2017 narrative reporting issues

In this update we look at: 

• EU audit reform implementation
• Financial Reporting Council publications
• Investment Association publications
• Updated UK and US institutional guidance
• Miscellaneous new and updated reporting requirements 

EU audit reform implementation

Background. Although the EU audit reforms seem to have been a long time coming and although companies will turn to their auditors for detailed advice in this area, it is perhaps useful to summarise here the changes that have taken place in 2016 to effect the widely-anticipated EU audit reforms. 

In our 2016 AGM season briefing, we covered, as a development for 2017, the EU Audit Regulation (EU/537/2014) and the EU Audit Directive (2014/56/EU) (together the EU audit reforms), to be implemented in Member States by 17 June 2016. The changes resulting from the EU audit reforms that are of most relevance to AGMs and narrative reporting for the Public Interest Entities to which the Regulation in particular applies (broadly, all listed companies and also credit institutions and insurance undertakings, even if the latter are not listed), concern the regular mandatory rotation of auditors and re-tendering of the audit contract, specifically requiring rotation at least every 20 years with re-tendering at least every 10 years. As a result, companies will have to conduct more regular audit tenders and more regularly vote at their AGMs on a new set of auditors. Other relevant reforms are those relating to audit committees, which make adjustments to existing rules as regards audit committee composition and functions, elements of which then have to be reported on.

We note below the key legal and regulatory changes that effect the EU audit reforms, effective for accounting periods starting on or after 17 June 2016. Although the effective dates mean most companies need not report on these changes until their 2017 annual reports and accounts published in 2018, those who may need to effect changes to ensure compliance will want to consider this sooner rather than later, if they have not already.

Changes to the Companies Act 2006. As we noted in our July 2016 Quoted Company Newsletter, The Statutory Auditors and Third Country Auditors Regulations 2016 (2016 No. 649) have amended the Companies Act 2006 (in particular Parts 16 (audit) and 42 (statutory auditors)). The changes here implement the key EU reform noted above on mandatory rotation of auditors and re-tendering of the audit contract and related matters.

2016 Corporate Governance Code and Guidance for Audit Committees. New versions of the UK Corporate Governance Code (2016 Code) and Guidance on Audit Committees (2016 guidance) were published by the Financial Reporting Council (FRC) and are applicable for accounting periods beginning on or after 17 June 2016. Changes to the 2016 Code relate to audit committees and are minor:

• C.3.1: addition such that the audit committee as a whole shall have competence relevant to the sector in which the company operates.
• C.3.7: removal of the provision that FTSE 350 companies should put their audit contract out to tender at least every ten years, as duplicative.
• C.3.8: addition such that advance notice of any retendering plans should be included in the audit committee report in annual reports.
  Changes to the 2016 guidance are numerous, including updates for the 2016 Code, the EU audit reforms, the new ethical and auditing standards for auditors, the Competition and Markets Authority 2014 Statutory Audit Services for Large Companies Order and as regards a company's interactions with the FRC's Audit Quality Review Team and Corporate Reporting Review Team.

Changes to DTR 7.1 – audit committees. Also effective on 17 June 2016 are a variety of changes to DTR 7.1 on audit committees to effect the EU audit reforms. Changes relate to, among other things, composition of the committee (for example that a majority of members be independent; that members of the committee as a whole are to have competence relevant to the sector in which the issuer is operating; and that the chairman must be independent and appointed by the board); and also to the committee's functions (for example that it should be responsible for the procedure for selection of the company's auditors and make recommendations to the board; that it should monitor non-audit services; and that it should inform the board of the outcome of the audit and explain various related matters).

The Financial Conduct Authority continues to helpfully state (in DTR 7.1.7) that compliance with certain provisions of the 2016 Code (namely A.1.2; C.3.1; C.3.2; C.3.3; and C.3.8) will, in its view, result in compliance with the audit committee DTRs. Therefore for those premium listed companies, and others, who already comply with the 2016 Code, the changes to the DTRs should not entail much if any change. However, for affected companies who do not already comply (for example, listed companies that explain their non-compliance with any of the relevant Code provisions), they will need to consider DTR 7.1 as amended and ensure they comply with it since the DTRs are mandatory (and not comply or explain). 

Changes to PRA rules – audit committees. The Prudential Regulation Authority has also amended its rules (subject to transitional arrangements) to apply the EU audit reforms on audit committees to, amongst others, credit institutions and insurance undertakings. As already noted, the EU audit reforms, and so the PRA rules applying them, apply to credit institutions and insurance undertakings regardless of whether they are listed or not.

