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Learning objectives At the end of this chapter, you should be able to: LO 3.1 discuss what is meant by sustainability reporting and explain the

Global Reporting and Integrated Reporting initiatives

LO 3.2 identify the factors that should help determine appropriate ethical behaviour for accountants

LO 3.3 explain what is meant by the term ‘corporate governance’ and identify the eight ASX Corporate Governance Council principles

LO 3.4 discuss the issues associated with the role of the board of directors and the audit committee in corporate governance

LO 3.5 identify the approaches to enforcing corporate governance requirements in Australia and the USA.

Chapter 3

Sustainability reporting, ethics and corporate governance

Copyright 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202 Hancock, Phil, et al. Contemporary Accounting, Cengage, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/deakin/detail.action?docID=6135923. Created from deakin on 2021-03-22 07:12:19.

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Introduction In Chapter 2 we considered aspects of financial reporting and the types of financial statements. In addition to financial information, many organisations now provide social, environmental and governance information. In this chapter we discuss sustainability reporting and explain the most commonly adopted protocols in relation to sustainability reporting, which in most countries is largely a voluntary exercise.

An inevitable consequence of a capitalist-based economy that rewards profit is the failure of companies. This may be due to poor management, inadequate capital, excessive risk taking and, unfortunately in some instances, greed! The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (also known as the Banking Royal Commission) in Australia in 2018 yielded many examples of unacceptable behaviour in business. The spectacular failure of companies such as Enron and Lehman Brothers among others in the USA, Vivendi and Parmalat in Europe and the Hastie Group and Centro among others in Australia provide further examples of unethical behaviour.

In 2009 the sub-prime lending debacle precipitated the Global Financial Crisis, which resulted in unprecedented problems with the world’s financial system. This caused governments in many countries to intervene to guarantee bank loans and acquire shares in many banks. The failure of such high-profile companies and banks raises serious concerns about many issues, including ethical behaviour, regulation of financial institutions, transparency of financial reporting, the appropriateness of accounting standards and corporate governance.

In this chapter we first look at sustainability reporting before turning our attention to the issue of ethics and ethical behaviour in business. We then discuss corporate governance and explain what is meant by internal and external corporate governance. We examine issues associated with the role of boards of directors and the audit committees as part of corporate governance. We finish by highlighting the corporate governance requirements in Australia and other countries.

3.1 Sustainability reporting Traditionally, organisations, particularly listed organisations, have pursued the maximisation of profit as their major objective. In accounting, reporting on financial performance has been their central focus and is the central focus in this book. But in the twenty-first century there has been a growing concern about the ability of the world’s resources to be able to meet the needs of future generations if not properly managed. The 2009 Global Financial Crisis caused a rethinking of the capitalist model and its focus on short-term outcomes. Sustainability and sustainable development are now important issues on the world agenda, but what is meant by the term ‘sustainable development’?

The following definition is the one used by Dantes (2005):

The concept of meeting the needs of the present without compromising the ability of future generations to meet their needs. The terms originally applied to natural resource situations, where the long term was the focus. Today, it applies to many disciplines, including economic development, environment, food production, energy and social organisation. Basically, sustainability/sustainable development refers to doing something with the long term in mind.

Dantes. (2005). Akzo Nobel, www.dantes.info/ Projectinformation/Glossary/Glossary.html

corporate governance (Chapter 3) Mechanisms such as the board of directors and audit committees which exist to provide some assurance to the absentee owners that the management of a company is accountable for its actions and to minimise agency costs in respect of its management.

audit committees (Chapter 3) A subcommittee of the board of directors, and part of the corporate governance of a company. Its roles depend on the company, but in general it ensures that the financial statements have been reliably prepared and verified.

LO 3.1 Discuss what is meant by sustainability reporting and explain the Global Reporting and Integrated Reporting initiatives.

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Many organisations have for some years provided additional information in relation to environmental and social issues beyond what is required in financial statements. The practice of publishing various types of corporate social reports is largely voluntary and has emerged with the increasing concern about sustainable development. There are a variety of names for this type of report. These include: environmental report, corporate social report, sustainability report, social impact report, stakeholder impact report, corporate social responsibility report and triple bottom line (TBL) report.

A TBL report refers to the publication of economic, environmental and social information in one report and has three components: » Environmental: disclosures about many issues associated with the environment and the organisation’s

activities within this area. These may include issues to do with air, water, land, natural resources, flora, fauna and human health (e.g. greenhouse gas emissions, water contamination and workers’ safety).

