Since our Summer 2016 publication, there have continued to be a number of corporate governance and narrative reporting developments. This briefing summarises those developments and looks at future developments in a number of areas that companies need to start preparing for.
Corporate governance developments
- Corporate governance review
- Other reports/developments on governance and directors’ duties
- Remuneration developments
- Diversity developments
- Developments relating to corporate culture
- Developments in relation to board evaluations
- Institutional investor developments
BIS Select Committee inquiry and general review of corporate governance in the UK
It is evident that reviewing corporate governance is high on the Government’s agenda. Theresa May made this clear in a speech soon after she secured the Conservative Party leadership nomination. In a statement to Parliament on the G20 Summit in China in early September 2016, she said that to restore greater fairness in society, the Government would be consulting this autumn on new measures to tackle corporate irresponsibility, including cracking down on executive pay, poor corporate governance, short-termism and aggressive tax avoidance and giving employees and customers representation on company boards, and she repeated this theme at the October 2016 Conservative Party Conference.
In addition, in September 2016, the Business, Innovation and Skills (BIS) Select Committee announced the launch of an inquiry on corporate governance, focussing on executive pay, directors’ duties and the composition of board rooms, including worker representation and gender balance in executive positions. The inquiry follows on from recent inquiries by the BIS Select Committee into BHS and Sports Direct. Written submissions were requested by October 26, 2016 and particular points on which the Select Committee sought submissions included the following:
- Is company law sufficiently clear on the roles of directors and non-executive directors, and are those duties the right ones? If not, how should it be amended?
- Is the duty to promote the long-term success of the company clear and enforceable?
- How are the interests of shareholders, current and former employees best balanced?
- How best should the decisions of boards be scrutinised and open to challenge?
- Should there be greater alignment between the rules governing public and private companies?
- Should additional duties be placed on companies to promote greater transparency, for example, around the role of advisers?
- How best can shareholders have confidence that executives are subject to independent challenge?
- What factors have influenced the steep rise in executive pay over the past 30 years relative to salaries of more junior employees?
- How should executive pay take account of a company’s long-term performance?
- Should executive pay reflect the value added by executives to companies relative to more junior employees? If so, how?
- Should government seek to influence or control executive pay?
- Should shareholders have a greater role in controlling executive pay?
Composition of boards
- What evidence is there that more diverse company boards perform better?
- How should greater diversity of board membership be achieved and what should diversity include?
- Should there be worker representation on boards and/or remuneration committees and, if so, what form should this take?
- What more should be done to increase the number of women in executive positions on boards?
Tomorrow’s Company report on bringing employee voice into the boardroom
In November 2016, Tomorrow’s Company published a report presenting options to increase employees' voices in company governance structures. The report offers two options to achieve this. One option incorporates employees as insiders by introducing them as employee representatives on the board and the other is designed to give them a powerful channel of communication and challenge as outsiders based on some form of employee advisory panel.
Tomorrow’s Company suggests that, while offering companies flexibility, these options would apply to all companies with more than 500 employees in the UK. These companies would be required to demonstrate that they have offered effective employee voice within their governance structure. This could either be demonstrated by the formal introduction onto the board of one or more employee directors, or by the use of employee consultative structures outside the board. In both cases the company would be required to report on how its arrangements achieved employee voice. In the case of the second ’outside’ option the company would be required to give the employee advisory panel an opportunity to report publicly on its activities and its views of the effectiveness of the arrangements at the AGM, in its annual report, and on its website. There would be a transition period of two years during which the principle of ‘comply or explain’ would apply, as companies start to experiment with either option and explain what they are doing.
Companies with more than 50 per cent of employees in the UK would be required to demonstrate employee voice at the group level, while those below 50 per cent would have the option to demonstrate employee voice at the UK subsidiary level.
TUC report on worker representation on company boards
In October 2016, the TUC published a report setting out the case for worker board representation, how it works in practice in other European countries and detailed proposals for its implementation in the UK.
The report suggests the following:
- A timetable for implementation - The TUC says that if the Government begins a consultation shortly, the policy could be on the statute books within 12 months.
- Scope - The new law should apply to all firms with workforces of over 250, and could be phased in gradually, starting with larger businesses.
- Quotas - The report calls for a third of company board members to be worker representatives, who should be directly elected by their colleagues.
The report notes that similar requirements are in place in 12 other EU member states, including Germany, Sweden, Austria and the Netherlands, and that surveys there reveal that the majority of businesses view employee representatives on the board positively. The TUC says that allowing workers to sit on company boards would encourage the long-term success of individual firms, as both employees and directors work together in the interests of long-term company performance, and it believes that the current approach of relying solely on shareholders to hold companies to account has delivered neither economic success nor social justice.
ICGN’s updated Global Governance Principles
In October 2016, the International Corporate Governance Network (ICGN) published an updated version of its Global Governance Principles (the Principles). There have been no significant changes from the previous version published in 2014.
The Principles describe the responsibilities of boards of directors and institutional investors respectively, and aim to enhance dialogue between the two parties. The Principles apply predominantly to publicly listed companies and set out expectations around corporate governance issues that are most likely to influence investment decision-making. They are also relevant to non-listed companies which aspire to adopt high standards of corporate governance practice. The Principles are relevant to all types of board structure, including one-tier and two-tier arrangements.
Institute of Directors’ 2016 Good Governance Report
In September 2016, the the Institute of Directors (IoD) published a report setting out the findings from its research into two key questions it asked of practitioners – what is good corporate governance and how can it be measured? The purpose of its research is to encourage the study of good governance among UK companies and stimulate public debate on the importance of corporate governance in rebuilding the reputation of the UK business community.
Corporate governance is assessed in the report across five key categories: board effectiveness; audit and risk/external accountability; remuneration and reward; shareholder relations; and stakeholder relations. The results indicate that different components of corporate governance have different impacts on practitioners' perceptions of it. Measures of board effectiveness have little effect on the perceived quality of corporate governance of a company. However, measures of the quality of audit and risk/external accountability are the most important determinant of the perception of good corporate governance, followed by shareholder relations, then by remuneration and reward, then stakeholder relations, in that order.
The study also confirms that there is no agreement across stakeholders about the definition of good governance. Although measures of the quality of audit and risk/external accountability are important across all types of respondents, different types of respondents emphasise different aspects of corporate governance. Customers care about audit and risk/external accountability and shareholder relations. Suppliers and the media care about audit and risk/ external accountability. Investors and analysts care both about audit and risk/external accountability and stakeholder relations.
LAPFF letter to chairs of FTSE 350 companies on discharging the contractual and statutory duties of directors
The Local Authority Pension Fund Forum (LAPFF) published a letter it sent in September 2016 to chairmen of FTSE 350 companies suggesting that the position of the Financial Reporting Council (FRC) should be disregarded if directors are to discharge their duties lawfully in preparing accounts and making lawful distributions.
The LAPFF first wrote to chairmen in November 2015 setting out this position, following an opinion of George Bompas QC that the LAPFF received in August 2015, and the purpose of this letter is to claim that the Department for Business, Energy and Industrial Strategy (BEIS, formerly BIS) has never disagreed with the LAPFF and would probably have informed the LAPFF if the LAPFF’s position had been incorrect.
The issue concerns the determination of a company’s distributable profits for the purpose of making a distribution. Mr Bompas states that if the numbers in the accounts do not enable the distributable profits to be determined, then they will not give a true and fair view. However, he believes that in following the FRC’s financial reporting standards, accounts may conflate realised profits with unrealised gains, or leave out losses altogether, so distributable profits cannot be determined from the numbers in the accounts. This means two sets of books are required which is not permitted by law.
The LAPFF states that following the advice of Mr Bompas carries no risk of illegality and is a safe option, whereas following the position of the FRC carries a significant risk that accounts will be defective, thus putting boards in a position of approving unlawful distributions, and potentially trading whilst insolvent whilst presenting accounts that show a healthy financial position.
ICSA Guidance Note on minute taking
The ICSA Governance Institute issued new guidance in September 2016 on minute taking. The Guidance Note recognises that minutes are as individual as the board to which they relate. However, it advises that decisions as to format, style and content should be taken from a position of knowledge of the law and of regulatory and market practice so as to provide an accurate, impartial and balanced record of meetings, but comments that this a deceptively difficult task.
The Guidance Note, which follows a consultation launched in May 2016, highlights the following key points:
- The purpose of minutes is to provide an accurate, impartial and balanced internal record of the business transacted at a meeting.
- There is no ‘one-size fits all’ approach for minute writing and no ‘right way’ to draft minutes. Context is always important and each chairman and each board member will have their own preference for minuting style. It is up to each individual organisation to decide how best its meetings should be recorded.
