The six sets of principles are:
i.The starting point for directors:
- knowledge and experience;
- skills and competencies;
- good faith,honest judgements.
ii.The starting point for the OFR:
- the objective of the OFR;
- purpose and values of the business;
- taking a broad view.
iii.The scope of the information in the OFR:
- the balance between historic review and a focus on the future;
- quantitative and qualitative information;
- facts and events,probabilities,risks and opportunities.
iv.Identifying the information for the OFR:
- nature and size of items;
- significance of issues;
- variability and volatility.
v.Reporting in the OFR:
- measuring and describing;
- consistency from year to year;
- consistency with other information and reports.
vi.The approach to disclosure in the OFR:
- balanced judgements;
- confidential information;
- future possibilities.
The starting point for directors
It is self-evident that judgements are most likely to be sound when those making them have a sound basis of knowledge and experience. The OFR will be concerned with all the key aspects of the business and the judgement as to what is material will thus require knowledge and experience of all these key aspects. It is a fundamental principle of good corporate governance that there needs to be available around the board table, from amongst the executive and non-executive directors taken together,the appropriate knowledge and experience to run the company in the best interests of its members; in this sense the requirements of the OFR are the same as those anyway needed to run the company. And the OFR will, potentially, reflect the issues that are on the board’s agenda.
The overall objective of the OFR does,however, require a broader range of judgements on materiality to be made by directors than may have been needed for other, more limited forms of reporting.It therefore highlights the importance of the balance of skills and competencies available to the board, both fromamongst the directors themselves and indirectly from advisers and others,and the need for this to be adequate in relation to all the potentially material issues. Boards have, for example,found that assessing the significance of some of the wider issues identified in the CLR as likely candidates for inclusion in the OFR, such as environmental, community, social or ethical considerations, may require access to additional skills and competencies.
It is also an important principle that,in making judgements about materiality, the board should act collectively. Such judgements need to be the well-informed, good faith, honest judgements of the board as a whole. This means that, whatever arrangements are made for doing the detailed work in advance,the whole board must be fully engaged in the judgement-making process.
The starting point for the OFR
We have argued above,in defining materiality in the context of the OFR, that directors should be governed by the high level objective of the OFR, which is to enable users to assess the strategies adopted by the business and the potential for successfully achieving them.This has to be the primary starting point and the framework for decision-making and for the exercise of judgement that follows.
We also consider,however,that, to achieve this objective,directors will find that they need to start their consideration of materiality from an informed understanding and expression of their vision as to the purpose and values that govern the business and drive their decision-making as directors. This will provide the basis for the essential criteria against which to assess the strategies of the business; without it, the objective of the OFR cannot be met.And alongside this,as we have also argued above,we think it essential, if the objectives of the OFR are to be met, that directors in making their judgements on materiality take a broad view about the approaches and perspectives that users of the OFR, in the first instance the members but also other key stakeholders, will bring to their assessments. This implies taking a proactive approach,including a willingness to consider society’s changing norms and expectations of business,and to explore and understand the agendas of arange of different stakeholder groups that may reasonably be expected,directly or indirectly,to affect significantly the performance of the business,including customers, employees, suppliers,and local, national and international interest groups of a variety of kinds.Such groups can often not only articulate the normsand expectations that society has of business but can anticipate future changes in consumer behaviour and can influence regulatory change.
The scope of the information in the OFR
It is fundamental to the objective of the OFR that the information contained in it will be relevant to an assessment of the future as well as of the past and the present.The emphasis hitherto in financial reporting has been more towards describing and explaining past events.Of course, the OFR must do this too. But it also has a broader scope. It should not only include material information in relation to past events but also information about,and the directors ‘views on,the trends and future events that will shape the prospects for the business. This does not mean formal forecasting;it means looking ahead and giving aview, where appropriate, not only in relation to next year but beyond.Hence, in making their judgements as to what is material for the purposes of the OFR, directors will wish to strike a proper balance between historic review and a focus on the future in their thinking.
