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Ethics = Profits
One of modern management's most persistent questions has apparently been
answered - do good business ethics translate into a positive bottom line? The
answer, according to research from the Institute of Business Ethics, is yes.
Although many research projects have tackled the subject before, conclusions
have often been contradictory. The study by the Institute of Business Ethics
is the most thorough yet conducted, based on four indicators of business success
– economic value added (EVA), market value added (MVA), price / earnings
ratio volatility (P/E) and return on capital employed (ROCE). It compared two
groups of companies: those with a demonstrable commitment to ethical behaviour
through having a published code of business ethics, and those without. Performances
were analysed over the five years 1997 to 2001. On three of the four indicators
(EVA, MVA, P/E) the companies with codes were clearly superior and on ROCE the
results were less clear but supported the overall trend.
Using the MVA criterion, there was a substantial bonus for those with a code
of business ethics. Similarly, there was superior performance for those companies
using the EVA test. The price / earnings ratio demonstrated less volatility
among those with a code – reflecting similar analysis previously conducted
by the Ethical Investment Research Service. Assessment of ROCE showed those
with codes marginally underperformed between 1997 and 1999, while outperforming
by 50 per cent between 1999 and 2001.
The study also concluded that companies with a code of business ethics scored
above average in Management Today's ranking of Britain’s most admired
companies and in the SERM Risk Reduction Rating. The findings reflect similar
results using the same methodology in separate research looking at market value
added conducted in the United States. IBE argues that the lower P/E volatility
results from the fact that companies with a code of ethics have a commitment
to consistent management. A stable P/E ratio has been shown to result in lower
cost capital, reflecting the more secure investment. IBE concludes that the
study does not necessarily prove that a code leads to better financial performance,
rather that the existence of a code of business ethics is ‘one hallmark
of a well-managed company’.
The drive towards stronger corporate social responsibility was underlined by
the launch by CSR campaigners AccountAbility of AA1000AS, the world’s first
assurance standard to provide quality of public reporting on social, environmental
and economic performance. AccountAbility argues that while social reporting
has increased, it has lacked credibility because there is no consistent approach
to measurement or analysis.
In a personal capacity, Roger Adams, ACCA’s executive director –
technical, is a member of the AccountAbility Technical Committee which approved
the new standard. He says that while ACCA’s Audit Committee has not yet
considered the assurance standard, it is in line with ACCA’s desire to
encourage initiatives in this area.
“We believe that independent assurance provision is an important way of
contributing to the overall credibility of a sustainability report – though
not necessarily the only way,” Adams explained. “The recent FEE position
paper on assurance and sustainability reporting is also important. It may well
be that multiple approaches to assurance provision will operate in parallel
for some years to come, until a de facto market standard develops. This may
be AA1000AS, it may not. For ACCA, it is too early in the process to consider
endorsing one approach to the exclusion of other methods.”
There is other important evidence that CSR concerns have become central to
effective management. In line with the Myners Report, which urged institutional
investors to become active shareholders, large fund managers are strongly lobbying
corporations to adopt corporate governance best practice. This has most obviously
been demonstrated by the alliance of many leading fund managers to demand that
public companies implement the Higgs review in the appointment of fully independent
non-executive directors.
Just as significant, has been the demand from ISIS Asset Management, together
with one of the largest pension funds – the University Superannuation Scheme
– for pharmaceutical companies to adopt more benevolent CSR policies. They
focused specifically on the lack of affordability of HIV / AIDS drugs and said
that if this continued pharmaceutical companies’ share prices could fall
in the face of resistance to patent recognition by developing countries with
high rates infection.
A few days later, KPMG put out a statement which said: “A far more committed
approach to corporate social responsibility is urgently needed if the financial
success of the pharmaceutical industry is not to go into a steep decline.”
It added: “A lot of the problems currently facing the pharmaceutical industry
in the areas of pricing and intellectual property would have been much reduced
if the industry as a whole had implemented better CSR approaches earlier.”
