Countdown to EU NFR Directive day

August 2016  |  COVER STORY  |  COMPANY LAW

Financier Worldwide Magazine

August 2016 Issue

August 2016 Issue

With the implementation date of the EU’s Non-Financial Reporting (NFR) Directive now less than six months away, effective as of 1 January 2017, companies across the EU-28 that fall within its scope are preparing themselves for its arrival.

In a nutshell, Directive 2014/95/EU, amending Directive 2013/34/EU, requires certain companies – i.e., public and private companies of a certain size, as determined by number of employees (upwards of 500), balance sheet total and revenues – to disclose to authorities information relating to policies, risks and outcomes as regards environmental matters, social and employee aspects, respect for human rights, anticorruption and bribery issues and boardroom diversity.

Having established its scope, the obvious question to then ask is just why this particular Directive should be afforded any consideration above the norm, especially in light of the plethora of legislation that is pumped out by the EC on a regular basis.

According to the legislative text of the Directive, the EC identified a need to raise the transparency levels of the social and environmental information provided by organisations in all sectors across all EU member states (which includes the UK for now, despite the vote for ‘Brexit’). The Directive goes on to say that it is possible that further improvements to the transparency of non-financial information will be required, a process which the legislation characterises as being “a continuous endeavour”.

In terms of the benefits that compliance with the forthcoming NFR legislation will have for companies, Deloitte noted that it will assist firms in: (i) attracting, retaining and maintaining a satisfied workforce; (ii) saving resources and decreasing operating costs, as well as managing risks; (iii) improving efficiency and process management; (iv) improving business reputation; (v) differentiating themselves from competitors to win new business opportunities; (vi) strengthening customer retention; (vii) enhancing relationships with customers, suppliers and stakeholders; and (viii) generating positive publicity and exposure in the media.

In addition, CDP, an international not-for-profit organisation, has described the disclosure of non-financial information as being “as strategically important for investors as financial information” and declared that “companies will need to move this forward over time in order to provide confidence in reported information”.

What all this means is that for those entities across the EU member states that fall within the Directive’s remit, compliance with the new reporting rules and regulations is a key obligation – a duty that, in some cases, is compounded by the need to integrate the new legislation alongside existing statutory reporting requirements.

Intent of the Directive

Many companies already have a strong history of voluntarily disclosing non-financial information within well-established reporting frameworks. The UK is a good example, having considerably improved the quality of its narrative reporting in recent years. So how do organisations within the scope of the Directive plan to comply with its requirements?

“It is estimated that around 6000 companies – the actual number affected will only become known once the transposition of the Directive is complete – will be subject to the new requirements,” says Teresa Fogelberg, deputy chief executive of the Global Reporting Initiative (GRI). “Other companies, such as the EU subsidiaries of non-EU headquartered corporations, will also be impacted by the transparency requirements. These organisations are encouraged to disclose non-financial information that will help them to measure, monitor and manage their performance and their impact on society, and ultimately contribute towards a sustainable global economy by combining long-term profitability with social justice and environmental protection.”

The EC identified a need to raise the transparency levels of the social and environmental information provided by organisations in all sectors across all EU member states.

In addition to requiring the reporting of information relating to the environment and social and employee-related matters, the forthcoming NFR Directive also turns the spotlight on human rights and anticorruption and bribery issues – the reporting of which is strongly supported by bodies such as the Institute of Chartered Accountants in England and Wales (ICAEW) at a national, European and international level.

For its part, the ICAEW envisages the Directive’s impact as being variable across EU jurisdictions according to current national requirements for disclosure of NFR information. “It will also depend on whether jurisdictions apply the new regime to only the minimum number of companies that fall under the scope of the Directive,” asserts Dr Nigel Sleigh-Johnson, head of ICAEW’s Financial Reporting Faculty. “In all cases implementation will require a substantial amount of work and preparation by national legislators, businesses affected and their advisers. That includes businesses in the UK, as my understanding is that the EU referendum result has no impact on plans to implement the Directive in the UK.”

Although the scope and intent of the Directive is largely clear, details as to how the legislation will actually be implemented are still somewhat sketchy at this stage. For example, the Department for Business, Innovation & Skills in the UK is yet to provide any specific implementation guidance. That said, Julie Bamford, head of policy, corporate at ICSA: The Governance Institute, makes the point that the UK’s already extensive reporting requirements for non-financial information in place is likely to mean that “the Directive will impact the UK less than many other member states,” generally-speaking.

Despite the apparent lack of detail surrounding how the legislation should be implemented, there is, however, some advice available on strategies that companies could adopt. One organisation to have approached the EC is the Federation of European Risk Management Associations (FERMA), which suggests that companies should focus on reporting their corporate social responsibility risks.

For Ms Fogelberg, the next few months presents a good opportunity for companies that do not yet disclose information on their sustainability impacts to start measuring, understanding and communicating their economic, environmental, social and governance performance, as well as setting goals and managing their risks more effectively. At the same time, she recognises that those companies that are already reporting on their sustainability impacts – using nationally or internationally recognised sustainability frameworks – are “on the right track to comply with the legislation”.

The purpose of the NFR Directive, suggests Paul Gisby, manager of Accountancy & Tax at the Federation of European Accountants (FEE), is not to create an administrative burden. “Its principles-based approach is meant to minimise the impact on preparers,” he says, Moreover, Mr Gisby considers the overall intention of the legislation as being a mechanism for changing the behaviour of companies and enhancing consideration of environmental, social and governance (ESG) matters – conduits, essentially, for increasing the ultimate competitiveness of European companies.

