companies are generally good at providing descriptions of their business and markets, together with their strategies and objectives, although some improvements could be made in providing information on their external environment.
• All companies within the sample are providing satisfactory or better descriptions of the current development and performance of the business.
• There has been an increase in companies reporting environmental, employee and social issues, although very few discuss their contractual arrangements and relationships in any depth.

Areas for improvement

• The greatest area of difficulty for companies when producing their narrative reports is the disclosure of forward-looking information. The proposed ‘safe harbour’ provisions in the Companies Act 2006 may encourage companies to provide greater detail in the future.
• Companies need to improve their descriptions of resources available to the entity, in particular intangible items such as brand strength, corporate reputation and natural resources not reflected in the balance sheet.
• Companies need to describe more carefully their principal risks and uncertainties, and set out their approach to managing and mitigating those risks, rather than simply providing a list of all their risks and uncertainties (33 risks in one case).
• Many companies are providing a good deal of information on measures and indicators, but improvements can be made in identifying their Key Performance Indicators, both financial and non-financial.

Announcing the publication of the report, Ian Mackintosh, Chairman of the ASB, stated:

“Narrative reporting is an increasingly important feature of corporate reports, providing an opportunity for directors to set out a clear and balanced analysis of the strategic position and direction of their business. It is pleasing to see that many companies are reporting beyond simple compliance with the law and moving towards best practice. The ASB’s work seeks to support this trend and we hope that more and more companies will regard good narrative reporting as a means by which they can achieve transparent and open communication with their shareholders.

However there is room for improvement in the difficult areas of providing forward looking information, describing available resources, disclosing principal risks and uncertainties and on identifying key performance indicators”

In undertaking the review, we analysed the annual reports of 23 listed companies, with a year-end of March 2006 or later (and so required to comply with the current legal provisions to prepare a Business Review). We also drew on surveys by a number of other organisations (listed in editorial note 7) and the work of other parties with an interest in narrative reporting. Together these reviews of annual reports cover a significant number of the FTSE 350 leading quoted companies.

1. The Accounting Standards Board (ASB) is an operating body of the Financial Reporting Council (FRC), the UK’s independent regulator responsible for promoting confidence in corporate reporting and governance. Its functions are exercised principally by its operating bodies (the ASB, the Auditing Practices Board, the Board for Actuarial Standards, the Financial Reporting Review Panel, the Professional Oversight Board and the Accountancy Investigation and Discipline Board) and by the Council. The Committee on Corporate Governance, whose members are drawn from the Council, assists it in its work on Corporate Governance.
2. The role of the ASB is to issue accounting standards. The ASB collaborates with accounting standard-setters from other countries and the International Accounting Standards Board (IASB) both in order to influence the development of international standards and in order to ensure that its standards are developed with due regard to international developments.
3. The ASB has up to ten Board members, of whom two (the Chairman and the Technical Director) are full-time, and the remainder, who represent a variety of interests, are part-time.
4. The ASB’s Reporting Statement on the Operating and Financial Review sets out what the ASB believe to be best practice guidance for companies to follow. The guidance set out in the statement is more specific than the requirements set out in legislation, in particular with regard to forward-looking information. As part of this review, the ASB has assessed how companies are reporting against some of the key provisions of the Reporting Statement.
5. Under an EU Accounts Modernisation Directive for company financial years starting on or after 1 January 2005, large and medium-sized (but not small) companies are required to provide a Business review which is “a balanced and comprehensive analysis of the development and performance of the company’s business…[which] shall include both financial and, where appropriate, non-financial key performance indicators … including information relating to environmental and employee matters”. Medium-sized companies can be exempted from the latter part of this obligation.
6. This report fulfils the commitment in the Financial Reporting Council (FRC) Plan and Budget for 2006/7 to review the quality of narrative reporting in company reports.
7. The ASB has liaised throughout with a number of other organisations who have been conducting research in this area and carried out their own surveys. The review draws on their research and the ASB acknowledges the support of the following organisations who have (i) devoted their time and expertise as part of the review; and (ii) allowed the ASB to quote from their most recent reports on narrative reporting, as follows:
   
   
   • Black Sun plc – ‘The first 23 – Reporting under the Business Review’ (August 2006);
     
   • Radley Yeldar – ‘Narrative reporting content in the FTSE 100 – how does it stack up?’ (September 2006);
     
   • Deloitte - ‘Write to reason: Surveying OFRs and narrative reporting in annual reports’ (October 2006);
     
   • The Virtuous Circle - ‘Preparedness for the new corporate reporting requirements: A study of FTSE200 Business Reviews and a consideration of their readiness for the new Companies Bill’ (October 2006); and
     
   • PricewaterhouseCoopers – ‘Show me more than the money: An assessment of how prepared companies are for the business review’ (November 2006).
8. Copies of FRC publications, including this Report, can be downloaded free of charge from the Publications section of the FRC’s web site (www.frc.org.uk/publications/pubs.cfm). Printed copies of the Report can be obtained free of charge from:
   FRC Publications
   145 London Road
   Kingston upon Thames
   Surrey KT2 6SR
   
   Telephone: 020 8247 1264
   Fax: 020 8247 1124
   Email: customerservices@cch.co.uk  
9. Press enquiries should be addressed to Ian Mackintosh (Chairman) on 020 7492 2434, David Loweth (Acting Technical Director and Secretary) on 020 7492 2420 (mobile 07866 668515) or Simon Billingsley (Project Director) 020 7492 2428.

