Directors have to dig, dig, and dig some more to root out the ethical threats to a company's hard-won reputation and its bottom line, advises Guy Jubb
The Tesco fraud case shows how poor reporting can affect corporate reputation as much as its bottom line. Misleading accounts undermine the confidence of investors and other stakeholders to the point where financial support can dry up and the franchise is lost. In Tesco’s case, news of the scandal wiped £2bn off the company’s share price.
Directors and in particular, independent non-executive directors, have a responsibility to ensure they do the right thing as a board when it comes to making choices about how to present profits and other key financial data. Yet this is more than just a question of conforming to the rules laid down by standard setters. Most accounting involves judgment and all judgment contains an ethical dimension.
The hallmarks of responsible financial reporting are not negotiable. They are: truthfulness, integrity, fair presentation and freedom from bias, prudence, consistency, completeness and comprehensibility. Responsible financial statements show a truthful account of the company’s performance and financial position. They need to have integrity from start to finish. This hallmark represents an unashamedly very high standard that is expected of directors. The independent non-executive directors have a responsibility to challenge management in order to satisfy themselves, individually as well as collectively, as to the truthfulness of the information to be reported; they have an implied responsibility always to seek the truth. This means that they have to keep asking questions – gnawing on the bone – until they are satisfied that the information is complete and is trustworthy. It is not acceptable for independent non-executive directors to put truthfulness into the “too difficult tray”. They must dig, dig and dig some more, until they are satisfied that they have established the truth.
Directors must be vigilant to the ethical threats to responsible financial reporting and the ways in which they can corrupt the true and fair presentation of the financial information. These threats include the self-interest of directors, inappropriate culture and tone from the top, and the asymmetry of information between executives and non-executives.
A root cause of material misstatements and fraud is often the self-interest of executives, who are below the radar organisationally from the board’s perspective, but nevertheless play a key role in channelling critical information into the financial reporting process. It can be challenging for boards to identify where these pockets of self-interest are festering, but internal audit can go some way to mitigate this risk. A good internal auditor will be well attuned to the signs of cultural problems, and the audit committee should have regular face-to-face sessions with them to discuss their findings on cultural environment.
Executive pay linked to the achievement of financial performance targets is clearly a potential threat to the integrity of the financial reporting process and the judgements made, especially when the performance targets are very stretching and the marginal rewards to the executives for achieving them are significant. Compound this with a toxic culture and you threaten the health of the reporting process. If a corrupt culture infects the financial reporting process, it is like a cancer that progressively undermines the true and fair view of the financial statements unless it is treated – and treated swiftly and effectively.
Companies that are acclaimed for having an unbroken run of rising profits are particularly vulnerable to putting a favourable gloss on lacklustre performance
The market also has a role to play here. Companies that are acclaimed by the market for having an unbroken run of increased profits are particularly vulnerable. The market reaction to the trend being broken can be savage on the share price, and shareholders can be unforgiving when it comes to the company’s leadership. Conversely, companies that have a torrid reputation for delivering consistent losses are vulnerable to putting a favourable gloss on lacklustre financial performance with a view to breaking free from the shackles of shame. These reputational risks to responsible financial reporting can present serious challenges to independent non-executive directors, who can be torn between their responsibility to do the right thing in presenting a true and far view, and their feelings of loyalty to the unitary board on which they serve, and the senior management that supports them. Also, because by association their own reputations are intrinsically entwined with that of the company, they are exposed to the risks of bias with a view to keeping their own reputation untarnished.
The threat of a takeover poses a different set of ethical threats to responsible financial reporting, especially when the short-term financial performance is likely to expose the company’s vulnerability to an offer that undervalues its long-term potential. The board can find itself between a rock and a hard place when assumptions and judgements have to be made that could determine the fate of the company and its employees.
The audit committee may be economical with the truth when they report to the board, seeking to avoid awkward questions
When preparing and approving financial statements, management may be tempted to use their knowledge advantage in order to hide fraudulent activities by not disclosing material information to the board and its audit committee. Similarly, the audit committee might be economical with the truth when reporting to the board in a way that is designed to avoid awkward questions being asked.
Asymmetry of information is a fact of corporate life and underscores the importance of having an open culture that embraces integrity. Independent non-executive directors have a responsibility to follow through on concerns until they are satisfied.
Corporate values have to be applied throughput the company – and the boardroom is no exception. At all stages of the corporate reporting process, the board must keep the company’s values at the centre of its discussions and decision-making. Audited financial statements that purport to show a true and fair view provide the lifeblood for capital markets as well as the basis on which shareholders hold the board of directors to account for their stewardship of the company’s assets. It is essential that they are prepared and presented such that shareholders and others trust their integrity.
Guy Jubb is author of the IBE’s Latest Board Briefing Responsible Financial Reporting: doing the right thing available to download for £32.50 from www.ibe.org.uk
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