- The degree of detail recorded will depend to a large extent on the needs of the organisation, the sector in which it operates, the requirements of any regulator and the working practices of the chairman, the board and the company secretary. As a minimum, minutes should include the key points of discussion, decisions made and, where appropriate, the reasons for them and agreed actions, including a record of any delegated authority to act on behalf of the company.
- Minutes should be clear, concise and free from any ambiguity as they will serve as a source of contemporaneous evidence in any judicial or regulatory proceedings.
- Minutes should facilitate regulatory oversight, but this is not their primary purpose. Nonetheless, those drafting minutes should be mindful of regulatory needs. The well-written minutes of an effective board meeting should convey all the assurance that a regulator needs.
- Minutes should not be a verbatim record of the meeting.
- Minutes should document the reasons for a decision and include sufficient background information for future reference.
- Individual contributions should not normally be attributed by name, but this will be appropriate in some cases.
- Draft minutes should be clearly marked as such and amendments to the draft minutes should be thought of as ‘enhancements’ rather than ‘corrections’.
- The audio recording of board minutes or the publication of board minutes is not, generally, recommended. Any such recording should be deleted once the minutes have been approved.
The full Guidance Note is available to ICSA members only.
Executive Remuneration Working Group’s Final Report
In July 2016, the Executive Remuneration Working Group, established by the Investment Association in September 2015 to review pay structures in UK listed companies, issued its Final Report. The Working Group published its Interim Report in April 2016 and consulted widely throughout May and June 2016 with a wide range of stakeholders. The Working Group’s core recommendation in the Final Report is that companies be given the flexibility to select the remuneration structure that is most appropriate for their business, rather than focusing solely on the currently dominant Long Term Incentive Plan (LTIP) pay structure. The Working Group has set out a framework of structures to illustrate what this flexibility might look like in practice.
The Report contains the following ten recommendations aimed at rebuilding trust in executive pay structures in the UK:
- There should be more flexibility afforded to remuneration committees to choose a remuneration structure which is most appropriate for the company’s strategy and business needs.
- Non-executive directors should serve on the remuneration committee for at least a year before taking over the chairmanship of the committee. The Financial Reporting Council should consider reflecting this best practice in the UK Corporate Governance Code.
- Boards should ensure the company chairman and whole board are appropriately engaged in the remuneration setting process. This will ensure that the decisions of the remuneration committee are agreed by the board as a whole.
- Remuneration committees need to exercise independent judgement and not be over-reliant on their remuneration consultants, particularly during engagements with shareholders. To ensure independent advice is maintained, the remuneration committee should regularly put their remuneration advice out to tender.
- Shareholder engagement should focus on the strategic rationale for remuneration structures and involve both investment and governance perspectives. Shareholders should be clear with companies on their views on and level of support for the proposals.
- Companies should focus their engagement on the material issues for consultation. The consultation process should be aimed at understanding investors’ views. Undertaking a process of consultation should not lead to the expectation of investor support.
- Remuneration committees should disclose the process for setting bonus targets and retrospectively disclose the performance range.
- The use of discretion should be clearly disclosed to investors with the remuneration committee articulating the impact the discretion has had on remuneration outcomes. Shareholders will expect committees to take a balanced view on the use of discretion.
- The board should explain why the chosen maximum remuneration level as required under the remuneration policy is appropriate for the company using both external and internal (such as a ratio between the pay of the CEO and median employee) relativities.
- Remuneration committees and consultants should guard against the potential inflationary impact of market data on their remuneration decisions.
Revised GC100 and Investor Group Directors' Remuneration Reporting Guidance
In August 2016, the GC100 and Investor Group (Group) published a second edition of its directors' remuneration reporting guidance (Guidance), which was initially published in September 2013. The second edition reflects changes resulting from a review by the Group of experience over the 2014 to 2016 AGM seasons, and feedback from companies, investors, advisers, other market participants and government. It is to be reviewed on a regular basis to ensure it remains relevant and useful.
The Guidance notes that there has generally been an improvement in the quality of remuneration reporting since the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (as amended) (Regulations) were introduced, but the Group believes that companies should continue to focus on clarity and conciseness. It states that remuneration committees may find it helpful to consider:
- any feedback from shareholders on the last remuneration report and policy, and whether this suggests matters that could be set out more clearly and concisely in the next;
- what might make it easier for investors and other stakeholders to assess and understand each part of a remuneration report (or policy); and
- whether the report clearly explains the thinking and purpose behind the remuneration committee’s decisions and choices.
New provisions in the revised Guidance include the following:
- A decision by a remuneration committee to apply upwards discretion will inevitably be the subject of considerable shareholder scrutiny and will require careful explanation and, in certain cases, prior dialogue with shareholders. For example, where qualitative performance measures are used and performance against those measures is assessed as being very good, but the company’s overall financial performance over the relevant assessment period is not commensurate with that assessment, investors generally expect the remuneration committee to give careful consideration to a moderation of formulaic outcomes – through the exercise of discretion – so that the remuneration outcome balances management performance and the shareholder experience.
- In the 2014 AGM season, a notable number of assurances were given by remuneration committees in order to narrow discretions that investors found too broad after publication of the annual report but prior to the AGM. The provision of such assurances is generally undesirable.
- Investors understand that prospective disclosure of the targets related to certain short-term incentive measures would commonly give rise to commercial sensitivity issues. In such circumstances, investors do not generally expect prospective disclosure of the targets in the statement of implementation of the remuneration policy in the current financial year, but they generally expect retrospective disclosure of those targets. The retrospective disclosure could be at the end of the reported year, in the short-term incentive information that appears after the single total figure table. However, where the directors conclude that commercial sensitivity remains an issue, the retrospective disclosure could be made at a later time; in this situation, investors generally expect the remuneration report to contain a commitment to disclose at a specified time in the future.
- Investors generally expect prospective and retrospective disclosure of the targets related to long-term incentive measures. Where the nature of a long-term incentive’s performance measure is such that commercial sensitivity exists (for example, it relates to a key strategic initiative that would be valuable information to major competitors if disclosed), investors generally expect the remuneration report to contain a commitment to disclose at a specified time in the future.
- Linking remuneration to the company’s strategy remains an important area for investors. While this is required as part of the future policy, investors generally expect that this should be supplemented by relevant disclosures in the annual remuneration report.
- Some remuneration committees have published assurances about the way aspects of their proposed policies would be implemented. Any assurance should be disclosed on the accounts and reports section of the company’s website, alongside the items required to be published there and an assurance should be set out in remuneration reports in the following years of the remuneration policy’s term, as a disclosure regarding policy implementation in those years.
- Although the Regulations do not state expressly that the maximum that may be paid in respect of each component of remuneration should be disclosed at an individual level in the future policy table, they state that “the table must also include any particular arrangements which are specific to any director individually”. Accordingly, the maximum level of each component of remuneration should be disclosed for each executive director.
Restoring responsible ownership - Ending the ownerless corporation and controlling executive pay
In September 2016, the High Pay Centre published a report by Chris Philp, a Conservative MP and member of the Treasury Select Committee, on controlling executive pay. The report discusses the rise of the “ownerless corporation”, noting that fragmented shareholdings and short-term investor horizons mean that some shareholders are not exercising proper oversight of companies they own, that the market does not work if shareholders are not always responsible custodians of their capital, and that shareholder interests and the wider public interest are often not served by executives who over-compensate themselves, do not focus on the long-term or engage in unchallenged strategic initiatives, such as reckless acquisitions.
On the rise of excessive executive pay, the reports states that one symptom of the rise of the ownerless corporation is the rapid rise in total executive pay, with FTSE 100 CEO total pay in the UK now averaging £6 million per year, or 150 times average worker income. This ratio has doubled in 10 years as worker pay has stagnated. The author comments that this level of inequality is socially divisive and public opinion is firmly against it.
The report suggests three main proposals to address these issues:
- Mandatory publication of pay ratios: The report proposes mandatory publication of total CEO remuneration to median worker total pay, creating transparency and downward pressure.
- Annual binding shareholder votes on executive pay: Besides the binding pay policy vote every three years, the report proposes an annual binding vote on actual pay awards, increasing shareholder control. This is already done in Switzerland, Holland and Denmark.
- Mandatory shareholder committee with employee representative attending: The report recommends that all Main Market companies should establish a shareholder committee consisting of the largest five shareholders based on holdings longer than 12 months. The chairman of the board and a non-union employee representative should also attend meetings of this committee as non-voting but speaking members. The committee would replace the nomination committee in recommending the appointment and removal of directors to the AGM, making directors more directly accountable to shareholders, it would ratify the pay policy and actual pay packages proposed by the remuneration committee before they go to a vote of all shareholders at the AGM, and it would pose questions to the board, including on corporate strategy and corporate performance, which the board would have to respond to.