» Social: disclosures about many social issues such as the diversity of the organisation’s employees, treatment of minorities, employment conditions for employees and community activities (e.g. criticism of Nike’s ‘sweatshop’ production operations in Asian countries).

» Economic: the more traditional financial data and, for this reason, likely to contain more quantitative data than the previous two components. However, it is not the GPFS which are provided in annual reports. For example, financial information would include details about the entity’s ability to meet superannuation obligations to its employees. Some organisations, such as mining organisations, have certain mandatory reporting obligations and

conditions, such as restoring the land to its original condition after they have finished mining operations. However, such mandatory obligations only apply in certain industries and, in general, most organisations providing information about social and environmental issues do so on a voluntary basis.

The TBL is sometimes described as reporting about People, Planet and Profit (Figure 3.1), which is not entirely accurate as the financial disclosures in such reports are not the same as included in the GPFS discussed in Chapter 2.

Ethics/CSR Sustainability reports are largely voluntary.

PROFIT Financial

PLANET Environmental

PEOPLE Social

Figure 3.1 Triple bottom line of sustainable business models

The disclosure of information in sustainability reports is largely voluntary and so the question arises as to why profit-making companies produce such reports? In their 2017 sustainability report on page 6, the company Woodside stated that one of the reasons for producing such a report is:

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We recognise that long-term meaningful relationships with communities are fundamental to maintaining our licence to operate, and we work to build mutually beneficial relationships across all locations where we are active.

Woodside Sustainability Report 2017, p. 6

Key concept 3.1: Sustainability reporting

Reporting on an organisation’s environmental, social and financial activities so users can assess the sustainability of the organisation’s operations.

The Global Reporting Initiative (GRI) The most widely cited benchmark in the determination of what should be included in a TBL or sustainability report is the Global Reporting Initiative (GRI) – an institution based in the Netherlands. The GRI was established through the United Nations Environment Program with the objective of enhancing the quality, rigour and utility of sustainability reporting. In 2002, the GRI released the Sustainability Reporting Guidelines. In 2006 it released G2, containing revisions to the 2002 version, and in 2013 G4 was published with further revisions. In October 2016 the first set of global standards for sustainability reporting were released. These apply from 1 July 2018. The GRI identified a series of trends that added momentum to the need for techniques that enhanced an organisation’s ability to more consistently and comprehensively report on the economic, environmental and social dimensions of its activities, products and services.

The GRI indicators were created through a process of stakeholder dialogue. In G4 there are two options described as core and comprehensive. These options were retained in the new GRI Standards. The core option contains the essential components of a sustainability report. The comprehensive option contains all the parts of the core and has additional disclosures about the organisation’s strategy, governance and ethics. The guidelines discuss principles for deciding on the report content and report quality.

The content principles upon which the GRI guidelines are based are: » materiality – the report should cover topics and indicators relating to the organisation’s significant

environmental, social and economic performance, which enable users to make an informed assessment » stakeholder inclusiveness – the report should engage stakeholders in the development of reports » completeness – the TBL report should include all material information » sustainability context – the TBL report should attempt to place information in a larger context of

ecological or social limits. The quality principles upon which the GRI guidelines are based are:

» balance – the report should describe both positive and negative aspects of the organisation’s performance » reliability – information should be gathered, compiled and reported in such a manner that is capable of

being verified by an external party » accuracy – there should be a low margin of error » comparability – consistency should be maintained in the preparation of the report to enhance comparability » clarity – the report should be meaningful to as wide a range of users as possible » timeliness – the report should be available on a regular basis so that information is not meaningless.

In the guidelines, each of the three areas (economic, environmental and social) are detailed, and if there are applicable measurement methods these are also specified.

Under the environment theme, the GRI has specified, in detail, 34 indicators for organisations to report on. The headings in the environment area are: materials; energy; water; biodiversity; emissions, effluents

Global Reporting Initiative (GRI) (Chapter 3) The multi- stakeholder interest group that has taken on the task of developing and having adopted global guidelines for the reporting of organisation sustainability.

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and waste; products and services; compliance; transport; overall; supplier environmental assessment; and environmental grievance mechanisms.

In the social area, there are 48 indicators under the following headings: employment; occupational health and safety; labour management/relations; training and education; diversity and equal opportunity; equal remuneration for women and men; supplier assessment for labour practices; labour practices grievance mechanisms; investment; non-discrimination; freedom of association; child labour; forced or compulsory labour; security practices; Indigenous rights; supplier human rights assessment; human rights grievance mechanisms; local communities; anti-corruption; public policy; anti-competitive behaviour; compliance; supplier assessment for impacts on society; grievance mechanisms for impacts on society; customer health and safety; products and services labelling; marketing communications; and customer privacy and compliance.