Financial Reporting Council publications

Brexit – reminders for financial reports. Following the referendum result to leave the EU, the FRC issued, in July 2016, reminders for directors to consider the issue when preparing their financial reports. Whilst acknowledging that not all businesses would be equally affected, the FRC reminded directors that they should decide what level of disclosure would be needed to meet the needs of investors and regulatory requirements and instigate early dialogue with their auditors. Matters noted on narrative reporting include the following.

Brexit - some FRC reminders

• Business model. This should include a description of the main markets the company operates in and its value chain, and enable readers to make an assessment of the company's exposure arising from the vote result.
• Principal risks and uncertainties. Directors should consider the nature and extent of any risks and uncertainties from the vote result to the future performance and position of the business and, if judged to be "principal", should disclose and explain them. Company-specific (ie non boilerplate) disclosures are the most useful to investors, for example the impact of trade agreements for companies with a high level of exports to the EU.
• Viability statement. Boards should consider whether the referendum vote gives rise to solvency, liquidity or other risks that may threaten the long-term viability of the business and implications for the viability statement.

Annual report on developments in corporate governance and stewardship. In January 2017, the FRC published its annual report looking at corporate governance and stewardship in 2016. It has four main purposes: to give an assessment of corporate governance and stewardship; to report on the quality of compliance with, and reporting against, the Code (and the Stewardship Code, although this briefing does not cover the Stewardship Code); to assess the quality of engagement between companies and shareholders; and to indicate where the FRC would like to see changes in governance behaviour or reporting.

FRC 2016 governance report - some areas for improvement

• Disappointing reporting after significant votes against. This relates to Code Provision E.2.2 which requires companies to explain, when publishing meeting results, how they intend to engage with shareholders when a significant percentage have voted against a resolution. The report notes that some companies failed to make a statement, and for others the quality of disclosure was mixed.
• Poor quality explanations of non-compliance. The report notes that better explanations of non-compliance include company-specific context and background, reasons why the approach is in the interest of the company (not simply repeating the Code) and information on mitigating actions the company is taking to address the extra risk involved in the non-compliance. 
• Too little variation in viability statements. The reports notes too little variation in time horizons and the need for clearer explanations and more alignment between business model, strategy, principal risks and viability (see next table also). 
• Boilerplate nomination committee reporting. The report notes a tendency for nomination committee reporting to be boilerplate and that better reporting provides details of the committee's focus in the previous year and what the year ahead holds. Investors want clarity on the company's approach to board evaluation, succession planning and refreshment. 

Annual review of corporate reporting 2015/2016. In October 2016, the FRC published its annual review of corporate reporting 2015/2016, giving its assessment of the state of corporate reporting in the UK, focusing on those aspects of annual accounts where it has monitoring powers, namely the strategic report and the financial statements. Although most of the annual review concerns financial statement issues which we do not cover in this briefing, we set out briefly key areas mentioned as regards narrative reporting.

FRC annual review - key messages on narrative reporting

• Are strategic reports sufficiently balanced? A common area of challenge by the FRC is whether strategic reports are sufficiently balanced. For example, do they acknowledge when things have not gone well and include information of particular interest to investors? 
• Viability statements. Some 75% of the statements that the FRC reviewed cover a three-year period. The FRC states that three years should not become the default and encourages companies to give better explanations of why and how they chose the period and the underlying analysis.
• Business model and principal risk reporting. Good business model and principal risk reporting gives valuable insights into the business and how it generates cash, and also how it operates more broadly and its culture. The FRC notes its Lab report on business model disclosure which aims to suggest characteristics of good reporting and practical ways that companies might meet investors' needs.
• Increasing focus on companies' tax arrangements. Companies need to respond to increasing stakeholder scrutiny of their tax strategies, including where they pay tax and whether their strategy is sustainable and what risks there are to it.
• A broader range of disclosures. FRC discussions with shareholders show a growing appetite for more disclosure on a broader range of issues, for example climate-related matters and culture. 
• Clear and concise reporting. This remains a theme although the FRC recognises the challenges for companies.