IA’s Principles of Remuneration 2016
In October 2016 the Investment Association (IA) published its revised Principles of Remuneration (the Principles) for 2016 and an accompanying letter which outlines the key changes to the Principles. These changes reflect the IA’s response to the Executive Remuneration Working Group’s July 2016 Final Report (see above) and highlights some issues IA members will be focusing on ahead of the 2017 AGM season.
The main changes to the Principles are as follows:
- The Principles have been slimmed down to a set of high level issues and updated to reflect the recommendations of the Executive Remuneration Working Group.
- The Principles have been amended to acknowledge the need for increased flexibility of remuneration structures, and updated to ensure that they do not promote a single remuneration structure.
- The Principles have also been updated to ensure that the level of remuneration has appropriate focus and to require companies to disclose pay ratios between the CEO and median employee, and the CEO and the executive team, to provide the context of the remuneration provided.
- The guidance includes a new section on the importance of improving shareholder consultation on remuneration on structures, ensuring that it is based on the strategic remuneration issues rather than minor pay details.
- It is recommended that post-employment shareholding guidelines are implemented for executive directors.
- The Principles note that the definition of any performance measurement should be clearly disclosed and add that any adjustments to reported metrics should be clearly explained and the impact on the outcome detailed. The impact of share buy backs and other capital management decisions should also be taken into account when determining whether a performance measurement has been satisfied.
In relation to issues to consider for 2017 AGMs, in particular, IA members have asked for the following aspects of the Principles to be re-emphasised:
- Levels of remuneration: Any salary increases or increases to variable remuneration should be justified with clear and explicit rationale. Companies must be sensitive to the prevailing mood regarding executive remuneration, and take into account the effect of executive pay levels on all stakeholders.
- Bonus disclosure: Shareholders require the retrospective disclosure of bonus targets so that they can ensure that there is an appropriate link between pay and performance. IA members’ beneficiaries continue to seek explanations as to why the IA supports the remuneration packages of investee companies; therefore, the IA needs this information to justify supporting remuneration packages to its clients. For 2017, members expect full retrospective disclosure of the threshold, financial target and maximum performance targets, the level of performance achieved against these targets and the resulting bonus outcome and a thorough explanation as to why personal or strategic targets have been paid out, not just a description of non-financial performance indicators. Where targets are not disclosed or the company has not made a commitment to disclose the target range in future, IA members have asked the Institutional Voting Information Service (IVIS) to highlight this issue on a Red Top, as without such disclosures there is insufficient information to make an informed voting decision. Where IVIS deems there to be insufficient information on non-financial targets, members have asked IVIS to Amber Top the report.
- Policy renewals: IA members expect companies to have maximum limits on each aspect of variable remuneration. Whilst discretion is an important part of the remuneration policy, IA members do not expect companies to seek discretions to provide payments outside the scope of the policy.
- Use of discretion: Discretion is an important tool to ensure that the remuneration outcomes are appropriate for the overall performance of the company, shareholder experience, and fair to executives. Members wish for companies to be clear when the remuneration committee has exercised discretion and fully outline the circumstances, reasons and outcomes of the use of the discretion.
- Pensions: For a number of years the IA has highlighted the disparity in executive director pension provision compared to that provided to the general workforce. IA members are concerned with the lack of progress made on this issue. Therefore, the IA reiterates that, in instances where contribution rates for executives and the general workforce differ, the differences should be clearly justified.
ISS’s benchmark policy 2017 consultation
In October 2016 Institutional Shareholder Services Inc. (ISS) announced the launch of its 2017 benchmark voting policy consultation. ISS is consulting on changes to its policy on executive remuneration, its policy on audit and remuneration committee composition, and its policies on European pay for performance methodology.
Policy on executive remuneration
ISS is consulting on changes to its UK & Ireland executive remuneration policy to clarify that when forming a view on new remuneration arrangements, ISS will pay particular attention to the following points:
- how far the proposals are consistent with the good practice principles set out in ISS voting guidelines;
- the linkage between the proposals and the company's strategic objectives;
- whether or not the proposals have an appropriate long-term focus;
- the extent to which the proposals help simplify executive pay; and
- the impact on the overall level of potential pay.
Furthermore, ISS is considering recommending a vote against the re-election of the chair of the remuneration committee (or, where relevant, another member of the remuneration committee) in cases where a serious breach of good practice is identified, and typically where issues have been raised over a number of years. ISS also requests comment on whether, if serious concerns have been raised with pay practices over a number of years but the remuneration committee chair position is being rotated, respondents support the view that the longest serving member of the remuneration committee should be held accountable.
Policy on audit and remuneration committee composition for smaller companies
The change under consideration is that ISS' voting guidelines for audit and remuneration committee composition at AIM companies should reflect the Quoted Companies Alliance (QCA) position, namely that these committees should comprise independent non-executive directors only. ISS is consulting on whether to recommend voting against non-independent non-executives being members of such committees.
Policies on European pay for performance methodology
ISS is proposing to formalise the existing process on assessing pay performance by including a formal reference to the European pay-for-performance methodology in its UK and Ireland and continental European voting guidelines. The reference to the methodology will be as part of the current policy principles.
ISS plans to publish its final 2017 policies shortly. The revised policies will be applied to shareholder meetings taking place on or after February 1, 2017.
ICGN’s guidance on executive director remuneration
In October 2016, the International Corporate Governance Network (ICGN) published an updated version of its Guidance on Executive Director Remuneration. The Guidance on Executive Director Remuneration replaces guidance published in 2012 and aims to provide a consistent and global perspective focused on major aspects of remuneration policy and practice that will assist companies in better understanding long-term shareholders’ views, as well as serve as a tool for investors when engaging with companies.
The updated Guidance discusses the remuneration committee, remuneration structure and contractual provisions and includes four main changes from the previous edition:
- Greater clarity has been provided on committee leadership.
- Reference is made to the consideration of intrinsic motivational considerations beyond financial remuneration when determining effective remuneration structures.
- It is made explicit that base salary is payment for achieving what is expected of the executive, and that variable remuneration is payment for out-performance.
- Environmental, social and governance factors have been included in the assessment of performance to help achieve sustainable long-term value creation. The ICGN notes that this social sensitivity has particular relevance given public concerns about the high quantum of pay for executives in the context of building social awareness of the problems of economic inequality.
ICGN’s guidance on non-executive director remuneration
In October 2016, the International Corporate Governance Network (ICGN) published an updated version of its Guidance on Non-executive Director Remuneration. The Guidance replaces a previous version published in 2013 and sets out the ICGN’s position regarding remuneration structures for non-executive directors (NEDs), including board chairs. The updated Guidance discusses structure, accountability and transparency in NED remuneration and contains two main changes, specifically:
- expectations on NEDs to attain a significant shareholding are more clearly defined; and
- explicit reference is made to the remuneration of board chairs.
High Pay Centre’s briefing on executive pay
Following its annual survey of FTSE 100 CEO pay packages, the High Pay Centre published a briefing on executive pay in August 2016, revealing that rewards at the top continue to grow at a double digit rate.
In summary, the High Pay Centre found:
- average pay for a FTSE 100 CEO rose to £5.480 million in 2015, an increase from £4.964 million in 2014, but significantly higher than the £4.129 million in 2010;
- median FTSE 100 CEO pay in 2015 was £3.973 million, a slight increase from £3.873 million in 2014, but up from £3.391 million in 2010;
- the slower growth in median pay suggests that the increases in average pay are driven by big pay increases for a small number of CEOs at the top;
- in 2015, the average pay ratio between FTSE 100 CEOs and the average wage of their employees was 147:1, in 2014 the ratio was 148:1;
- the average pay ratio between FTSE 100 CEOs and the average total pay of their employees in 2015 was 129:1;
- the ratio of FTSE 100 CEO pay to the median full-time worker across the whole UK economy was 183:1 in 2014, 182:1 in 2013 and 160:1 in 2010;
- only a quarter of FTSE 100 companies are accredited by the Living Wage Foundation for paying the living wage to all their UK-based staff;
- most FTSE 100 companies fail to disclose how many people they employ in the UK in their annual reports - only 22 companies from a sample of 72 did so;
- one FTSE 100 company has employee representatives on the board. TUI, which recently merged with German incorporated TUI AG, has an airline pilot and a travel agent on its supervisory board;
- no FTSE 100 company currently publishes its CEO to employee pay ratio;
- no women made it into the top ten highest paid CEOs in 2015 or 2014; and
- 10 per cent of FTSE 100 companies had no female executive directors and no female remuneration committee members.
ICSA calls for fresh approach to tackle remuneration
In September 2016, the Institute of Chartered Secretaries and Administrators (ICSA) published a press release noting that its Governance Institute questions whether increasing shareholder voting rights will curb executive remuneration excesses and that it has written to the Prime Minister to advise caution in adopting such an approach.
