Public Companies Update January 2006

6 OPERATING AND FINANCIAL REVIEWS

6.1 Repeal of Mandatory Operating and Financial Reviews

On 12 January 2006 the regulations repealing section 234AA of the Companies Act 1985, which require all UK listed companies to publish an operating and financial review (OFR), came into force. The OFR regulations would have required 1,300 or so publicly listed companies in the UK to produce narrative statements assessing their performance at year end and their performance for the next financial year. Such analysis was to assist shareholders in assessing the development, performance and strategies adopted by a company and the potential for those strategies to succeed. OFRs were also to include social and environmental risks and opportunities. The first statutory OFRs were due to be published in April 2006 as part of a company's annual accounts.

However, in late November 2005, the Chancellor of the Exchequer, Gordon Brown, announced that the government was to abandon the OFR requirement for UK-listed companies. The decision was based on an attempt to relieve businesses from yet another regulatory burden and to avoid the unnecessary "goldplating" of current EU regulations. Mr Brown was referring to the EU Accounts Modernisation Directive (2003/51/EC) (AMD) which broadly requires all large companies to meet similar requirements to those of the OFR. The AMD imposes mandatory obligations on UK companies to produce documents similar to the OFR, although the legislation does not extend directors' liability, which the OFR regulations purported to do. The government estimated that by removing the OFR requirement, business costs would be reduced by up to £33m per year.

6.2 FRC statement of best practice

The Financial Reporting Council (FRC) however, has emphasised that even though the OFR is no longer operational or mandatory for listed companies, it should still remain best practice. The FRC has stressed that the publication of a narrative explaining the company's trends, policies and strategies should be encouraged as a crucial element of best practice in corporate reporting.

On 26 January 2006 the Accounting Standards Board (ASB), an operating council of the FRC, took this one step further by issuing a Reporting Statement 'The Operating and Financial Review'. Following the repeal of the OFR regulations, the ASB had withdrawn Reporting Standards (RS1) 'The Operating and Financial Review', which provided further details of what items should be included in an OFR and has now converted RS1 into a statement of best practice.

The provisions requiring all UK companies (including AIM and OFEX companies) except for 'small companies' to prepare an enhanced review of their business (the Business Review) remain in place. The Business Review is required to be included as part of the directors' report under section 234ZZB of the Companies Act 1985 and its provisions are deemed adequate to meet the minimum requirements of the AMD . They include a fair review of the business of the company and a description of the principal risks and uncertainties facing the company.

What has been lost from the OFR regulations is the requirement for detailed reporting, which some investors, analysts and accountants believe helps focus the minds of directors on significant matters. The intention behind the OFR regulations was to improve the quality of narrative reporting and to better aid resource allocation. The OFR required reporting on the main trends and factors likely to affect a company's future development and performance, whereas the Business Review is predominantly more focused on the financial year in question with less focus on detailed forward-looking statements.

A significant number of FTSE 100 companies, however, already publish an OFR on a voluntary basis. The ASB is now encouraging companies to continue to do so and to use its Reporting Statement as an up-to-date and authoritative source of best practice guidance. The ASB has endeavoured to change the language of the Reporting Statement to reflect the conversion from a mandatory reporting standard into a statement of best practice. There will be no further consultation in relation to this Reporting Statement given the extensive consultation that took place in developing the RS1.

The FRC intends to keep a close eye on developments in this area. Under the 2006/07 Plan and Budget, which is currently out for consultation, the FRC has made it one of its aims to review the quality of narrative reporting in company reports. Ian Mackintosh, the Chairman of ASB announced:

"The Operating and Financial Review has for some years been an important feature of corporate reporting, providing an opportunity for directors to set out clear and balanced analysis of the strategic position and direction of their business. Whether or not the OFR is a statutory requirement, the publication of a narrative explanation of a company's development, performance, position and prospects should continue to be encouraged as an important element of best practice. The reporting statement gives companies clear guidance and a framework within which they can achieve transparent and open communication with their shareholders."

The ASB has sought to limit its changes to those which first and foremost reflect the repeal of the OFR regulations. The OFR may now accompany, rather than be included in a company's annual report, although the ASB recommends that the OFR is presented in a way which complements the format of the annual report. A company no longer needs to specify exactly which information and analysis of which particular matters have been included in the OFR, nor do they need to include particulars of, and reasons for, any departure from RS1.

6.3 OFRs and the Prospectus Rules

The removal of the OFR statutory requirement should not be confused with the detailed prospectus requirements which are contained in the Prospectus Rules Instrument 2005. The content requirements oblige companies to include an OFR in prospectuses for equity securities (Prospectus Rules Instrument 2005, Minimum Disclosure Requirements for the Share Registration Document, Annex 1, paragraph 9). It should be noted that this provision of the Prospectus Rules is carved out for AIM admission documents which do not constitute a Prospectus. The OFR for prospectuses must include details of the causes of material changes from year to year as part of a company's financial information, to the extent necessary for a third party to understand the issuer's business as a whole. The content and format of the OFR is similar to a US"MD&A" section (management's discussion and analysis of financial condition and results of operations).

6.4 Conclusion

Even though UK listed companies are no longer required to publish an OFR in their annual report, they may still feel the pressure to, given the expense and effort gone into preparing their first OFR, as well as the response from the FRC and other business organisations. It shall be a wait and see game as to whether the OFR really has been abandoned or adopted as a way of gaining market advantage.

If you require further information on any matter covered in this note, please contact your principal contact at Charles Russell or Simon Gilbert, Clive Hopewell or Alexander Keepin (London), Francis Rundall, Richard Norton, or Adrian Mayer (Cheltenham), Catherine Drew or Geoff Sparks (Guildford) or Peter Elliott (Oxford) on 0207 203 5000.

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