End-of-year letter. In October 2016, the FRC sent its end-of-year letter to audit committee chairmen and finance directors. On narrative reporting, it covers many issues already mentioned. Other areas include: dividends, noting its FRC Lab Report on dividend disclosures which suggests a scaled approach to disclosure of available cash and distributable profits, but equally noting that the FRC position remains unchanged on the fact that the Companies Act 2006 does not require the separate disclosure of a figure or figures for distributable profits; remuneration, noting that investors want more clarity and brevity in remuneration reporting; and audit committee reporting, noting that investors want more information about the specific actions taken by audit committees.

Updated UK and US institutional guidance

The Investment Association. The IA has published some new papers relevant to the forthcoming season (in addition to its 2017 principles of remuneration noted earlier).

Board oversight of profit expectations and dividend policy. In May 2016, the IA published a letter signalling its concern with companies that made significant changes to their profit expectations or asset valuations and/or reduced their dividend policy after the appointment of new management. It now intends to "amber-top" such companies, ie note that there is a significant issue to be considered.

Share capital management guidelines. In July 2016, the IA revised its share capital management guidelines. They are the same as the previous version other than noting the IA's support for the Pre-Emption Group's template resolutions mentioned earlier, and that IVIS will red top any company not using them when seeking the extra 5 per cent resolution.

Guidelines on viability statements, November 2016. This is a new set of guidelines given the viability statements seen in the past year. They note that the IA's corporate governance research arm, IVIS, will continue to monitor viability statements, now on the basis of these guidelines. Matters that the guidelines cover include (i) period for the viability assessment (for example, the IA considers there should be more differentiation between companies and that periods longer than three or five years should be chosen); (ii) prospects and risks when assessing viability (for example, the viability statement could address sustainability of dividends); (iii) stress testing (for example, more transparency on the stress testing that has taken place, the likely outcomes and specific mitigation that may be needed); and (iv) qualifications and assumptions (for example, that assumptions and qualifications should be distinguished from each other and be company-specific). 

Quarterly reporting and quarterly earnings guidance, November 2016. This is not relevant for annual reporting, but is worth noting for completeness. It is a new IA position paper in which the IA, among other things, calls for companies to cease quarterly reporting and refocus reporting on a wider range of strategic issues. See our December 2016 Quoted Company Newsletter for more.

The Pensions and Lifetime Savings Association 2017 corporate governance policy and voting guidelines. In January 2017, the PLSA issued its 2017 Corporate Governance Policy and Voting Guidelines which aim to promote the long-term success of the companies in which the PLSA’s members invest and ensure that the board and management of such companies are held accountable to shareholders, such as pension funds.

PLSA Governance Policy and Voting Guidelines 2017 - some key points

• Executive remuneration. Members to take a much stronger line on executive remuneration and on those who set it (see table earlier in this briefing). 
• Culture and working practices. New recommendations, taken from the 2016 PLSA stewardship toolkit, for better disclosures on corporate culture and working practices that relate the way a company manages and engages its workforce to its wider strategy and business models including information on workforce composition, stability, training, skills and engagement levels.
• Diversity. Increased emphasis on boardroom diversity, noting the targets in the Hampton/Alexander and Parker reports respectively (see more below).

Institutional Shareholder Services - UK and Ireland proxy voting guidelines 2017. ISS is a US-based provider of corporate governance services that issues its own proxy research and vote recommendations to assist institutional investors in meeting their responsibilities with respect to voting. It has published its proxy voting guidelines and 2017 benchmark policy recommendations for the UK and Ireland which are effective for shareholder meetings on or after 1 February 2017.

Key changes to its guidelines include: (i) updates on remuneration including that it may give an adverse vote recommendation on the remuneration committee chair if there are serious breaches of good practice identified, typically over a number of years; (ii) clarification of language regarding what it regards as "overboarding" (too many directorships) and when and at which company it may give an adverse vote recommendation; and (iii) in relation to (amongst others) AIM companies, an expectation (from 1 February 2018) that, in line with the QCA Code, their audit and remuneration committees must be fully independent.

Glass Lewis - 2017 UK proxy season guidelines. Glass Lewis is another US-based provider of global governance services assisting institutional investors to engage with their investee companies. In November 2016, it issued its UK guidelines for the 2017 proxy voting season. 

The key area of change, which is a notable change of policy for Glass Lewis, is that, following what it describes as constructive engagement with a number of UK companies, it has decided to change its policy with regard companies' resolutions for authority to call general meetings on only 14 days' notice. It will now generally support such resolutions so long as (i) such an authority has not previously been abused and (ii) as is best practice in the UK, companies provide assurances that such authority will not be used as a matter of routine and will only be used where there is an exceptional need for urgency and it is to the advantage of shareholders as a whole.