ICSA believes that the issue with excessive executive remuneration is not that shareholders lack the rights that would enable them to hold companies properly to account, but that they are often reluctant to use them and that, unless investors become more willing to use the powers they already have, it may be necessary to consider different reforms.
QCA’s revised Remuneration Committee Guide
In July 2016, the Quoted Companies Alliance (QCA) published its revised Remuneration Committee Guide for Small and Mid-Size Quoted Companies. The Guide, prepared to assist remuneration committee members of small and mid-size quoted companies in setting pay for executive directors and senior management in a fair and reasonable manner, was last published in 2012, and it has been revised and updated to address new remuneration regulations and developments in governance behaviour and best practice.
Key changes include:
- A new section providing a high-level explanation of the changes to the legal regime for main market companies that took place in 2013;
- Specific reference to clawback arrangements;
- Expanding the narrative on the roles and responsibilities of the people involved in the work of the remuneration committee, placing greater emphasis on the role of the remuneration committee chairman;
- Integrating aspects of the QCA’s Corporate Governance Code for Small and Mid-Size Quoted Companies (QCA Code), published in 2013 and of the Audit Committee Guide for Small and Mid-Size Quoted Companies, published in 2014;
- Expanding the section on communicating with shareholders and creating a new section on the remuneration report, to reflect the increased focus on relations with shareholders.
The Guide is available for purchase on the QCA website.
PwC’s “Time to listen” - Report on public attitudes to executive pay and inequality
PricewaterhouseCoopers (PwC) published a report in July 2016 on public attitudes to inequality and executive pay in response to Theresa May’s campaign launch speech in which she discussed corporate irresponsibility.
PwC discusses the following in the report:
- Public attitudes to executive pay and inequality: PwC finds that there is a large gap between current pay practices and what the public believes to be fair, that executive pay and inequality are significant issues in voters’ minds and so of interest to politicians, attitudes are driven more by concerns about employment prospects than by the level of inequality itself, and that solutions need to address pay and prospects of the wider workforce, not just the pay at the top.
- Potential solutions: PwC provides an analysis of possible changes to executive pay regulation, which were initially considered as part of the 2013 review by the Department for Business, Innovation & Skills and concludes that more power for shareholders is the most popular option.
PwC concludes that new regulation in this area is best avoided. The appropriate locus of power is with shareholders but there needs to be a change in attitudes and behaviour to rebuild trust. PwC then sets out actions for companies and actions for shareholders to follow.
Actions for companies
- Remuneration committees need to be prepared to take tougher decisions and set tougher targets
- Companies should develop a set of fair pay principles.
- Companies should review their approaches to retraining and support due to the upcoming period of uncertainty for the economy and trends toward labour displacement by technology.
- Companies need to redouble their efforts to communicate the benefits of business in terms ordinary people understand, rather than producing company reporting directly aimed at shareholders.
Actions for shareholders
- Shareholders need to continue putting pressure on companies and engage fully on the pay issue, individually and with other shareholders.
- Shareholders should embrace change, from the complexities of the current system and the demands imposed by rigid adherence to the long-term incentive model promoted by agency theory.
- Shareholders should be prepared to work with policy makers in the event that new regulations or guidelines emerge.
Hampton-Alexander review: FTSE Women Leaders – Improving gender balance in FTSE leadership
In November 2016, the Hampton-Alexander Review led by Sir Philip Hampton and Dame Helen Alexander published a report on improving gender balance in the leadership of FTSE companies. The report extends the recommendations of the Davies Review by increasing the target of representation of women.
The report’s recommendations include the following:
Women on boards
FTSE 350 companies should aim for a minimum of 33 per cent women’s representation on their boards by 2020. More women should be appointed to the roles of chair, senior independent director and executive director positions on FTSE 350 boards and FTSE companies which have yet to address gender imbalance on their boards should take prompt action to address any shortfall.
FTSE women leaders
- All CEOs of FTSE 350 companies should take action to improve the under-representation of women on the executive committee and in the direct reports to the executive committee. FTSE 100 companies should aim for a minimum of 33 per cent women’s representation across their executive committee and in the direct reports to the executive committee by 2020.
- The chair of the nomination committee should take an active role in overseeing the progress made to improve women’s representation on the executive committee and the direct reports to the executive committee. At least once a year the nomination committee should review action plans and assess progress.
- FTSE 350 companies should voluntarily publish details of the number of women on their executive committee and in the direct reports to the executive committee on an annual basis. This should be disclosed in the corporate governance section of the annual report and accounts and/or on websites. In addition, this data should be lodged with the Hampton-Alexander review, details of which will be advised early in 2017.
Government reporting requirements
- As soon as is feasible, the Financial Reporting Council (FRC) should amend the UK Corporate Governance Code so that all FTSE 350 listed companies disclose in their annual report and accounts the gender balance on the executive committee and direct reports to the executive committee.
- Current legislation requires companies to disclose the gender balance amongst directors, senior managers and employees within companies’ annual strategic reports. The current definition of ‘senior managers’ does not easily lend itself to making clear comparisons between companies in order to assess progress on gender diversity. The Government should, in consultation with business, consider how best to clarify or supplement the definition of ‘senior managers’ to achieve a more consistent metric. This should be based on the executive committee or its nearest equivalent in each company, and direct reports to members of that committee. The Government should act as soon as possible in order to inform progress against the 2020 target set by this Review.
- Progress on gender balanced boards and in the leadership ranks of FTSE 350 companies should be assessed as a key corporate governance issue when investors consider their responsibilities under the UK Stewardship Code.
- All institutional investors should have a clear process in place for evaluating disclosures and progress on gender balance for FTSE 350 investee companies at board level, on the executive committee and in the direct reports to the executive committee. They should also have a clear voting policy on gender balance which could include voting against the re-election of chairs, nomination committee chairs and the annual report and accounts, where insufficient measures are in place in investee companies to address gender imbalance.
- Investors should discuss and engage with investee companies on gender balance, in particular where progress has been slow, and vote in accordance with their policy. They should also publicly disclose their voting records.
Executive search firms
- Executive search firms should build on success so far and continue their efforts to increase the number of women on FTSE 350 boards. They should apply the same effort and skills in supporting clients to increase the number of women on FTSE executive committees and in senior leadership positions.
- Executive search firms should consider extending their Code of Conduct and Enhanced Code of Conduct to include the executive committee and direct reports to the executive committee.
The report also contains evidence for the rationale for improving diversity, a ‘how to” for companies to consider for improving diversity, CEO comments, emerging research, focus features on several industries, and a discussion on the progress for women on boards, as well as detailed analysis of progress in FTSE 100 and 350 companies.
Parker Review Committee’s report into ethnic diversity of UK boards
In November 2016, the Parker Review Committee led by Sir John Parker published a consultation version of a report into the ethnic diversity of UK boards. The report highlights that ethnic minority representation in the boardrooms across the FTSE 100 is disproportionately low, especially when looking at the number of UK citizen directors of colour, and it makes recommendations for increasing diversity, underpinned by strong industrial logic and the need for UK companies to be competitive in the increasingly challenging and diverse marketplace.
The report’s recommendations are as follows:
Increase the ethnic diversity of UK boards
- Each FTSE 100 board should have at least one director of colour by 2021; and each FTSE 250 board should have at least one director of colour by 2024.
- Nomination committees of all FTSE 100 and FTSE 250 companies should require their human resources teams or search firms (as applicable) to identify and present qualified people of colour to be considered for board appointment when vacancies occur.
- Given the impact of the “Standard Voluntary Code of Conduct” for executive search firms in the context of gender-based recruitment, the report recommends that the relevant principles of that code be extended on a similar basis to apply to the recruitment of minority ethnic candidates as board directors of FTSE 100 and FTSE 250 companies.
Develop candidates for the pipeline and plan for succession
- Members of the FTSE 100 and FTSE 250 should develop mechanisms to identify, develop and promote people of colour within their organisations in order to ensure over time that there is a pipeline of board capable candidates and their managerial and executive ranks appropriately reflect the importance of diversity to their organisation.
- Led by board chairs, existing board directors of the FTSE 100 and FTSE 250 should mentor and/or sponsor people of colour within their own companies to ensure their readiness to assume senior managerial or executive positions internally, or non-executive board positions externally.
- Companies should encourage and support candidates drawn from diverse backgrounds, including people of colour, to take on board roles internally (e.g., subsidiaries) where appropriate, as well as board and trustee roles with external organisations (e.g., educational trusts, charities and other not-for-profit roles). These opportunities will give experience and develop oversight, leadership and stewardship skills.
Enhance transparency and disclosure
- A description of the board’s policy on diversity should be set out in the company’s annual report, and this should include a description of the company’s efforts to increase, amongst other things, ethnic diversity within its organisation, including at board level.
- Companies that do not meet board composition recommendations by the relevant date should disclose in their annual report why they have not been able to achieve compliance.