There are,in addition,two further aspects relating to the scope of the OFR that directors will wish to recognise in making their judgements on materiality. As we observed above,information provided in the OFR may be qualitative as well as quantitative. Where information can be quantified it should be quantified,but in some instances qualitative information may be crucial to an assessment of the strategies and potential of the business. For example,in commenting on a company’s plans to embark on a new business venture, a qualitative assessment of the depth, breadth and relevance of top management’s experience in relation to such a venture might well be material to its chances of success.
And the information in the OFR may be a description of an important issue or the expression of a probable future event as often as a past event or a matter of fact.These should be judged in the context of the risks, opportunities and threats facing the business,including an assessment of non-financial ssues, such as environmental, ethical or reputational risk. So facts and events, probabilities, risks and opportunities may all be material and qualify for inclusion in the OFR if it is to meet its objectives. For example, the directors’ opinion on the strategic implications for the company of the UK’s deferring for some years a decision on whether or not to join the European Single Currency might be material. Or, for a business involved in mobiletelephony, the directors’ views on possible health hazards arising from masts or from use of handsets might well be material for its future reputation.
Identifying the information for the OFR
Whether or not a piece of information is material will depend upon the nature and,where relevant,the size and effect of the item concerned judged in the particular circumstances of the case. This concept applies equally to the OFR as it does to the preparation of financial statements,and similar considerationsapply also in that directors need to consider not only the size and nature of an item taken individually but also set it in the wider context of the OFR as a whole. An item of information that does not appear material when taken on its own may become so when considered in the context of other disclosures. For example, the resignation of an individual board director of a subsidiary company might itself not ordinarily warrant mention in the OFR,but if a number of directors resigned from the same board in quick succession this information might well be deemed material.The test should be whether the information,were it to be omitted, mis-stated or inadequately described,would change or influence an understanding of other matters reported upon and thus, potentially, influence decisions.
A particular issue arises in the context of materiality judgements in the case of an issue that is well-managed,and thus does not give rise to material consequences for the business, but where it is,of itself, nonetheless of significance. An obvious example is the management of business continuity risk where not only does the extent of the risk vary significantly by organisation and over time but also management’s ability to mitigate the risk varies too. The principle determining materiality here should be the significance of the issue to the business in the future, not just its actual consequence in terms of its quantified impact today; users’ decisions may well be affected by an appreciation both of the risk and of the management action to mitigate it.
Similarly,directors will,in considering materiality, wish to consider not only the size of an item this year in comparison with last year,and its likely size in the future,but also the degree of variability or volatility that it exhibits. Averages that conceal significant variations may not be an adequate pointer to materiality. For instance, for an insurance company it may not be sufficient to report on the effect of global warming on claims experience if in fact it is the variability of claims experience that impacts more substantially on profitability.
Reporting in the OFR
Once the directors have determined that an item is material,precisely how it is reported upon in the OFR may be subject to whatever detailed rules are laid down in due course by the standard-setting body. Directors will,however, wish to have in mind in considering their materiality judgements the whole range ofmeasures used by the company itself to assess performance and prospects. Whilst the discipline of preparing the OFR may itself reveal areas of the business where existing measures are inadequate or need revision,the requirements of the OFR are unlikely to diverge markedly from the needs that the board anywayhas in order effectively to oversee the management of the business.So existing measures of performance and prospects will provide a useful starting point.But the OFR will need to go beyond those factors that affect performance and prospects and can be measured.Although it will be desirable to providemeasurement wherever possible, by its nature the OFR may need to contain information that does not readily lend itself to clear measurement.Directors should not exclude from the OFR information that is material to an assessment of the performance or,in particular,the prospects for the business solelybecause it cannot be measured,although they will need to consider how best to describe the information – the state of affairs, the expectation or the assessment – that is in their view material.