Other areas of update to the Glass Lewis guidelines include remuneration; when directors have material business or professional services relationships with their companies and director tenure.

Miscellaneous new and updated reporting requirements

New non-financial information statement and enhanced diversity disclosures. See the "Developments for 2018 or later" section below in relation to (i) the new non-financial information statement and (ii) the enhanced diversity disclosures, both of which have been brought into force for certain large companies for financial years commencing on or after 1 January 2017 as a result of an EU Directive. These disclosures, unless already covered, will feature in reporting in annual reports and accounts published in 2018. As explained in more detail below, although several of these "new" reporting requirements overlap with existing requirements, some are new and others are similar but more rigorous and may therefore entail some extra reporting by affected companies and hence preparation in the course of 2017 to achieve that.

Reporting on diversity on boards –Hampton/Alexander review – FTSE Women Leaders. In November 2016, Sir Philip Hampton and Dame Helen Alexander (tasked with building on the work of Lord Davies and his Women on Boards goals), published their report on improving gender balance in FTSE Leadership. The next stage focuses not only on board appointments but also on executive committee composition and on direct reports to the executive committees of FTSE 350 companies.

Hamton/Alexander review - some recommendations

• FTSE 350 companies to aim for at least 33 per cent of women on their boards by 2020.
• FTSE 100 companies to aim for at least 33 per cent of women across their executive committees and the direct reports to their executive committees by 2020.
• The FRC to amend the Code to require FTSE 350 companies to disclose more on the gender balance of their executive committees and their direct reports.

Reporting on ethnic diversity on boards – the Parker Review Committee consultation document. In November 2016, Sir John Parker and the Parker Review Committee published a consultation version of their report on the ethnic diversity of UK boards. This follows their having been invited, in late 2015, to conduct an Official Review of the ethnic diversity of UK boards, with the aim of suggesting ways of encouraging businesses to increase the ethnic diversity of boards. The consultation period is scheduled to end on 28 February 2017.

Parker review - some recommendations

• Increasing the ethnic diversity of boards to have at least one director of colour by 2021 for FTSE 100 companies and by 2024 for FTSE 250 companies.
• Companies that do not meet the board composition recommendations by the suggested dates should explain why not.
• Developing and promoting candidates of colour in the pipeline of board candidates.
• Enhancing transparency and disclosure. For example, the description of the board's policy on diversity in its annual report should include a description of the company's efforts to increase ethnic diversity in its business and on its board.

Reporting on the gender pay gap. This is not a reporting requirement for annual reports and accounts, but we note it briefly for completeness. The Government has decided to introduce mandatory gender pay reporting for large employers in Great Britain i.e. those in the private and voluntary sectors with 250 employees or more. Similar rules are also being introduced for large public sector employers. Draft regulations - The Equality Act (Gender Pay Gap Information) Regulations 2017 - setting out the detail of the new reporting rules were published on 6 December 2016 and are intended to come into force on 6 April 2017. For more, see our December 2016 briefing. 

Reporting on business payment practices and policies – updated draft regulations. This is not a reporting requirement that relates to annual reports and accounts, but nonetheless as a long-awaited new reporting requirement, we mention it here for completeness. 

In December 2016, the Department for Business, Energy and Industrial Strategy published its response and updated draft regulations on the proposed new mandatory duty to report on payment practices and performance. Broadly, large UK companies and LLPs, namely those not qualifying as medium-sized or smaller under standard Companies Act 2006 definitions, will be required to submit a report, every six months, onto a (freely- accessible) government web-based service, giving certain information on their payment terms and performance metrics. This includes a description of their standard terms and the maximum payment period as well as the average number of days they take to make payments to suppliers.

The regulations are intended to come into force on 6 April 2017. The first companies and LLPs to have to comply with the new duty to report (subject to exceeding the relevant thresholds on the relevant date or dates) are those with a financial year beginning on 6 April 2017. Such qualifying companies or LLPs will have to submit their first report within 30 days of the first six months of the financial year, namely by 6 November 2017. 

Most businesses, however, will not have to report so soon. Qualifying companies and LLPs with 31 December and 31 March year-ends will have to submit their reports by 31 July 2018 and 31 October 2018 respectively. For more detail, see our December 2016 corporate briefing.

Please click on the links below to view other articles in our 2017 AGM briefing:

• 2017 AGM issues
• Developments for 2018 or later