The appendices to the report contain a set of questions for directors and a resource toolkit to help boards meet the report's recommendations. The questions have been drafted to be consistent with the key considerations that directors need to make in the satisfaction of their statutory duties under the Companies Act 2006 and in a manner that is consistent with the UK Corporate Governance Code.
Comments on the consultation version of the report are requested by the end of February 2017 and a report containing the final recommendations and findings of the review will be published in 2017.
ICGN’s guidance on diversity on boards
In October 2016, the International Corporate Governance Network (ICGN) published Guidance on Diversity on Boards which builds upon the ICGN Guidance on Gender Diversity on Boards published in 2013. The original guidance identified the responsibilities of shareholders and companies alike to promote gender diversity on boards, ultimately to enhance corporate governance and the overall success of companies. The new Guidance recognises that a range of social and economic factors contribute to a fully diverse board, beyond gender diversity.
The Guidance identifies principles, policies and practices which promote board diversity in general, such as the adoption of robust board evaluation processes and shareholder engagement to promote good governance practices. As such, the Guidance aims to enhance dialogue on the subject between companies and investors. It also aims to provide a balanced view on the respective roles of companies and shareholders alike in promoting and supporting diversity on boards.
The ICGN encourages companies to develop and disclose board diversity objectives. Boards play a role in fostering diversity and inclusiveness within a company’s operations through overseeing recruitment and human capital management strategies. Boards should provide oversight on diversity measures and ensure that there is reporting across the organisation.
The ICGN also encourages shareholders to establish a dialogue with companies and, if necessary, hold the board accountable in instances of company non-compliance with market regulations or deficient disclosure with market protocols. Companies which do not meet such protocols should expect heightened shareholder interest. Shareholders may be able to facilitate greater board diversity by submitting their own nominees for consideration to the board. The ICGN notes that significant shareholders in some developed markets are increasingly able to nominate director candidates through equitable proxy access rules allowing them a voice in advocating for qualified, diverse nominees. Where proxy access is not assured, the ICGN notes that shareholders should consider petitioning their securities regulators for the right to have proxy access so as to facilitate boards that are more responsive to their shareholder base.
Cranfield School of Management’s Female FTSE Board Report 2016
In July 2016, Cranfield School of Management published its 2016 Female FTSE Board Report. The Report notes that the percentage of women on FTSE 100 boards had increased to 26 per cent in March 2016, significantly more than in March 2015 (23.5 per cent), but similar to the recorded 26.1 per cent in the final report by Lord Davies published in October 2015.
The Report comments that progress among executive ranks and in the executive pipeline remains very slow. Female executive directorships stand at 9.7 per cent in the FTSE 100 and 5.6 per cent in the FTSE 250,with only 19.4 per cent of women holding roles on executive committees of FTSE 100 companies. The Report notes that this shortage of women in top senior roles will make it difficult to reach and sustain Lord Davies’ target of 33 per cent women on FTSE 350 boards by 2020.
The Report identifies some key points to be considered for future action to maintain momentum moving forward, including:
- The focus on boards must be preserved as the pace of change has not kept up since Lord Davies’ final report. Chairmen and search consultants must ensure that boards are continually refreshed and the board turnover rate should be at least 14 per cent. A larger share of new appointments must go to women, and the board appointment process must remain robust, transparent and gender-inclusive.
- Greater attention should be paid to the female pipeline. Women are under-represented on FTSE 100 executive committees, especially in operational and C-suite roles, compared to functional roles. Future action should consider how organisations can develop talented women more effectively and how they can encourage more of them to take up operational roles.
- More robustness and transparency in reporting gender composition at executive committee level and below is needed. Companies should be encouraged to monitor and report gender balance across all seniority levels.
- Metrics and targets are effective tools to create a disciplined approach to gender balance and cultural change in organisations and the Report sets out principles of target setting and provides case studies of organisations that use voluntary gender targets.
HM Treasury reports that 72 firms have signed up to the Women in Finance Charter
In July 2016, HM Treasury announced that 72 financial services firms have now signed up to its Women in Finance Charter which commits financial services firms to link the remuneration packages of their executive teams to gender diversity targets and to set internal targets for gender diversity in their senior management, publish progress reports annually against these targets, and to appoint a senior executive responsible for gender diversity and inclusion.
FRC report on corporate culture and the role of boards
In July 2016, the Financial Reporting Council (FRC) published a report, “Corporate Culture and the Role of Boards”, which looks at the increasing importance which corporate culture plays in delivering long-term business and economic success. The report is the culmination of the FRC’s Culture Coalition project in collaboration with a number of partners as well as interviews with more than 250 chairmen, CEOs and leading industry experts, from the UK’s largest companies. The report explores the importance of culture to long-term value and how corporate cultures are being defined, embedded and monitored.
The FRC outlines key elements boards should take into consideration to create a healthy corporate culture:
- Recognise the value of culture: A healthy corporate culture is a valuable asset, a source of competitive advantage and vital to the creation and protection of long-term value. It is the board’s role to determine the purpose of the company and ensure that the company’s values, strategy and business model are aligned to it.
- Demonstrate leadership: Leaders, in particular the chief executive, must embody the desired culture, embedding this at all levels and in every aspect of the business.
- Be open and accountable: Openness and accountability matter at every level. Good governance means a focus on how this takes place throughout the company and those who act on its behalf. It should be demonstrated in the way the company conducts business and engages with and reports to stakeholders.
- Embed and integrate: The values of the company need to inform the behaviours which are expected of all employees and suppliers. Human resources, internal audit, ethics, compliance, and risk functions should be empowered and resourced to embed values and assess culture effectively. Their voice in the boardroom should be strengthened.
- Assess, measure and engage: Indicators and measures used should be aligned to desired outcomes and be material to the business. The board has a responsibility to understand behaviour throughout the company and to challenge where they find misalignment with values or need better information. Boards should devote sufficient resource to evaluating culture and consider how they report on it.
- Align values and incentives: The performance management and reward system should support and encourage behaviours consistent with the company’s purpose, values, strategy and business model. The board is responsible for explaining this alignment clearly to shareholders, employees and other stakeholders.
- Exercise stewardship: Effective stewardship should include engagement about culture and encourage better reporting. Investors should challenge themselves about the behaviours they are encouraging in companies and reflect on their own culture.
A number of case studies are included in an Appendix to the report and the FRC proposes to take feedback to the report into account when reviewing its Guidance on Board Effectiveness in 2017.
Tomorrow's Company’s consultation on governing culture, risk and opportunity
In July 2016, Tomorrow's Company published a consultation paper, “Governing culture: risk and opportunity? – A guide to board leadership in purpose, values and culture”, which is intended to help boards determine how they might approach the key questions around culture.
Through its past research, Tomorrow's Company have identified six “pillars” of success for boards:
- inspiring purpose and set of values;
- aligning purpose, values, strategy and capability;
- promoting and embodying purpose and values;
- using purpose and values to guide decisions;
- encouraging desired behaviours; and
- assuring progress is being achieved.
Tomorrow's Company recommends that boards take time every year to review and discuss progress towards achieving the desired culture, its maintenance and development. To aid these discussions, Tomorrow's Company has provided an agenda for these discussions, using the six pillars and providing core questions a board might ask itself, and a roadmap for boards showing the behaviours boards should expect to see that address the questions in the agenda.
Tomorrow’s Good Governance Forum: Improving board evaluation to achieve greater board effectiveness
In September 2016, Tomorrow’s Company released guidance produced by its Good Governance Forum on improving board evaluations, focusing on how this is a process of shared learning and feedback. The guidance addresses matters such as critically evaluating self-performance and tackling weaknesses as part of the evaluation process, which as a result will enhance shareholder and stakeholder confidence in the board’s effectiveness and adaptability.
The guidance sets out factors which contribute to an effective board evaluation and it considers points arising from the action plan resulting from the board discussion about the review of the evaluation, issues in relation to disclosing the results of the board evaluation, appointing an external evaluator, widening the sources of feedback in the evaluation process and the roles of the chair, senior independent director and company secretary in the process.
IBE report on stakeholder engagement
In July 2016, the Institute of Business Ethics (IBE) published a report, “Stakeholder engagement: values, business culture and society”, which was commissioned by the Financial Reporting Council as part of its Culture Coalition project. The report contains a series of case studies detailing how companies have brought ethical values to bear in dealing with stakeholders.
Among the conclusions are that:
- It is important for companies to engage with a wide range of stakeholders;
- Where shareholders are concerned there is an important challenge in improving the quality of dialogue and broadening the agenda;
- The attitude to customers is critical to culture and therefore to a sustainable business, but evidence shows that an engaged workforce is usually associated with a strong commitment to customer value;
- Social media is an opportunity as well as a risk. Companies need to have a clearly defined approach; and
- In all cases companies should regard engagement as being about listening rather than simply communicating their own views.