Summary of Conclusions

This report sets out the results of a review of narrative reporting by UK companies in 2006 carried out by the staff of the Accounting Standards Board (ASB). The purpose of this review of narrative financial reporting is to highlight strengths and weaknesses of current reporting in the interests of the widespread adoption of best practice. The ASB as part of its role to promote high quality financial reporting will continue to review narrative reporting as practice develops. The objectives of the review are to assess:

• Best practice - the degree to which companies are reporting above and beyond the legal requirements and have adopted the recommendations in the ASB’s Reporting Statement on the Operating and Financial Review (OFR), which the FRC believes is the most up-to-date and authoritative source of best practice guidance (covered in section 2); and
• Compliance - how UK companies are performing in the light of the requirement under the Companies Act 1985 to provide a Business Review within the directors’ report (covered in section 3 of this report). As noted in Appendix A of this report, further legal requirements will be brought in when the Companies Act 2006 comes into force.

In carrying out the review the ASB has drawn on the results of 5 independent surveys of narrative reporting, in addition to its own detailed review of 23 Annual Reports published since the above legal requirements became effective.

Best Practice

In terms of how companies are reporting against the best practice recommendations set out in the ASB’s Reporting Statement, we found the following:
Areas of good reporting

• Companies are generally good at providing descriptions of their business and markets, together with their strategies and objectives, although some improvements can be made in providing information on their external environment.
• All companies within the sample are providing satisfactory or better descriptions of the current development and performance of the business.
• There has been an increase in companies reporting environmental, employee and social issues, although very few companies have discussed their contractual arrangements and relationships in any depth.

Areas for improvement

• The greatest area of difficulty for companies when producing their narrative reports is the disclosure of forward-looking information. The proposed ‘safe harbour’ provisions in the Companies Act 2006 may encourage companies to provide greater detail moving forward.
  • What can companies do? To help think about how they can improve their reporting in this area, companies should review paragraphs 8-12 and 48-49 of the Reporting Statement, which outline the principle that the OFR should have a forward looking orientation, and sets out potential areas which may affect the future development and performance of the business. A number of companies have been assessed as providing good disclosures in this area with, for example, one company in the sample providing details of forecast demand and planned capital investment over the next ten years.
• Companies need to think carefully about the description of the resources available to the entity, in particular on those intangible items not reflected in the balance sheet.
  • What can companies do? Companies can refer to paragraph 51 of the Reporting Statement, which sets out examples of resources not included in the balance sheet that may be disclosed. A number of companies have provided information judged as Best Practice, for example, one company in the sample providing details of contractual agreements, reputation, employees and trade marks as examples of resources.
• Companies need to assess carefully what are their principal risks and uncertainties, and report on those, together with the approach to managing and mitigating those risks, rather than simply provide a list of all their risks and uncertainties. The number of risks and uncertainties reported in our sample ranged from 4 to 33. We question whether a company can really have 33 principal risks and uncertainties.
  • What can companies do? Companies should review paragraphs 53-56 of the Reporting Statement which sets out the disclosure recommendations for principal risks and uncertainties. The Best Practice companies in our sample provided details of their principal risks, the potential impact on the business if the risks crystallised and details of how the risks are mitigated.

Many companies are providing a good deal of information on measures and indicators, but improvements can be made in identifying their KPIs, both financial and non-financial.

• What can companies do? Companies can review the implementation guidance accompanying the Reporting Statement, which sets out 23 illustrative KPI’s which may assist companies in meeting this recommendation. The Best Practice companies in our sample provided a description of their KPIs and how they link to overall strategy and, in addition, provided details of the results of the KPIs with comparative figures and target figures.

Compliance

In terms of compliance with the current legal requirements, we were able to draw the following overall conclusions;

• Companies are in general complying with the legal requirements for the Business Review.
• However in meeting their legal requirements, companies need to take care that there is appropriate cross-referencing in the directors’ report to the other elements of the report and accounts, to ensure compliance with the law.
• All companies surveyed are providing a ‘fair review’ of their business.
• There is a legal requirement for a ‘balanced’ analysis and in considering ‘balance’ companies need to assess what the prominence should be of reporting ‘bad’ news, where appropriate. The achievement of the legal requirement of balance will require the exercise of judgement by companies.

Areas for improvement

• The legal requirement is for companies to describe their principal risks and uncertainties. As noted above, companies need to assess carefully what are their principal risks and uncertainties, rather than simply provide a long list of all possible risks and uncertainties.
• Many companies are finding the disclosure of KPIs, both financial and non-financial, challenging. While the requirement to disclose KPIs is a matter of judgement for the directors, the lack of inclusion of any KPIs in a Business Review in the future will provide the Financial Reporting Review Panel (FRRP) with a possible indicator that the Review may not be compliant with the law.
• The disclosure of forward-looking information is also proving to be a challenge. All the companies surveyed met the current legal test of giving an ‘indication’ of likely future developments, but the legal requirement will increase in the future and companies will need to prepare themselves to be ready to disclose more forward-looking information.

Overall conclusions

• Companies should think carefully about the structure and placement of their narrative reporting to ensure that cross-referencing is kept as simple as possible and does not adversely impact on the flow of the narrative.
• In the absence of any guidelines on preparing a statutory Business Review, the principles outlined in the Reporting Statement are being widely adopted by quoted companies as best practice in narrative reporting when preparing their annual report.
• This acceptance is higher amongst the larger market capitalisation companies in the FTSE 100, although there are examples of good practice among companies below the FTSE 100. As the survey shows, some companies are achieving Good or Best Practice scores across nearly all the recommendations of the Reporting Statement.
• As compliance with the Reporting Statement will in general more than meet the legal content requirements for the Business Review, there is a practical benefit for companies in following the statement to achieve legal compliance as well as fulfilling best practice.
• The proposed additional reporting requirements for quoted companies contained in the Companies Act 2006 should encourage even more companies to comply with the best practice Reporting Statement. The additional disclosure requirements in the proposed Companies Act are all existing recommendations of the Reporting Statement.