Finally, in the financial area there are nine indicators under the following headings: direct economic value generated and distributed; financial implications and other risks and opportunities for the organisation’s activities due to climate change; coverage of defined benefit plan obligations; financial assistance received from government; ratios of standard entry-level wage compared to local minimum wage at significant locations of operation; proportion of senior management hired from the local community at significant locations of operation; development and impact of infrastructure investments and services supported; significant indirect economic impacts including the extent of impacts; and the proportion of spending on local suppliers at significant locations of operation. Figure 3.2 is an extract from page 46 of the Woodside Sustainable Development Report 2016 and shows the type of financial information consistent with the GRI.

Value generated and distributed ($ billion)*

4.5 4.08 (0.28)

(2.07)

(0.66)

Value generated

1. Consistent with the Group’s Financial Statements, consolidated statement of cash flow. It includes Woodside’s gross payroll costs reported on a cash basis.

* Amounts have been derived from the Woodside Annual Report 2016, or converted into USD using the average rate of 0.74 AUD/USD.

2. Supplier costs are consistent with the Group’s audited financial statements. They include operating capital and exploration expenditure paid to suppliers and contractors for materials and services and exclude employee wages and benefits, payments to governments, payments to community groups, investments and repayments, interest, depreciation, amortisation, impairments and relevant indirect taxes.

Dividends1 Suppliers2 Employees1 Interest1 Communities1 Taxes1 Investments and repayments1

Value retained

(0.16) (0.01) (0.38)

(0.35)

0.17

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

Figure 3.2 Woodside value add

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Integrated reporting In this section we examine the concept of integrated reporting, which involves organisations reporting on all activities relevant to value creation. Such reporting includes financial information but also includes information on strategy, environmental, social, governance and other value-relevant activities in an integrated report. The International Integrated Reporting Committee (IIRC) was an outcome of a Sustainability Forum meeting on 17 December 2009 initiated by Prince Charles of the United Kingdom.

While a triple bottom line (TBL) report refers to the publication of economic, environmental and social information in one report, integrated reporting extends the TBL to include information on governance, strategy and any other relevant information about how an organisation creates value. The target audience for an integrated report is the providers of financial capital, while a sustainability report is aimed at a broader range of stakeholders who want to know about an organisation’s environmental and social impacts and how it is managing them. An integrated report adds information about governance and strategy to the TBL with the understanding that these areas are often linked. Rio Tinto workforce policy for its mines’ workers is a good example:

In Western Australia in our Iron Ore product group, we employ 10 500 people: 13.5% of the residential workforce are members of Indigenous groups from the Pilbara region.

Rio Tinto, 2018, p. 52

Having a local workforce is a cheaper alternative than the ‘fly-in, fly-out’ workforce and has a number of social benefits for the region, including the employment of a large number of Indigenous people.

The IIRC began a pilot program in 2011 so as to underpin the development of a framework for integrated reporting. There were over 90 organisations involved in the pilot, including organisations like Coca-Cola and National Australia Bank (for more information go to www.theiirc.org). It has grown since then and now many companies around the world publish an integrated report but it is only mandatory in South Africa.

What then are the main differences between an integrated report and a sustainability report? The two are closely related – especially if an organisation chooses the comprehensive option in the GRI’s G4 Guidelines and GRI Standards – as both provide information about an organisation, its governance and its economic performance as well as many aspects of its social and environmental impacts. It is argued that the objective is different as the integrated report is aimed at providers of financial capital and provides such users with details about how its strategy, governance, performance and prospects lead to the creation of value over time. On the other hand, the sustainability report is aimed at a broad range of stakeholders with the objective of providing information about the economic, social and environmental impacts of its operations. Will organisations provide two separate reports? Only time will tell but it is unlikely given the similarity between the two and the costs involved in preparing two separate reports.

integrated reporting (Chapter 3) A framework intended to guide the preparation and dissemination of periodic reports about how an organisation’s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value in the short, medium and long term.

Stop and think 1

Why do profit making companies voluntarily provide a TBL or integrated report?

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3.2 Ethics in accounting Figures show that corporate fraud costs billions of dollars each year, as shown by the collapse of companies in many countries including the US, Italy and Australia. Fraud is also not restricted to the for-profit sector, as illustrated by the 2014 BDO survey of fraud in the not-for-profit sector. How does a large public company like Dick Smith collapse, resulting in the loss of billions of dollars? How do we solve problems of corporate fraud and embezzlement?

