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Narrative in Annual Reports remains for most companies a matter of mere compliance with statute and regulation, offering limited insight. Only a relatively small minority of companies presents clear strategic thinking that is logical, consistent and indicative of their future potential. The structure of their strategy frameworks and the words they use confer understanding to even the least skilled investor. Yet, because the majority of strategic reports are short on true strategic thinking and its execution in the respective business, few users pay much attention to them. What needs to happen for investors to trust reporting narrative when reviewing comparatively a company’s prospective performance?
Three dimensions of failure
There is a simple, fundamental logic to business strategy. Statute (CA2006) requires companies to report most of the elements of the classic, universal strategy framework. Sadly, the inherent logic and the clarity that flow through this classic strategy framework are rarely evident in reporting narratives. This shortcoming is as much the fault of the regulator as it is of the reporting companies. There are three dimensions to the inherent failure. One is in the quality of the guidance provided to help companies originate their Strategic Report narratives – it leaves too much to interpretation. The second is in the adoption of a vaunted yet inherently ineffectual ‘principles-based approach’ to reporting. This permits companies to interpret that guidance as they choose and adopt a free-form narrative structure of their own making. Trumpeted as a distinct and British way of enabling companies to express themselves to investors, ‘principles-based reporting’ has become a neat way for companies to obscure, obfuscate and confuse, indulging all too frequently in sloppy thinking and inept articulation. Compounding this second dimension is the third. This is an apparent unpreparedness of the regulator to take reporting companies to task for inadequacies in their Annual Reports. This is a ‘Catch 22’ and a direct consequence of the principles-based reporting environment. Why a Catch 22? When companies have such freedom to interpret guidance as to what they report how can the regulator to go beyond a mere tick-box compliance-checking regime to determine the relative value of any single company’s reporting?
Precision, rigour and logic
We need a more exacting definition of the core elements of a Strategic Report as a minimum in future reporting. The universal strategy framework is a simple fact of logical thinking. The terminology is familiar – purpose; business model, mission or vision, corporate strategy, operating strategy, risks to model and to strategy, operational performance, metrics. It is the rigour of their respective definitions and the precision of their articulation in a tightly specified, interconnected framework that is missing from reporting guidance. Current guidance correctly identifies the existence of most elements of the framework – “An entity’s purpose, strategy, objectives and business model are inter-related concepts”. But loose and incorrect ordering of these strategy terms suggests a lack of understanding of the critical nature of the interrelationship of these elements within the classic universal strategy framework. For example, the guidance correctly states that: “an entity’s purpose is why it exists”. Many companies report this well while for others their purpose statement is more marketing strapline, social declaration or tree-hugger’s charter. There is no evidence of FRC taking any company to task over a reported purpose statement that is not existential? Yet ’purpose’ provides the context for the whole of the rest of the strategy framework. The regulatory guidance in respect of business model description is on the right lines, too: “the entity’s business model should explain how it generates and preserves value over the longer term”. But this guidance doesn’t go far enough. It does not ask also why a company can be confident its model will generate that value over the longer term? Explaining this unique feature of a company’s business model – the ‘why?’ – is the critical missing element. Without it investors learn little about the sources of advantage or distinct strengths that will enable a company’s to remain profitable and grow over time. The best reporting companies understand this without guidance. This is not the place to go through every aspect of the universal strategy framework. The point is that precision, rigour and logic in narrative is required, to match the accuracy attached to numbers and figures in the financial statements.
What might the new regulator [ARGA] put in place to make Strategic Reports of real value to investors? It should set out a clear, exact universally accepted strategy framework, spelling out how each element of the framework relates one to the other. It should tightly define what each element means with clear examples. It should then set out the requirement for a six-page template document that is in effect a Summary Strategic Report to contain this framework as well as ‘at a glance’ structural details and linked performance highlights. Reporters would have a limited number of characters to describe each element of the framework to encourage conciseness. The aim is to require companies to present the simple logic of clear and rigorous strategic thinking in the context of performance in an unambiguous way that is comparable between companies and consistent over time. And to enable this will require a prescriptive approach to reporting of the Summary – an end to the principles-based approach in the key aspect of reporting. The Summary will signpost underlying, material detail later in the Annual Report, or on the company’s website. This prescriptive approach would also permit tagging for effective XBRL reporting, enabling easier comparisons across companies. Assuming ARGA is confident in its strategy expertise the new regulator should then feel more able to take reporting companies to task as occasion demands. This would be not just for compliance but, and more importantly, for the quality of their Strategic Reports and inherent usefulness to investors.
A demonstrated robust and no-nonsense approach to dealing with shortcomings would quickly get Boards much more engaged in the origination of their respective Strategic Report Summaries. Integration of strategy and governance reporting, a step further, would really focus their minds on the reality that narrative reporting matters. Then, strategy reporting will cease to be the middle management chore that it has become in this all too laid back reporting era. It will become a focused Board pre-occupation, as it should be. All stakeholders will benefit, and above all investors. This becomes real and connected stakeholder engagement.