John Morris, European head of pharmaceuticals at KPMG, explained: “All
major pharma companies no doubt have a CSR team, with executive leadership,
but the issue is the degree of influence these groups have on the strategic
business decisions related to pricing and patents. Improving CSR is not just
about throwing more money at charitable causes.
“The key change needed of the pharma industry is to listen and to hear
the warning signs. Other sectors – the oil industry being a good example
– have learned that real dialogue with NGOs, the public and politicians
is sound business practice in the current world. Industry reputation and its
importance make good long-term business sense.
“There is no doubt that the attitude of the industry towards corporate
social responsibility practices has improved but a lot of the damage is already
done. Policies already proposed on pricing and intellectual property mean that
no amount of further concessions or rearguard actions can save the industry
from damage. What is important is that the lessons learned from this will stand
the industry in better stead when considering its approaches to issues of social
responsibility and reputation in the future.”
A new publication from ACCA targeted at the City further underlines the importance
of CSR and consideration of the environment in sustaining a profitable business.
The ‘Big Picture’ examines how profitability can be affected by environmental
compliance and emerging economic instruments, which require greater social and
environmental disclosures. These include environmental taxation, carbon emissions
trading and changes to pension fund regulation and proposed amendments to company
law.
The 'Pussycat' Roars
The UK National Audit Office and the Charity Commission have demanded stricter
compliance with good accounting practices. The NAO has qualified the accounts
of 16 government departments, highlighting poor record keeping. And The Charity
Commission has warned that many charities are mismanaging their reserves.
Government departments have been required to use resource accounting as their
sole accounting systems since 2001/2, after a period of transition in which
both cash and resource accounts were used. The NAO says that while most departments
have moved efficiently to the new system, a minority are failing to adopt sufficiently
rigorous management information systems.
Those departments whose accounts have been qualified for poor record keeping
are the Home Office, the Ministry of Defence, the Department for Work and Pensions,
the Department for Environment, Food and Rural Affairs, the Office for National
Statistics and the security services. The inclusion of some of these is no surprise:
the Department for Work and Pensions has repeatedly had its accounts qualified
over the quality of its benefits processing; the Ministry of Defence struggled
more than any public body with the introduction of resource accounting, with
many problems over the valuation of its diverse range of assets; and the Department
for Environment, Food and Rural Affairs has had to overcome the legacy of the
foot and mouth disease and allegations of compensation fraud.
But the qualification of the other departments is a humiliation for them, particularly
for the Office for National Statistics whose entire raison d’etre is founded
on the public’s ability to trust its figures. A further 10 departments
have had their accounts qualified because of over-spending, including the Charity
Commission, the Royal Mint and the Serious Fraud Office.
The Comptroller and Auditor General Sir John Bourn – once memorably described
by a retired permanent secretary as ‘a pussycat’ – further asserted
his independence by demanding that some departments develop their arrangements
for corporate governance and risk management. He suggested that while the Higgs
report on non-executive directors was aimed at the private sector, the recommendations
could be regarded as having “great relevance for similar developments in
the central government sector”.
Sir John also drew attention to the complexity involved in accounting for Private
Finance Initiative projects. He added that this has not “to date”
caused him to qualify any departmental accounts. His report put particular emphasis
on his “concern” that in “a number of PFI deals” the assets
and related liabilities did not appear on the accounts of the client or special
purpose vehicle consortium supplying the services.
Significantly, Sir John further put a spotlight on the issue of contingent
liabilities. He says that he will qualify departmental accounts where he believes
they fail to show liabilities, including contingent liabilities. Specifically
he said that Network Rail should be regarded as a public body, with its assets
and liabilities included in the consolidated balance sheet of its funder, the
Strategic Rail Authority.
Meanwhile, the Charities Commission has found that many charities have weak
financial management, accounting and corporate governance practices. At the
end of 2001, charities in England and Wales had reserves in excess of £26bn,
yet over £5.5bn of this was held by charities with no policy on the use
or level of reserves. Often where policies had been adopted, these were inadequate.