Dr Rushworth Kidder, president of the Institute for Global Ethics in the USA, argues that this will not happen if companies adopt codes of ethics and create departments responsible for monitoring these codes. Employees should receive training about the codes of ethics and be required to follow them.

What is the relationship between business and ethics? Are ethics good for business? The answers to such questions depend on how we assess what is good for business. If we use short-term profitability as a measure, it may be that, on some occasions, doing what is ethical may not lead to short-term profitability. It may well improve long-term profitability, but if you are not in the company for the long haul, why bother being ethical? This raises issues about the objectives of business. Does the goal of profit maximisation conflict with ethical behaviour? Is there a conflict between self-interest and ethical behaviour? In Chapter 1 we introduced agency theory which explains the reason for contracts which try to align the interests of shareholders and managers. Such contracts may in fact be the reason some managers engage in unethical behaviour.

Two frameworks developed by ethicists that are relevant to our discussion are utilitarianism and deontology. Utilitarianism judges the moral correctness of an action based entirely on its consequences. The action that should be pursued is the one where the favourable consequences to all parties outweigh the unfavourable consequences. The consequences to all parties that will be affected must be included.

In deontology the underlying nature of the action determines its correctness. There are two types of deontologists. Some feel the action itself is the only thing to be considered – lying, for example, is always unacceptable. Other deontologists believe that, for example, the nature of the action and its consequences in a particular situation should be considered. Therefore, in particular circumstances, lying may be acceptable.

Given the enormous costs of fraud and embezzlement, the potential gains to society of ethical behaviour are significant. The difficulty lies in developing an appropriate code of ethical behaviour that is adhered to by all people in business.

Business or professional behaviour is governed by sets of rules laid down by controlling bodies, and members of organisations or the profession are expected to follow these rules. In some professions, ‘ethics’ has come to mean these rules. For example, professional ethics should be regarded as ‘standards of professional conduct (the ethics of lawyers)’ (Statsky, 1985).

The financial problems of companies like Enron and HIH in the late 1990s and early 2000s can be attributed, in part, to some accountants substituting ‘the rules’ for genuine ‘ethical behavior’. In 2018 the Banking Royal Commission provided many examples of unethical behaviour. Is it acceptable to follow the requirements of the Corporations Act, even when, by following the strict letter of the law, one was able to gain an unfair advantage that did not reflect the spirit of the law?

As noted earlier, a lack of ethics contributed in some way to the gains made by some of the high-flyers involved in companies like Enron and HIH in the late 1990s and early 2000s. In 2013 allegations of corruption were made against Leighton Holdings in Australia. In 2016 Dick Smith retailer failed, leaving many disgruntled customers and employees. The Global Financial Crisis again highlighted issues around ethical behaviour and governance. However, many individuals and organisations have since paid a very high price for being unethical.

LO 3.2 Identify the factors that should help determine appropriate ethical behaviour for accountants.

Ethics/CSR How do we solve the problems of corporate fraud and embezzlement?

agency theory (Chapter 3) A theoretical model describing relationships where one party (i.e. the principal) delegates decision- making powers to another (i.e. the agent), and the mechanisms by which the principal seeks to mitigate the risks of the agent acting only in his/ her own interests.

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Because they offer so many services to the general public and the business community, professional accountants should always conduct their business in an ethical manner. Major professional accounting bodies in all countries have developed codes of professional ethics to help members deal with the range of situations they encounter in their professional lives. A CPA Australia survey on professional ethics asked respondents to rank various types of ethical issues. The results showed that the issues of greatest concern were: » client proposal for tax evasion (83.3%) » client proposal to manipulate financial statements (80.2%) » conflict of interest (79.3%) » presenting financial information in the most proper manner so as not to deceive users (76.3%) » failure to maintain technical competence in the discharge of duties (71.3%) » coping with a superior’s instructions to carry out unethical acts (70.6%).

In Australia, the major professional accounting bodies have now adopted the Code of Ethics for Professional Accountants as developed by the Accounting Professional and Ethical Standards Board (APESB). The full code can be viewed at http://www.apesb.org.au/page.php?id=12.

The rules of the professional bodies are intended not only to guide but, in some ways, to provide protection from the above types of ethical dilemmas for accountants. However, there are always some who are tempted to move around the rules for personal gain, and in the long run the profession and society are the losers. When dealing with accountants, individuals expect, and deserve to receive, conduct that will enhance the status of all who belong to that profession. Ethics in business and accounting are a matter of judgement based on rules and moral obligations.