Disclosure – challenges and issues

Naturally, the Directive raises a number of issues around its scope and implementation. “The scope of the Directive and the disclosure requirements are laid out clearly,” states Neil Parsons, a senior manager at Grant Thornton UK LLP. “In the UK, the main challenges and issues appear to be around transposing the requirements of the Directive into existing legislation that deals with similar disclosure requirements. For example, the UK government might extend the scope of non-financial reporting to smaller quoted companies, and will need to decide where the non-financial statement will be located. The NFR Directive permits the non-financial statement to be contained in a management report as part of an annual report, or on a corporate website.” Current UK legislation requires a strategic report to be published as part of an annual report.

“The ICAEW recommended a number of changes designed to ensure that the proposed new regime would be sufficiently proportionate and flexible,” notes Dr Sleigh-Johnson. “Our principal recommendation – the adoption of an approach to disclosure based consistently on an ‘to the extent necessary’ formulation, to avoid generic, boilerplate information regarding human rights, bribery and corruption and environmental, social and employee matters – was reflected in the final text.”

The flexibility of the legislative framework should encourage companies to focus on the information of key importance to them and their stakeholders. A potential downside to this flexibility, however, could be a lack of consistency and comparability of non-financial information across Europe. “This could be exacerbated by the requirement that member states permit businesses to choose between using national standards or using internationally recognised frameworks or standards,” suggests Mr Gisby.

To overcome this potential for inconsistency, the EC should work closely with member states to ensure an efficient and coherent application of the Directive, with discussions that take into account the needs of each jurisdiction’s business community. “This will be imperative to help companies contribute effectively to consistent reporting processes, avoiding excessive burden, and ultimately creating long-term economic growth,” says Ms Fogelberg.

Scope for confusion

Although many of the companies that fall within the scope of the new non-financial reporting requirements are already subject to similar obligations, there is clearly an overlap between existing NFR duties and the new NFR compliance requirements.

“There could be some confusion in implementing the NFI requirements for those companies that do not have a history of ESG disclosure,” suggests Mr Gisby. “As member states must allow the use of other national or international frameworks when disclosing non-financial information, companies will be faced with the choice of which framework or combinations of frameworks they should utilise.” He adds that there is currently confusion in some member states because it is not clear how the new requirements will fit into the existing local legislative framework and whether the size criteria will be reduced, thereby bringing more companies within the scope of the requirements.

Of course, many companies are already using international sustainability frameworks to inform their sustainability strategy and disclose sustainability information. “The Directive has been designed in a nonprescriptive manner, leaving significant flexibility for companies to disclose relevant information in the way that they consider most useful,” attests Ms Fogelberg. “It is important that member states follow the recommendation of the EC to rely on recognised national or international frameworks in providing this information, in order to make sure that the current non-financial information disclosure practices are taken into account.”

Evolution of the Directive

Looking briefly beyond the 1 January 2017 implementation date, it goes without saying that the text of the NFR Directive will need to evolve to accommodate fresh objectives as and when they arise. The legislation must have the capacity to grow, otherwise it may quickly become an unwieldy beast which yields only low quality information that is ultimately of no significance.

“In terms of information quality, this is the responsibility of preparers,” believes Mr Parsons. “As with financial reporting, there is a danger that disclosing too much information means that important messages could become obscured and will detract from the overall quality. Entities within the scope of the Directive are thus encouraged to take a step back and consider the perspective of stakeholders in terms of making their reports meaningful. In my view, a post-implementation review of the effectiveness of the Directive is fundamental to its success.”

Indeed, once the legislation has been enshrined in law and applied to the companies within its scope, the intention is for the EC to review the implementation of the Directive and then submit a report on its efficiency, effectiveness and level of guidance provided to the European Parliament and European Council. This report is scheduled for 6 December 2018 and may well feature additional legislative proposals.

Such proposals may help ensure that the Directive has a positive effect in terms of the overall transparency and performance of EU companies, as well as having a big impact on European business and society in general, according to Ms Fogelberg. In turn, these companies will become more successful and competitive.

Countdown to implementation

Clearly, the countdown to the implementation of the NFR Directive has begun in earnest, with companies across the EU-28 keen to adopt reporting systems which facilitate disclosure (including information relating to their supply chain), ensure compliance (by providing information that is meaningful and of a high quality) and avoid confusion with their extant NFR obligations.

The key to effective implementation of the Directive may lie in providing companies with the flexibility to report non-financial information in the way that is most appropriate for their individual circumstances. “The Directive needs to provide context for other reporting and meaningful information for the reader,” suggests Ms Bamford. “It also needs to provide the option for companies to put certain information on their website where appropriate. Provided the implementation of the Directive gives companies this flexibility, we do not envisage any significant problems for companies.”

Others see the implementation of the Directive as being relatively straightforward, with companies needing to ensure they understand the forthcoming requirements and plan ahead. As part of the implementation process, the EC is in the midst of preparing non-binding guidelines to aid companies in the disclosure of the relevant non-financial information, as well as running workshops to assist member states during the transposition process.

The genuine hope is that the Directive – which aims to enhance the consistency and comparability of the non-financial information disclosed by large EU businesses – will not just improve the quality of narrative reporting per se, but also play a major part in the creation of long-term economic growth across European member states.

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Fraser Tennant

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