Narrative reporting developments
- Guidance on preparation of annual reports
- Developments in corporate reporting reviews
- Developments in reporting of non-financial information
- Developments in environmental reporting
- Reporting by extractives companies
- Amendments to the accounting framework
FRC’s reminders for half-yearly and annual financial reports of listed issuers following the EU referendum
In July 2016, the Financial Reporting Council (FRC) published a reminder for directors highlighting some matters for them to consider when preparing their forthcoming half-yearly and annual financial reports in light of the referendum vote for the UK to leave the EU.
The considerations discussed include:
- Business models: The FRC encourages clear disclosure of a company’s business model as part of the strategic report, including a description of the main markets in which the company operates and its value chain. The disclosure should be sufficient to enable readers to make an assessment of the company’s exposure arising from the outcome of the referendum.
- Principal risks and uncertainties: Directors must consider the nature and extent of risks and uncertainties arising from the result of the referendum and the impact on the future performance and position of the business. The FRC notes that care must be taken to avoid ‘boilerplate’ disclosures, with company specific disclosures being more informative and useful, for example, the impact of trade agreements for companies with a high level of exports to Europe.
- Market volatility: The volatility in the markets following the referendum result may have an impact on balance sheet values at June 30, 2016 or at subsequent reporting dates. There could be an impact on the value of financial instruments, assets may be impaired and future earnings could be impacted by the decline in the value of sterling for non-UK sales.
- Going concern basis of accounting: As part of the preparation of the financial statements, directors must consider whether the going concern basis of accounting is appropriate and whether disclosures of material uncertainties are needed, particularly where there is a material risk of breach of covenants.
- True and fair: There is an overarching requirement for annual financial statements and half-yearly reports of listed issuers to give a true and fair view and the FRC encourages directors to consider whether additional disclosures are necessary to ensure that this requirement is met.
- Half-yearly financial reports: There is a general requirement that the interim management report of listed companies must include disclosure of important events that have occurred during the first six months of the financial year, and an indication of their impact on the interim financial statements.
FRC’s guidance to preparers of 2016 annual reports of listed companies
Subsequently, in October 2016, the Financial Reporting Council (FRC) published a letter addressed to audit committee chairs and finance directors of listed companies highlighting key issues and improvements that can be made to annual reports in the 2016 reporting season to help to foster investment in the UK.
The FRC’s advice addresses various issues within separate parts of the annual report, including the following:
- Clear and concise presentation – while material matters need to be explained in sufficient detail to be useful and understandable, the FRC points out that explanations can still be clear and concise. Smaller companies are reminded to consider whether they have adequately discussed their financial position and cash flows as well as their company’s performance.
- Business model reporting – the FRC notes that it will be releasing a Financial Reporting Lab report on this topic and that the biggest areas for improvement are the clarity of the explanation of how the company makes money and what differentiates it from its peers.
- Alternative performance measures (APMs) – APMs are often used in strategic reports to supplement information prepared in accordance with IFRS or UK GAAP and the FRC believes it is important that their use does not replace or obscure IFRS or UK GAAP information. It reminds issuers that the European Securities and Markets Authority’s (ESMA) 2015 Guidelines on Alternative Performance Measures codify best practice in this area, that the FRC issued FAQs on this topic in May 2016, and that it will publish a thematic study on the use of APMs in interim reports in November 2016.
- Risk reporting and viability statements – the FRC encourages companies to consider a broad range of factors when determining the principal risks and uncertainties facing the business, for example cyber security and climate change. In relation to viability statements, it encourages disclosure of why the selected assessment period is appropriate, the qualifications and assumptions made and how underlying performance was analysed.
- UK referendum result – the FRC states that companies will need to consider the consequential risks and uncertainties in the political and economic environment and the impacts of those risks and uncertainties on their business. Not all businesses will be affected to the same extent and boards must determine what disclosures, if any, are required to meet the needs of investors and comply with regulatory requirements.
Financial statement disclosures
- Tax – the FRC states that companies’ tax arrangements are an area of increasing public focus, which can give rise to significant risk and that companies need to respond to increasing stakeholder scrutiny of their tax strategies, including where they pay tax, and to consider carefully whether they are sustainable and ensure that any material risks to which this gives rise are clearly described in the report and accounts.
- Dividends – the FRC has noted examples of improved dividend disclosures but considers that there is room for further improvement in linking more detailed disclosure of how dividend policies operate in practice to how those policies may be impacted by the risks and capital management decisions facing the company. Additionally, the FRC notes that the Local Authorities Pension Fund Forum (LAPFF) recently wrote to a number of listed companies urging companies to disregard the position taken by the FRC (see above). Despite this, the FRC’s position remains that it encourages good disclosure and companies paying close attention to their investors’ views whilst noting that the Companies Act 2006 does not require the separate disclosure of a figure for distributable profits or, specifically, multiple figures for distributable profits.
- Low interest rates – the FRC states that companies should consider the impact of low interest rates on the amounts reported in their financial statements and give careful consideration to the valuation of long term assets and liabilities. Companies may need to provide sensitivity analysis to highlight the potential impacts.
- Critical judgements and estimates – disclosures of critical judgements should explain clearly the specific judgements the board has made and their effect on the financial statements.
- Accounting policies – the FRC believes there is room for improvement in the disclosure of accounting policies, particularly in relation to revenue recognition. There should be a clear link between the sources of income described in the business model and revenue recognition policies and the FRC expects companies to explain exactly when revenue from complex long-term contracts is measured.
- Developments in IFRS – the FRC notes that the International Accounting Standards Board has published three major standards that will become effective in the next few years (IFRS 15, IFRS 9 and IFRS 16). Given that comparative periods for IFRS 15 and IFRS 9 will be commencing from January 1, 2017, the FRC expects that most companies that apply IFRS will have made substantial progress in their implementation of these standards and notes that companies should provide information on this progress and disclose the likely impacts of each of the new standards once they can be reasonably estimated.
Audit committee reporting
The FRC notes that investors would like to see more informative reporting about the specific actions taken by audit committees and the significant issues that they have considered. It also refers to its “Audit Quality Practice Aid” published in 2015 which helps audit committees evaluate and report on audit quality.
FRC’s discussion paper on improving the statement of cash flows
In October 2016, the Financial Reporting Council (FRC) published a discussion paper which presents ideas to improve the usefulness of the statement of cash flows. This is in the context of an IASB project on “Primary Financial Statements” which is examining the purpose, structure and content of the primary financial statements, including the statement of cash flows.
The statement of cash flow tells investors where their company’s cash has come from and where it has gone, providing an insight into the quality of earnings. The discussion paper suggests several ideas for improving the transparency and consistency of the statement, while providing the company’s own perspective on the management of liquid resources. These include the following:
- Notional cash flows should not be reported in any section of the statement of cash flows but transparent disclosure of non-cash transactions should be required.
- Operating activities should be positively defined or described (perhaps as including transactions with customers, employees and suppliers) rather than being a residual or default classification.
- It should be clear that items should not be excluded from operating activities merely because they are unusual or non-recurring but these items should be separately disclosed and items that do not relate to operating activities (or another defined section of the cash flow statement) should be reported in a separate section of the cash flow statement.
- Cash outflows to acquire property, plant and equipment should be reported as a cash outflow from operating activities. As such outflows are likely to be volatile, a sub-total of cash generated from operating activities before capital expenditure should be disclosed. Entities should be encouraged to disclose the extent to which expenditure on property, plant and equipment represents ‘replacement’ or ‘expansion’.
- Cash flows on financing liabilities (including the payment of interest) should be reported in the financing category of the cash flow statement. Cash received from customers (including any amount treated as interest income in the statement of profit or loss) should be reported within cash flow from operating activities.
- Cash flows relating to tax should be reported in a separate section of the statement of cash flows and the statement of cash flows should report inflows and outflows of cash, rather than cash and cash equivalents.
- A separate section of the statement of cash flows should report cash flows relating to the management of liquid resources. Liquid resources should be limited to assets that are readily convertible into cash, but should otherwise not be restrictively defined. Entities should also be required to disclose their policy for the management of liquid resources, and the classes of instruments that are treated as such.
- A reconciliation of profit and cash flow should be presented in all cases (including where a direct method cash flow statement is presented). Because the amounts reported in the reconciliation are not cash flows, the reconciliation should not be reported within the statement of cash flows itself, but as a supplementary note, perhaps immediately following the statement of cash flows.
The FRC has requested responses to the consultation by February 28, 2017.
Financial Reporting Lab’s report on business model reporting
In October 2016 the Financial Reporting Lab published a lab project report on business model reporting. Findings in the report include the following:
- Investors are unanimous that business model information is fundamental to their analysis and understanding of a company and its performance, position and prospects, both at the initial investment stage and for their ongoing monitoring and stewardship responsibilities.
