Corporate governance: a reporting perspective
David M H Phillips and Alison Thomas
PricewaterhouseCoopers
This book represents a unique collection of insights from various links in the corporate governance chain. Working within a professional services firm, we are privileged to be firmly embedded in this chain. Our role – to act as an independent go-between between manager and owner – remains the core of our profession. However, the scope and scale of this role appear to be changing. From an initial focus on financial matters, audit committees increasingly have to question all matters that are material for corporate success. After all, financial performance is coloured by all aspects of corporate performance. At the same time, investors are increasingly recognising a need to act like owners, to demand a more accurate statement of corporate – and not just financial – performance. The costs of failing to do so have been shown to be too great to ignore. Consequently, the breadth of the information that readers wish to be assured is true and fair is under review, with a number of countries, such as Denmark, expecting the audit opinion to cover a broad spectrum of the quantified historical data presented.
In this chapter, we therefore address four key questions:
• What do we mean by corporate governance?
• How does management know what to manage?
• How can management report credibly to stakeholders?
• What are the benefits of getting it right?
Corporate governance: the reporting view
When investing in a company, we want to be assured of one thing: that our money is in safe hands, that the assets with which management has been entrusted are being deployed effectively, in accordance with the stated strategy and with sufficient controls to protect us from excessive risk. Given this, from our perspective – and this is perhaps in contrast to other definitions of corporate governance that you will find in this book – good corporate governance is not some arbitrary limit to the number of executive versus non-executive directors. It is not the pre-definition of roles and responsibilities. Instead, it is the very lifeblood of the best companies in the world; it is a way of structuring business that ensures sufficient internal checks and balances; it is a way of reporting on business which means that management ‘tells it how it is’ rather than hiding behind the minimum statutory reporting requirement.
Are we expecting too much of management? Is this just some pipedream? Admittedly, there is certainly some way to go until all reach this state of corporate transparency. However, as accountants we are not renowned for our idealistic fervour, and so our comments are grounded in the world of the possible – and indeed, for a number of leading companies, in the world of the actual.
In the next few sections we split the governance debate into two distinct areas: the internal control structures that managements develop to run their businesses and the mechanisms employed to report on these control structures to external stakeholders. An examination of the different steps that must be employed to ensure good corporate governance is then followed by a brief description of the economic benefits which the leaders in this field may expect to reap.
Managing what’s material
Managing the assets of a firm has become increasingly tricky in recent years, not least because for many firms, the assets which are critical for ongoing success have changed quite radically from the reassuringly tangible plant and machinery to the somewhat more independently minded qualified staff and the all-too-fragile reputation of one’s brand.
Despite this substantial shift in the nature of these assets, the role of many audit committees has changed little over the years. Still preoccupied with financial performance and financial control mechanisms, they typically spend little time evaluating the appropriateness of the systems of checks and balances that underpin the other critical value-creating activities and risks of the business. If this emphasis on just the financial stopped within the audit committee, then one might feel less concerned about the state of the corporate governance structures of an enterprise. However, in our experience, the activities of most boards are similarly biased in favour of financial – rather than overall corporate – performance.
We are not suggesting that boards are wrong to emphasise the integrity of the processes that generate financial statements, which allow an assessment of the firm’s financial performance. Far from it. This remains the fundamental building block of good business. However, we do suggest that the overriding emphasis on the financial is no longer appropriate when assessing the adequacy of the operational control structures that exist within the firm.
So, what needs to be done?
In our experience, there are three steps that management must consider to ensure an auditable trail that runs from the operating processes and risks inherent in the business through to how management controls and reports them.
Step 1: identifying gaps
It is not enough to produce a list of value drivers and associated risks over lunch. New regulation in a number of territories is likely to require management to have a robust process for identifying, at the very least, all key business risks. This may sound obvious, and yet in our experience, there still appear to be many companies which do not employ an auditable process in their assessment of the adequacy of their internal information systems; which do not, for example, benchmark internal analyses against objective reporting frameworks such as Kaplan and Norton’s Balanced Scorecard, the Global Reporting Initiative or PricewaterhouseCoopers’ ValueReporting® framework in order to ensure that all value drivers and inherent risks have been captured.
Step 2: measuring the material
Once a comprehensive understanding of the business model and value dynamics has been established, it is critical that a process be embedded in the management control framework to evaluate, on an ongoing basis, both operational processes and business risks. This requires both an identification of measures to monitor activity and a process for assessing the impact of changing dynamics on the business. In short, does management have ready access to the breadth of data required to understand and subsequently present a true reflection of the business?