In making their materiality judgements directors should aim to be consistent from year to year in their approaches to the OFR. This does not mean that a matter once covered,or an item of information once included,should thereafter always feature in the OFR.It will,however,help to promote understanding of thedirectors’ approach if an explanation is offered as and when an item hitherto included is dropped from inclusion in subsequent years. Furthermore, if a matter was judged material and disclosed in an earlier year, and was unresolved at that point and remained open-ended, the presumption should be that it will continue to be covered in subsequent OFRs unless and until the matter is closed,when it can be reported upon as such. For example, in the run-up to Year 2000 many companies commented in their OFRs on the extensive preparations that were underway to ensure the continuity of their systems and processes, but fewercompanies commented after the event on whether or not these efforts had been successful.But this approach need not extend to matters that are not open-ended and are a matter of public record. For example, businesses that may be significantly affected by possible tax changes in a forthcoming Budget maywish to disclose that, and the possible consequences,in their OFR. If the change is then not made, however, there is no need for the ensuing year’s OFR to return to the issue. The possibility of Budget change is material but it is not open-ended and is a matter of public record.
Directors will also wish to ensure that their judgements, as well as being consistent from year to year, are also consistent with the judgements they make with regard to disclosure generally in other reports or statements that have been or may be issued by the company,for example preliminary resultsannouncements and other presentations to shareholders. They may also wish to consider the approaches adopted by others in the same industry sector to see whether a consistent approach with some or all of these might be appropriate.
The approach to disclosure in the OFR
The OFR requires the disclosure of material items. It does not imply the disclosure of non-material items; indeed,the inclusion of too much information in the OFR may be as likely to result in a failure to meet its objectives as the inclusion of too little (although the OFR, desirably, can act as an effective ‘signpost’ to more detailed information published elsewhere). There will be occasions,however,where directors are undecided about whether or not a particular matter is material and in these circumstances a bias in favourof disclosure is entirely reasonable. Directors will wish to ensure their judgements are balanced in this regard in the light of the high level objective of the OFR.
With regard to the disclosure of confidential information, the CLR recommended that “companies should be permitted not to disclose information which is, in the directors’ judgement,of such confidentiality or commercial sensitivity that to do so would materially prejudice the company’s interests”. The draft clausesin the White Paper contain no provision regarding the disclosure of confidential information, with the Government preferring to seek further views on the issue. We are not persuaded that such a provision is needed; nonetheless, we have considered what principles, given the high level objective of the OFR, might govern directors ‘judgements as to whether,if a matter is in their view material, it nevertheless need not be disclosed in the OFR. This would appear to relate in practice to the approach to commercially sensitiveinformation. Price-sensitive information in the case of listed companies must anyway be disclosed without delay and,although it would need to be considered for repetition in the OFR, it is very unlikely that,for listed companies,the OFR would ever be the vehicle for first disclosure of such information.And confidential information (information that is subject to an obligation to a third party such as an employee,customer or supplier) would,as now,be subject to disclosure if it were material unless it were “materially prejudicial” tothe company’s interests .The principle that directors should have in mind, therefore,ought to be that all material information should be disclosed in the OFR unless the directors have explicitly satisfied themselves that,in all probability, disclosure would of itself result in “material prejudice” to the company’s interests. This is consistent with the recommendations of the CLR.
The forward-looking nature of the OFR also has implications for the approach to disclosure. The need to prepare an OFR will encourage boards to consider and comment upon the full implications of plans and projects that may be very long term in nature. This, however,does not imply the disclosure of all possiblefuture decisions that, if taken,or events that, if they were to transpire,could have material consequences. This should not be necessary to meet the objective of the OFR and could be highly damaging to the business.The approach adopted in the Listing Rules provides a useful principle here: “A company need notnotify to a Regulatory Information Service information about impending developments or matters in the course of negotiation”. The UKLA’s guidance on the dissemination of price sensitive information goes on to suggest that, in general terms, this would cover such matters as merger talks or new productdevelopment. Our view is that,in the context of the OFR, information about future possibilities need not be disclosed unless these are much more likely to happen than not,i.e.they are probable rather than merely possible,or unless failure to disclose might itself be misleading (because, for example, market expectations are to the contrary).