- There are a number of advantages to companies in providing comprehensive business model disclosure that meets investor needs, including (i) making the company’s clear and comprehensive definition of their business model the primary source of business model information for investors, thereby avoiding the risk that others less close to the business develop their own definition of the business model; (ii) demonstrating the board’s clear understanding of their business and its key drivers engenders investor trust; and (iii) developing and sharing the business model definition can strengthen alignment of understanding within the company.
- Practice by companies is varied, with business model disclosures ranging from very high level to quite detailed, and covering different information sets.
- Investors are concerned when companies fail to articulate their business model well, and comment that many annual report business model disclosures do not yet fully meet their needs.
- Investors need more detail than is currently provided by most companies. Investors ask companies to assume the reader knows nothing about the company and provide disclosure that stands alone in describing the business model – something as fundamental as stating what the company does is often omitted from the disclosure as it is described elsewhere in the annual report or is assumed knowledge.
- In particular, investors find disclosures are often lacking information that answers questions such as what the key revenue and profit drivers are and how profits convert to cash, whether there are any key asset and liability items that support the business model, and what the competitive advantage is.
- Investors note improvement is needed in linkage and consistency between the business model and other information in the annual report.
- Where a company operates more than one distinct business model, investors believe each significant business model should be disclosed, together with the rationale for having the different businesses within one company.
- Nearly all investors believe the business model should be presented near the front of the annual report, with some wanting it presented as the first section, as it provides context to the remainder of the information.
- Investors want the business model description to be written in plain, clear, concise, and factual language.
- Most investors believe business models are best communicated through a combination of infographic and detailed narrative.
- Once the business model disclosure has been clearly defined and meets investor needs, investors expect that companies will only modify the disclosure to reflect changes to the model. Changes in the year, and forthcoming changes, should be clearly identified, including their rationale.
- Business model disclosures tend to be developed for the annual report alone, and not used elsewhere. Sometimes there is a different, or more detailed depiction of the business model provided in investor presentations or online. Investors prefer one high quality disclosure to be provided consistently across the communication channels, as it provides confidence that the business model presented represents the real business model.
FRC’s annual review of corporate reporting 2015/2016
In October 2016, the Financial Reporting Council (FRC) published its Annual Review of Corporate Reporting for 2015/2016. This report provides the FRC’s assessment of corporate reporting in the UK based on broad outreach and evidence, including that obtained from the FRC’s own monitoring work, performed by its Corporate Reporting Review (CRR) team, on cases opened in the year to March 31, 2016, and from more recently performed thematic reviews.
The report includes:
- an annual assessment of corporate reporting;
- an overview of corporate reporting enforcement activity; and
- current and future developments
Annual assessment of corporate reporting
The FRC concludes that although compliance with the accounting framework is generally good, particularly by larger public companies, certain areas of corporate reporting have, for several years, required general improvement. The profile of these issues has been raised through annual activity reports, discussions with audit firms and the use of generic press notices.
There have been improvements in some of these areas this year, for example in respect of the disclosure of principal risks and uncertainties (PRUs) and capital management policies. Fewer instances were in evidence this year of:
- boilerplate PRUs;
- lack of discussion of how risks are managed; and
- capital management policies that failed to explain management’s approach in sufficient detail or provide the necessary quantified information.
In addition, there were fewer issues relating to cash flow statements, in particular relating to misclassifications between operating, investing and financing activities.
The review sets out the more significant findings from this year’s monitoring activity relating to the financial statements and the strategic report.
Corporate reporting enforcement activity
This section provides an overview of the disciplinary cases which have been concluded under the FRC Accountancy Scheme in the year to 31 March 2016. In April 2016 the FRC introduced changes to its enforcement and disciplinary arrangements in preparation for the implementation of the EU Audit Regulation and Directive. With effect from June 17, 2016 the FRC implemented a new Audit Enforcement Procedure for new statutory audit cases.
Current and future developments
In this section, the FRC provides an overview of current and future developments in corporate reporting and the expected impacts, including:
- Implications of Brexit for corporate reporting: The legislation underpinning the preparation of financial statements in the UK is generally derived from European law. Therefore, the decision to leave the EU may have significant implications for the corporate reporting framework in the UK, subject to the form and content of the UK settlement with the EU. Over the coming months the FRC will carry out a review to identify potential risks to the reporting framework at, and subsequent to, the date of exit from the EU. The FRC will also consider opportunities for improvement to more closely meet the needs of UK stakeholders.
- Current debates on the future of corporate reporting: The annual report focuses primarily on the information needs of investors, but increasingly there are calls for the provision of information to a more diverse set of stakeholders reflecting the wider societal impact of companies. Given developments in digital communication which are changing the ways people distribute, consume and analyse information and facilitating the reporting of some information outside the annual report, the annual report can be seen as one part of a wider framework of reporting by companies to their stakeholders. These two drivers, calls for greater accountability to stakeholders other than shareholders and new communication channels arising from technological developments, will continue to change the form and content of corporate reporting in the broadest sense.
- New International Financial Reporting Standards (IFRS) and their adoption in Europe: Whilst the UK remains in the EU the legislative framework for the adoption of new IFRS will remain the same. New IFRS are reviewed and adopted on a standard-by-standard basis. IFRS requires disclosures in the financial statements on the future impact of standards before their effective date and as that date approaches the FRC expects those disclosures to become more detailed and descriptive.
A few days after publication of its Annual Review, the FRC published a presentation describing the accounting and corporate reporting issues most often raised by Corporate Reporting Review activity conducted in the year ended March 2016. This supplements the wider discussion of the quality of corporate reporting in the UK in the Annual Review.
The most frequent areas of questioning by the Financial Reporting Review Panel (FRRP) concerned the following:
- Strategic Report: The FRRP challenged companies where the business review did not appear appropriately balanced, where it did not discuss all relevant aspects of performance, or where there were issues with the comprehensiveness of the review of the financial position. While the FRRP noted improvements in the reporting of principal risks and uncertainties it challenged where there was a question as to whether all principal risks and uncertainties disclosed were genuinely principal or there was no discussion of how risks were managed or mitigated, and where there was a lack of linkage between KPIs and strategic elements of the business, or KPIs were not adequately identified and discussed.
- Accounting policies: The FRRP questioned lack of policies for transactions or balances that were material to the business and accounting policies that had not been updated for new accounting standards. The FRRP expects companies to replace boilerplate statements lifted from accounting standards with tailored, relevant disclosures. It also informed companies where it identified accounting policies for items or transactions that were immaterial, no longer relevant or non-existent and where there was unnecessary repetition of accounting policy descriptions and other narrative.
- Critical judgements: The FRRP expects critical judgement disclosures to state explicitly what those judgements are and differentiate them from estimates. It also queried lack of disclosure where needed to understand how management applied its most significant accounting policies.
- Estimation uncertainties: Companies need to disclose the relevant amounts or provide other useful information such as sensitivities and if the audit committee report or audit report mention judgements and estimates not identified in the financial statements, the FRRP may ask if these disclosures should have been expanded in the notes.
- Revenue recognition: Companies whose accounting policies are insufficiently tailored to their significant revenue streams were challenged, as were those that did not explain how they applied the percentage of completion model to long-term contracts or failed to disclose revenue by category.
- Impairment: The FRRP notes issues with, among other things, discount rates, levels at which goodwill impairment was tested and failure to describe each key assumption driving the cash flow projection determining value in use.
- Other common areas of questioning: These include business combinations, financial instruments, exceptional and other items, income taxes, complex supplier arrangements, pensions, cash flow statements, capital management, presentation of financial statements, consolidation and intangible assets.
FRC’s corporate reporting thematic review on tax disclosures
In October 2016, the Financial Reporting Council (FRC) published a corporate reporting thematic review on tax disclosures. This report shares the FRC’s findings from the targeted review of certain aspects of companies’ tax reporting, against which companies can assess and enhance their own disclosures to ensure they provide high quality information to investors in their annual reports and accounts.
In December 2015, the FRC wrote to 33 FTSE 350 companies informing them that the tax disclosures in their next annual report and accounts would be reviewed by the FRC’s Corporate Reporting Review. The objective of the review was to encourage more transparent reporting of the relationship between tax charges and accounting profit and the factors that could affect that relationship in the future, in accordance with existing requirements.
Overall, the FRC saw evidence of improvements in the transparency of tax disclosures included in companies’ strategic reports and saw examples of good practice in the following areas:
- tax in strategic reports;
- effective tax rate (ETR) reconciliation disclosures; and
- uncertainties relating to tax liabilities and assets.
The FRC notes that there is scope for companies to articulate better how they account for tax uncertainties by explaining the bases for recognition and measurement and will continue to challenge companies who do not disclose the amount of uncertain tax provisions when these are subject to risk of material change in the following year. The audit of uncertain tax provisions is an area of particular focus of the FRC’s audit monitoring activities for 2016/2017.