This may sound trivial, but reality often leaves much to be desired. Take, for example, the area of human capital management. If people were really the ‘number one asset’ of most companies today, firms would surely be expected to have basic workforce demographics data at their fingertips. However, a global human capital survey published by PricewaterhouseCoopers in 2002 suggests that, even in this critical asset class, the data is lacking. Of over 1,000 companies in 47 countries which responded to the survey, about 40 did not know the number of employees in the company, close to 100 had no idea about staff turnover levels, about 200 had no data on training and more than 750 did not monitor productivity.
Step 3: do you trust your own information?
Of course, having access to information per se is not enough to demonstrate that robust control structures exist within the firm or that the information is being used effectively to run the business. So, the next step is to investigate the appropriateness and reliability of the data used. This is often the source of much soul searching within the company. Although data on customer complaints may be routinely presented to the board, for instance, it is not unusual to find that this data has never been tested to ensure that the collection and analysis process is both reliable and effective. Indeed, major asset allocation decisions on employee or customer programmes are often found to have been made on the basis of information that has never been subject to any independent scrutiny.
This worrying observation can probably be best explained by considering the history of today’s reporting model. Many of the rigorous control structures of a business are centred on the financial reporting system, leaving non-financial data with an array of ad hoc systems that vary from division to division and over time. As John Dove, a director of Baring Brothers, said after the fall of the ill-fated bank: “I had always assumed – I had no reason to doubt – that our controls were in good shape and reflected management’s desire to run a very tight ship.”
Investors and regulators alike are increasingly expecting managers to acknowledge the wisdom of English statesman Charles James Fox and accept that “the right of governing is not a property but a trust”. Moreover, they have to demonstrate that they are increasingly prepared to back that expectation with regulation where necessary, such as the EU Modernisation Directive or the Department of Trade and Industry’s Operating and Finance Review for UK public companies. The latter, expected to come into force in 2005, lays out certain reporting requirements and expectations, including a clear articulation of all business issues and the processes that management employ to control the principal business risks. For much management today, fulfilling both the letter and the spirit of this legislation will be a stretch. And yet this must be the direction of legislative change globally. We would therefore recommend that management take stock to ensure that internal governance structures are sufficient to meet the demands to come.
Credible communication
Good internal control structures are a prerequisite for good business. However, in order to leverage these structures fully – to turn them into a source of competitive advantage – management needs to be able to signal its competence to key stakeholders in a credible and consistent fashion.
How this is best achieved is a source of heated debate. A number of regulators have taken their first tentative steps in this area by requiring that companies report on board structures and remuneration policies. There is, in this action, an implicit assumption that having sufficient independent directors will ensure that there is an adequate oversight of managerial action; that splitting the role of CEO and chairman will guarantee that decisions are challenged; that ensuring that CEOs are not allowed to assume the post of chair will lessen any propensity to sweep previous mistakes under the corporate carpet.
Although an interesting first step which provides some indication that governance issues are under review, in reality the external comfort gained is limited. Instead, our instincts lie far more with the spirit of the United Kingdom’s soon-to-be-launched Operating and Financial Review. We gain more comfort from the way management articulates how it is running the business, the challenges and risks it faces and how it measures success. It is the quality, depth and credibility of the picture that is articulated which give us a sense of the degree to which adequate control structures are in place – that governance is not a ‘tick done’ exercise, but is the lifeblood of all that the organisation does.
So, how might such a report be structured?
We are strong advocates of making life as easy as possible. If management has assessed the effectiveness of the internal control structure, if it has assessed the breadth of information which this covers and the suitability of the review process applied, then a synopsis of the board report would be an ideal starting point for demonstrating the strength of the governance structures in place.
From such a synopsis, stakeholders are made aware of management’s view of the material issues which the company faces; they learn about the nature of the process involved in managing each issue and can see at a glance whether the data used by management has been subject to independent review. This last point is not a trivial one. Although this may smack of the self-serving, the value of providing third-party assurance of the critical operational data cannot be underestimated. In a recent survey of bond and equity investors and analysts in the United Kingdom, there was near unanimity in the call for all historic data provided in the annual report to be covered by the audit opinion – indeed, there was surprise by some that this was not already the case. There appears to be no more expedient way of building trust in the statement of performance made.