Charity trustees are legally required to publish in their annual report their
charity’s reserve policy. It appears that in many cases the reasons for
charities’ information failures are not so much negligence, as the desire
to confuse donors.
The Commission reports that some charities split reserves into smaller ‘designated’
funds, hiding from stakeholders the real level of reserves or that reserves
were held at levels higher than that specified by the reserves policy. Concern
was also expressed at the one third of charities holding reserves at levels
lower than specified by their policies.
The issue of reserves has become more pressing because many charities have
large investments in shares, the value of which have diminished sharply. The
Commission is advising charities to properly account for their reserves on the
basis of a balanced and transparent policy. Charities with insufficient reserves
should consider income diversification and appeals which are directed at building
reserves.
Shirley Scott, director of the Charity Finance Directors’ Group, said:
“Reserves are an indicator of health and sustainability in a charity and
are an essential part of good financial planning. It is important that stakeholders
should look beyond the headline figure of how much a charity has in reserves
to examine why the charity is holding these reserves.”
The Charity Commission also issued a warning to charities, trustees and employees
after the successful prosecution of a former solicitor for causing the loss
of £311,000 to the Helston Downsland Charity. The charity’s clerk
was found guilty of forgery and deception after stealing money by persuading
trustees to sign blank cheques.
Companies Not Prepared for IASs
‘Uncertainty and confusion' is plaguing the European financial service sector's
preparations for international accounting standards in 2005, says a new report
from the Economist Intelligence Unit and PricewaterhouseCoopers.
The survey, ‘Illuminating Value’, says that executives remain unclear
about the new standards, with justification as important standards on insurance
contracts and financial instrument have still not been finalised.
Most worryingly, while 45 per cent of survey respondents confirmed that they
were required to comply with the new standards, only 34 per cent said they would
actually do so. Less than half of those who will have to use the new standards
have begun implementation. EIU and PwC say that companies which delay preparation
for the new standards are exposing themselves to dangerous business risk as
the standards will require significant changes in financial management.
In particular, companies are advised to begin running parallel accounts using
the new standards in advance of the 2005 compliance deadline. Companies which
also have SEC reporting requirements may need to prepare three years of historical
information for reconciliation with US GAAP. Impacts of the new standards go
beyond internal processes: companies have to change financial products, investment
strategies and risk management policies. They must also educate and warn shareholders
and investment analysts that the new standards will lead to much more volatile
financial results.
‘Banks, insurers and other institutions need to be prepared, and the highly
compressed timetable for implementation leaves little time for reflection, much
less for action,’ concludes the report. ‘Financial services firms,
not only in Europe but also outside it, need to act now, both to assess the
impact of international financial reporting standards on their operations and
to start making preparations to adapt.’
The move to international standards also applies to the audit of financial
statements, with the publication by the International Federation of Accountants
(IFAC) of its proposed amendment of ISA200, Objective and Principles Governing
an Audit of Financial Statements. Its latest proposals have been described by
ACCA as ‘extensive and procedural and their implementation would result
in a disproportionately large extra cost for audits of smaller entities’.
In its response to IFAC’s proposals, ACCA called for any proposed International
Standards on Auditing to have the support of three quarters of the membership
of IAASB – not the two thirds support as suggested by IFAC. This would
send clear signals to the profession that any standards produced by the board
had overwhelming international support, says ACCA.
ACCA has also called for the proposals to be clear and consistent and to be
based on principles, rather than adopting an unwieldy, procedural ‘rule
book’ approach, which could lead to exploitation of loopholes, as demonstrated
by the Enron scandal in the US.
ACCA President Jonathan Beckerlegge said: “While we welcome the approach
adopted by IFAC, we believe it is vital that any proposed auditing standards
should have the support of the overwhelming majority of IAASB to send out clear
messages about the strength of feeling behind those standards. In turn, this
should make enforcing those standards more straightforward.”
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