Additionally, the FRC encourages companies to:
- Consider carefully whether there are significant judgements and estimation uncertainties relating to tax. Where estimation uncertainties are repeated unchanged year on year, the FRC will question whether the disclosure of quantified risk specifically relating to the next year is clear.
- Appraise what specific information about judgements and estimation uncertainties would be most helpful to users of the accounts. It notes that in its July 2014 project report “Accounting policies and integration of related financial information” , the FRC’s Financial Reporting Lab found that investors value an understanding of the judgements made and estimations applied by management, including where that judgement sits within a range of possible or acceptable outcomes.
FRC's consultation on revised operating procedures for reviewing corporate reporting
In October 2016, the Financial Reporting Council (FRC) published for consultation a revised version of its Conduct Committee’s operating procedures for reviewing company reports and accounts. Earlier in 2016, the FRC made changes to its governance and executive structures which resulted in minor amendments to the Corporate Reporting Review (CRR), which came into effect on April 1, 2016. At the time, it was indicated that more extensive changes were likely to be proposed and that they would be subject to public consultation.
The consultation paper explains the rationale for the further proposed changes to the operating procedures. These are required to implement new ways of working to address requests for more transparency about CRR reviews and their outcomes, and to enhance the efficiency of CRR procedures without compromising the quality of decision-making. In addition, changes have also resulted from requests for greater transparency in respect of the review process and clarity in the content of the operating procedures.
Part 1 of the revised operating procedures sets out how reports are selected for review and it includes information on complaints and complainants. The FRC intends to publish lists of companies whose accounts and reports have been subject to review and where cases have been closed. The current two-stage review is to be reduced to a single stage review at the Review Group stage. Individual companies’ audit committee reports will need to disclose the nature of any FRC regulatory review or intervention, as noted in the FRC’s Guidance on Audit Committees.
The consultation paper sets out questions in Section 2 of the document and invites feedback from interested parties on or before January 4, 2017.
Amendments to DTR 7.2
In November 2016, the Financial Conduct Authority (FCA) amended DTR 7.2 in its Disclosure Guidance and Transparency Rules sourcebook in order to implement the new EU Non-Financial Reporting Directive requirement for issuers to disclose their diversity policy in their corporate governance statement.
New provision DTR 7.2.8AR requires listed companies (other than those which qualify as small or medium companies under the Companies Act 2006) to describe the diversity policy they apply to their administrative, management and supervising bodies, with regard to aspects such as age, gender or educational and professional backgrounds. They must also describe the objectives of that diversity policy, how it has been implemented and the results in the reporting period. If no such policy is applied, the statement must contain an explanation as to why this is the case.
This new reporting requirement applies to financial years beginning on or after January 1, 2017.
The Companies, Partnerships and Groups (Accounts and Non-Financial Reporting) Regulations 2016
On November 7, 2016 the draft Companies, Partnerships and Groups (Accounts and Non-Financial Reporting) Regulations 2016 were published, together with an explanatory memorandum. The Regulations amend Part 15 of the Companies Act 2006 (CA 2006) in order to implement articles 1(1) and (3) of the Non-Financial Reporting Directive (Directive 2014/95/EU) and to complete transposition of article 23(1) of the Accounting Directive (Directive 2013/34/EU).
Non-Financial Reporting Directive
The Regulations insert two new sections, 414CA and 414CB, into the CA 2006 in order to implement articles 1(1) and (3) of the Non-Financial Reporting Directive. Articles 1(1) and (3) amend the Accounting Directive, and insert a new requirement for certain companies to disclose certain non-financial information in a statement as part of the entity’s management report.
Section 414CA sets out the requirement for certain companies and groups which are not small or medium-sized and which have more than 500 employees to include a non-financial information statement in their strategic report. The companies to which section 414CA relates are traded companies, banking companies, authorised insurance companies and companies carrying out insurance market activities (public interest entities under the Non-Financial Reporting Directive).
Section 414CB provides that the non-financial information statement must contain information to the extent necessary for an understanding of the company’s development, performance and position and the impact of its activity, relating to, as a minimum: environmental, social and employee related matters, respect for human rights and anti-corruption and bribery matters (together "non-financial matters"). The information must include a brief description of the company's business model, a description of the policies pursued by the company in relation to such non-financial matters, the outcome of these policies, a description of the principal risks relating to such non-financial matters and how the company manages such risks. If the company does not pursue policies in relation to one or more of the non-financial matters, it must give a clear and reasoned explanation for not doing so. If a non-financial information statement complies with subsections (1) to (5) of section 414CB, it will be deemed to fulfil some of the requirements for non-financial information which are already contained in section 414C CA 2006 so as to prevent duplication. Section 414CB does not require disclosure of information about impending developments or matters in the course of negotiation, if the disclosure would, in the opinion of the directors, be seriously prejudicial to the commercial interests of the company, provided that such non-disclosure does not prevent a fair and balanced understanding of the company's development, performance or position or the impact of the company's activity.
The Regulations remedy a gap in the transposition of article 23(1) of the Accounting Directive. The amendments ensure that the parent company of a small group cannot benefit from an exemption from the requirement to produce group accounts under section 399 CA 2006 if a member of the group is established in an EEA State and is a public interest entity.
The Regulations will come into force on the seventh day after they are made and apply to financial years of companies and qualifying partnerships commencing on or after January 1, 2017.
In September 2016, the Climate Disclosure Standards Board (CDSB) published a handbook on EU environmental reporting. Directive 2014/95/EU on the disclosure of non-financial and diversity information (NFR Directive), which amends the Accounting Directive 2013/34/EU to require certain large companies to disclose information on policies, risks and outcomes as regards environmental matters, social and employee aspects, respect for human rights, anti-corruption and bribery issues, and diversity in their board of directors, is due to be implemented by Member States by December 6, 2016.
The transposition of the NFR Directive is still being worked on but this publication sets out a series of examples from annual reports of European companies to show how companies could respond to these new requirements. Examples are also provided which are focused solely on environmental matters, but some recommendations may also be useful for reporting other non-financial information.
Amendments to DTR 4.3A
In July 2016, the Financial Conduct Authority (FCA) published Handbook Notice No. 35 setting out a number of changes to the FCA Handbook, including amendments to the Disclosure Guidance and Transparency Rules so as to prescribe the reporting format for the annual reports on payments to governments prepared in accordance with DTR 4.3A.
The same reporting format and relevant schema as that prescribed by the Department for Business, Innovation and Skills and Companies House for Accounting Directive reports on payments to governments is prescribed and issuers need to file their reports with the FCA and upload them on the National Storage Mechanism. The changes came into force on July 29, 2016 and apply to issuers with a financial year beginning on or after August 1, 2016.
European Commission’s Implementing Decision on equivalence of reporting requirements of Canada on payments to governments to the requirements in the Accounting Directive
In October 2016, Commission Implementing Decision (EU) 2016/1910 of October 28, 2016 on the equivalence of the reporting requirements of certain third countries on payments to governments to the requirements of Chapter 10 of the Accounting Directive (Directive 2013/34/EU) was published in the Official Journal.
Chapter 10 requires large undertakings and all public-interest entities active in the extractive industry or the logging of primary forests to prepare and make public a report on payments made to governments on an annual basis. EU companies may choose to prepare their reports in compliance with the reporting requirements of a third country that have been assessed as equivalent to the requirements of Chapter 10.
This Commission Implementing Decision provides that, since adopting reporting requirements on payments to governments that deliver substantive outcomes equivalent to the provisions contained in Chapter 10, the reporting requirements of Canada should be considered as equivalent to requirements of Chapter 10 of the Accounting Directive on payments to governments regarding their activities in the extractive industry.
In July 2016, the Financial Reporting Council (FRC) published amendments to FRS 101 on the Reduced Disclosure Framework, which is an optional accounting standard intended to enable cost-efficient financial reporting within groups, particularly for those applying EU-adopted IFRS in their consolidated financial statements. The amendments follow a review of FRS 101 by the FRC and contain some minor changes to draft amendments published in December 2015, providing certain disclosure exemptions in relation to IFRS 15, “Revenue from Contracts with Customers”, and clarifying the order in which the notes to the financial statements are presented.
As a result of comments received during the consultation process, the FRC is separately consulting, in FRED 65, on a further amendment to FRS 101 to remove the requirement for a qualifying entity to notify its shareholders in writing that it intends to take advantage of the disclosure exemptions in FRS 101. A similar, consequential amendment is also proposed to FRS 102. The FRC aims to finalise the amendments in December 2016, with them applying to accounting periods beginning on or after January 1, 2016.
2019 guide to Foreign Private Issuer status
A company organized outside the US subject to provisions of the US federal securities laws receives benefits if it qualifies as an FPI.