And is any company reporting on the material issues of its business in such a fashion? Each year, PricewaterhouseCoopers pulls together a review of good reporting practice taken from across the world. In the most recent document, “Trends in Corporate Reporting, 2004”, we highlight a number of companies that are moving towards this vision. Of these, readers might consider reviewing the report of Watercare, a New Zealand company that very clearly presents its operational objectives, sets current targets and identifies future plans.
Or perhaps adidas-Salomon, which succinctly describes, for example, its supplier partnerships and processes, supported by information on developing standards of engagement, internal supplier engagement processes and factory scoring systems.
Or indeed Coloplast, a Danish company that has long striven to communicate its corporate performance in a clear and concise fashion.
But reporting of this nature is costly, both in terms of time and in terms of the resources that must be engaged in verifying the reliability of the data presented. So what, if any, are the benefits that might ensue?
The benefits of good governance
While the pressure to re-focus on the adequacy of internal governance structures is increasing, and the need to report on such control structures is becoming a reality, the message here is not one of doom and gloom. Significant economic benefits can be reaped from efforts to enhance operational processes and to improve external transparency in these critical areas.
The economic benefits fall into three main areas:
• better decision making;
• lower stock price volatility and cost of capital; and
• better stakeholder engagement.
Decision making
Ensuring that management has access to a sufficiently broad and reliable set of performance information is a necessary – but not a sufficient – step towards generating better business decision making. In a recently published paper, Wharton accounting professors Ittner and Larcker described their disappointment with the implementation of balanced scorecards: not because using a broad set of indicators is irrelevant to business analysis, but because management has tended to implement on a checklist basis; no routinised effort to convert information into an effective decision support tool has been made.
However, when companies do get it right, the economic consequences can be significant. Consider the findings of PricewaterhouseCoopers’ Global Human Capital Survey, which shows that those companies with a documented – and thus embedded – human resources strategy generate 35 per cent more revenues per employee, have 12 per cent lower rates of absenteeism and more efficient performance management systems.
Indeed, a broad set of non-financial indicators – not just people metrics – is associated with superior performance. For example, in 1999 McKinsey & Co demonstrated that companies with strong brands generate, on average, returns to shareholders that are 1.9 per cent above the industry average, while weaker brands lag behind the average by 3.1 per cent. Similarly, a 1999 University of Michigan study has shown that for a Business Week 1000 company with average assets of about US$10 billion, a 1 per cent increase in customer satisfaction was associated with an increase in firm value of about US$275 million.
The key message of these studies is clear. It is not the collection of data which generates superior returns; it is the way it is integrated into the overall business intelligence framework and the actions that ensue which generate results.
Stock price volatility and the cost of capital
Current financial reporting models do not allow the investment community to assess adequately the quality or sustainability of a company’s performance. They do not allow the reader to differentiate good management from bad, luck from skill.
So what do users say they need in order to gain confidence in their ability to evaluate corporate performance? The response is a consistent plea for better non-financial data that would allow them to set financial performance in context. If a company gives investors the information that they need to assess the quality of today’s performance and to forecast the future with greater certainty, investors will assign a higher valuation than they would were they left guessing. This is illustrated in the case study “A tale of two reports” presented on the following page.
Stakeholder engagement
Companies that are proactive in communicating corporate – and not merely financial – information in a credible fashion are likely to experience material benefits in their relationships with a broad set of stakeholders:
• Employees – here the ability to retain and attract the best and brightest is enhanced;
• Customers – a company’s reputation, the customer’s belief in its ability to deliver on its promises, is inextricably linked to its external reporting. If the company does not take control of the messages presented by the various faces of the firm, or if there is a lack of congruence in their content, it will be handing control of its reputation to the press and chat rooms;
• Joint ventures/partnerships – case studies illustrate that a company’s licence to operate in sensitive territories and its ability to negotiate contracts on favourable terms are enhanced if trust has been built through transparency; and
• Supply chain – the confidence with which suppliers are prepared to commit customer-specific capital is among the benefits that may accrue to companies which are building trust, through their reporting.
In conclusion
In this chapter we have argued that good corporate governance can be achieved only if it is an embedded part of corporate life: part of the DNA of the organisation, its internal processes and the way it makes information available externally. Given the regulatory pressures – such as the EU Modernisation Directive and the United Kingdom’s new Operating and Financial Review – which are increasingly encouraging companies to ‘tell it how it is’, and the substantial economic benefits that such transparency can provide, we urge companies to act today to optimise the breadth, quality and accessibility of all material operational information, so that it can be exploited to create greater trust and value.
