December 2005 – Operating and Financial Reviews

The uproar in some sectors created by Gordon Brown’s decision to scrap mandatory operating and financial reviews is understandable. So many noses were pushed out of joint in this single dismissive blow that the sound of cracking bone was almost audible across the auditing and consulting sectors.

But maybe Mr Brown has done everyone a service. The withdrawal of the legal requirement does not negate the business case for the OFR. Investors will still be seeking evidence of a well run company, particularly among the kind of businesses that rely on their intellectual capital rather than fixed assets for their future success.

Fixed capital is a kind of insurance policy against failure. If the business isn’t up to much you can strip away and sell off various assets and parcel up any remaining profitable bits for development or sale. The late Lords Hanson and White created a successful business doing just that.

But a growing number of companies these days are trading far ahead of their book values. This was why the OFR was proposed in the first place. It was envisaged as a new kind of valuation narrative that would tell the story that you could not find in historic cost accounting.

The need for this story is as strong today as it was when the OFR was first proposed by the Accounting Standards Board in 1993. At that time the idea seemed so sensible that it was quickly endorsed by the stock exchange. It wasn’t seen as red tape but as sound business sense.

The problem then was that neither companies nor auditors could agree on a cohesive and common approach with meaningful measures and comparisons. It took years of investigations and task forces to produce the regulations that Mr Brown removed at a stroke.

For those involved it must have been a crushing decision. No-one wants to see their hard work flushed away. On the other hand there were flaws in the final OFR guidelines, particularly when it came to the suggested approaches to employment reporting.

This was leading to a money-spinning free-for-all among consultants hawking their various approaches and proprietary measures. Companies could be forgiven if they felt as confused as ever. Most big public companies are already producing OFRs, but they still lack strong guidance on mean comparisons.

Last week speaking with members of the HR Society in London, there seemed to be general dismay at the chancellor’s decision but a determination, also, that companies should continue to develop their use and application of employee metrics.

A similar reaction emerged form Investors In People, where a meeting has been planned later this month to establish The Human Capital Management Standards Group, an industry-wide body devoted to creating a common set of employment measures that can be used for investor comparison across all sectors.

This particular initiative emerged from a conviction within the HR community that the OFR guidelines were inadequate in their approach to employee information. According to the reporting standard, even with the mandatory approach, companies would only have needed to supply information “to the extent necessary”, a legal framework that lacked the clarity embodied in the concept of materiality.

Most of those who have a stake in the success of a company don’t give two hoots for such legal niceties. They want useful information that ideally can be set against the information produced by a competitor company for the sake of comparison.

I’m not a horse-racing enthusiast but if did seek to place a bet at the races I would want to consult a form guide about the horses, jockeys and trainers. What had they done in the past? How well could the horse perform over a particular distance in particular conditions? Nothing will guarantee a winner but we all need the best information we can get when making our choices.

One of the biggest problems with the stock market today is that too often investors are behaving like track-side punters, interested in short-term gains that tend to be secured on reactions to short-term information such as quarterly reports and potentially volatile statements such as profits warnings or take-over bids.

The value of the OFR, particularly if it can get its approach to employment reporting right, is that it can provide strong long-term indicators of growth potential and sustainability. This is the business case for stability behind the OFR that all companies should heed if they are thinking of scrapping their reports after the chancellor’s intervention.

The business case is far more important than the case for compliance. But businesses need guidance. This is why the HCM Standards Group is seeking to pool the knowledge of the UK’s most authoritative organisations and people in this field.

If they can’t, through informed debate, put together a basic template of employment metrics to underpin the detailed work in which most big companies are already engaged, then it will not be for the want of trying.

In these deliberations the question of whether or not the OFR is mandatory is immaterial. The OFR had been concentrating minds and, in that sense, it was proving a useful peg. The challenge now is to build on the spirit of co-operation founded in the conviction that people make a difference in companies and that there are ways to represent this difference in a narrative, in figures and in qualitative reviews.

If the HR community cannot find a compelling business case for external human capital reporting, then the various bodies must go their separate ways and continue with the piecemeal approach that exists at present.

Those who favour complex matrices, elaborate calculations and trademarked metrics will probably prefer such division, since it will preserve their professional and consulting cabals, not to mention their distance from a bamboozled executive, wary of snake oil sellers.

But it doesn’t need to be like this. Enough chunks of work have been produced in the past few years that make the link between good people management and corporate performance. That work needs to be synthesised and simplified to give all companies the building blocks they need to construct individual strategies. At the same time these companies could utilise a few standard measures to provide a representative picture for outside investors and for their own employees.

The vital signs of a healthy company are the attitudes, skills, knowledge and approaches of its employees. So why not give investors a few vital statistics to support their overall impression of corporate potential? It’s not bureaucracy. It’s not red tape. It’s information.