ACCA - The global body for professional accountants

Audit and Society

research-insights137

The influence of non-financial factors on investment decisions is growing. Ernst & Young’s Andrew Hobbs explores what that could mean for audit

For anyone interested in looking, there is a wealth of information available about a company’s performance and prospects beyond the annual report and audited financial statements. Some of this additional information is provided by companies themselves, including preliminary reports and quarterly analyst calls. The internet is another treasure trove of corporate information, opinion and gossip.

The extent to which all this ‘noise’ influences investors varies but it can and does move markets. When a company loses control of the flow of its financial information, even temporarily, it can have a dramatic financial impact. Reputational damage is one of the non-financial factors that can also force a shift in the public and investor mood. And the fact that companies themselves are increasingly providing insights about their performance beyond what is in the annual report – for example, on social media or investor teleconference calls – suggests a demand for more than just financial information about companies’ overall performance.

With the financial crisis having reduced confidence in the corporate sector as a whole, it is perhaps unsurprising that investors are looking for more information about companies. After all, the less trust you have in something, the more you want to know about it.

Directors are obliged to share their views on the principal risks facing the company. But there are a range of non-financial risks that do not come within the scope of financial statements and on which no assurance is provided. Risks such as corrupt behaviour, human rights violations, control failures (including data losses and confidentiality breaches) and environmental incidents can all cause reputational damage and have significant adverse financial consequences.

This isn’t pie in the sky. A growing body of investors are already looking at these issues and integrating them into their investment strategies. ESG (environmental, social and governance) is a term you may have already come across. Investors are using ESG factors to evaluate corporate behaviour and to determine future financial performance. The Association of British Insurers advises its institutional investors that corporate reports should include information on ESG-related risks and opportunities and how they might impact the business.

That’s not to say all risk is bad nor that it is always viewed negatively by investors. Equity is called risk capital for a reason. High-quality risk disclosures by companies allow investors to better judge the company’s risk appetite and whether it is in line with their own.

In light of these factors, how might corporate reporting develop to help meet the demand from investors for more information about overall performance? What assurance might be sought on the information provided? Let’s focus on just three examples here: business ethics, sustainability and human capital.

Business ethics

There is a growing awareness that having the right behaviours within an organisation reduces risk and leads to better outcomes. There have been several recent examples where reports of unethical behaviour in large companies have caused significant reputational and financial damage. It is therefore reasonable to expect that shareholders and other stakeholders will demand more information from companies about how they encourage the right culture in their organisations.

Having the right tone at the top is key to developing good behaviours throughout an organisation. The tone from management plays a major role in determining and supporting an organisation’s culture. However, even a great tone at the top does not automatically translate into the right behaviours on the ground. Investors, regulators and other stakeholders will want to know there is alignment between the boardroom and the shop floor. How embedded are the company’s values? Are there controls to deter, detect and deal with unethical behaviour? In short, investors and others want confidence that the company is ‘walking the walk’ and not just ‘talking the talk’.

If companies do not step up here, regulators will feel obliged to act, in ways that may not encourage the ethical behaviours sought and could even create perverse incentives. Public policy responses to governance failures tend to focus on outputs – things that can be measured easily – rather than incentivising the right kind of behaviours which should lead to better outcomes. Indeed, by focusing on excessive risk taking by regulating structures and products, regulatory reform may even encourage compliance-oriented behaviours rather than motivate people to use their judgment and do the right thing.

Where there is a low level of trust in a sector, investors and the public are unlikely to take the word of a company in that sector when it comes to its culture. There may therefore be a role for some kind of external assurance. This could involve, for example, reviewing communications throughout an organisation for evidence that the tone from the top is reflected consistently in communications at all levels of the organisation.

Sustainability and environment

Stakeholders and the wider public are increasingly looking for more information about a company’s overall performance and how sustainable it is. This reflects not only concern with the impact of organisations on the environment and people, but a growing recognition that a company’s value can be affected by issues off the balance sheet, such as its access to natural resources.

Sustainability is not just about environmental sustainability. That is why there is increasing enthusiasm and support across a broad range of stakeholders for the introduction of integrated corporate reporting. Integrated reporting allows a company to communicate the overall value it creates – its social, environmental and ethical value as well as its financial and commercial value. 

A number of companies that already report sustainability information also seek assurance on it. External assurance could play a role in providing confidence to investors and others that a company’s performance is sustainable and to help answer such questions as:

·         Does the company have a strategy to manage commodity price increases?

·         Where does the company source its supplies from? Does it use ethical sources?

·         Above all, is the company thinking long term and sustainably?

Human capital

Human capital is another resource that could have a significant effect on the value of a company, particularly for those businesses with little in the way of physical assets, or where an individual or small group of individuals are closely associated with the success of the company.

A company’s management of its human capital is of increasing importance to stakeholders and the public – witness the increasing focus on the diversity of corporate boards and executive remuneration. Investors and others may in the future demand more information from companies about their human capital and evidence that they have robust strategies in place to manage human capital changes. An EY survey conducted in 2011 found that half of investors wanted better reporting of how intangibles such as human capital might affect a company’s ongoing performance.

Many shareholders already have a keen interest in succession planning. Other areas related to human capital where investors and others may seek additional information – and assurance – include the approach to equality and diversity. Is the tone from the top matched by the reality on the ground and reflected in the company’s policies and practices on recruitment, training and reward?

Conclusion

These are just three areas where corporate reporting and related assurance could be developed to provide more information to investors and other stakeholders in the future. Others might include the quality of corporate governance, regulatory risks and compliance, and emerging markets risks.

The audit and accountancy profession is well placed to work with preparers and investors to help develop corporate reporting in ways that are of value to shareholders and other users. The profession should challenge itself to think radically about areas of potential demand in corporate reporting and how audit and assurance may develop so that it remains relevant to the needs of shareholders and other users.

A number of questions must be answered before the profession can be expected to put ideas into production. For one, is there demand from companies and investors for new areas of assurance? Any new areas of reporting and assurance would also likely require the development of standards to help ensure quality and comparability by users between different organisations.

But these caveats should not stop the profession from thinking radically. Indeed, it arguably has a professional obligation to do so. The audit is there to protect investors. Investment decisions are now informed by non-financial factors to a far greater extent than was the case even a few years ago. It is therefore right to ask how the current system of corporate reporting, audit and wider assurance could develop to continue to provide confidence to a more inquisitive and sceptical investing public.

Andrew Hobbs is an associate partner leading Ernst & Young’s UK regulatory and public policy team.

This article first appeared in Accountancy Futures, Edition 6, 2013

 

Published: 13 Sep 2014