To highlight the importance of ethics we have included a case study involving an ethical dilemma at the end of each chapter.

Key concept 3.2: Professional accounting ethics

All members of the professional accounting bodies in Australia are required to comply with a code of ethics and they are expected to act with integrity, objectivity, exercise professional competence and due care, maintain client confidentiality and at all times act in a professional manner.

Many believe that good corporate governance is one of the main ways of minimising divergent behaviour by senior executives as seen in some of the company failures referred to earlier in this chapter. Better corporate governance should (some argue) increase the fear of being caught. We discuss corporate governance in the next section.

3.3 Governance Governance is concerned with the processes and systems in place to ensure an organisation is well managed, and that procedures are in place to enhance the operations. This also includes processes to protect the assets of the organisation from external and internal threats. Good governance is not only relevant to companies and the for-profit sector, but also for the not-for-profit sector where a large number of volunteers, often

LO 3.3 explain what is meant by the term ‘corporate governance’ and identify the eight aSX Corporate Governance Council principles.

Stop and think 2

How do you think you will handle your future ethical problems? Can you do anything now to make it easier to handle your future concerns?

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without management experience, find themselves sitting on management committees. In a survey in 2014 the Australian Charities and Not-For-Profits Commission found the two biggest concerns with charities were around governance and fraud.

What is meant by ‘corporate governance’? Corporate governance refers specifically to the governance in corporations. Corporate governance is not a new concept but it has come into prominence since the early 2000s in the wake of concerns about why and how the Hastie Group, Centro, Parmalat, Enron and WorldCom collapses happened. The result has been a major focus by regulators and governments on reviewing laws and regulations that govern corporations.

What do we mean by ‘corporate governance’? The following definitions assist in understanding the concept.

The system of relations between the shareholders, Board of Directors and management of a company, as defined by the corporate charter, by-laws, formal policy and rule of law.

Investor Protection Association, Executive Office, 2006

Corporate governance is about promoting corporate fairness, transparency and accountability.

J. Wolfensohn, President of the World Bank, as quoted by an article in Financial Times, 21 June, 1999

In Chapter 2, we looked at different types of business structures, including sole traders, partnerships and companies. As discussed in Chapter 2, the company is a separate legal entity and is often managed by professionals on behalf of its owners (shareholders). Corporate governance refers to the procedures and processes put in place because the company is managed by parties, normally on behalf of the owners. This separation of owners from management gives rise to agency problems, some of which were discussed in Chapter 1 in respect of the economic consequences and the choice of accounting policies. The board of directors is part of the process of corporate governance.

Key concept 3.3: Corporate governance

Corporate governance consists of mechanisms such as the board of directors and audit committees that exist to provide some assurance to absentee owners that the management personnel of a company are accountable for their actions and minimise agency costs in respect of their management.

Wolfensohn’s definition above mentions fairness, transparency and accountability. All these terms are commonly used in financial reporting, with accountability being an important objective.

The key concept definition above relates to what could be called internal corporate governance. External corporate governance refers to the discipline of the marketplace where a company, if it is listed on a stock exchange, is subject to the scrutiny of the share market. Companies can be taken over and managers replaced, and this threat acts as an incentive for managers to behave more in a manner that is in the best interests of shareholders. We use the term ‘corporate governance’ as it refers to internal corporate governance.

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Issues in corporate governance In this section we discuss the ASX Corporate Governance Council’s Corporate Governance Principles and Recommendations published in August 2007, with amendments in 2010 and 2014, and we consider the role of the board of directors and the audit committee.

The ASX Corporate Governance Council The ASX Corporate Governance Council issued the Corporate Governance Principles and Recommendations in August 2007, and companies have been expected to comply with them since 2008. In addition, some amendments were made in 2010 and 2014. This is the third edition of the corporate governance principles and recommendations. There are eight principles and a number of best-practice recommendations accompanying each principle. Listed companies are expected to comply with the principles and recommendations, and if they don’t comply, they are expected to explain why (known as an ‘if not, why not’ approach).

The eight principles are listed in the ASX Corporate Governance Council’s Corporate Governance Principles and Recommendations 3rd edition (and see Table 3.1 below).

The eight principles of corporate governance

Principle Explanation

Principle 1 Lay solid foundations for management and oversight – Recognise and publish the respective roles and responsibilities of board and management.

Principle 2 Structure the board to add value – Have a board of an effective composition, size and commitment to adequately discharge its responsibilities and duties. The chairperson should be an independent director.

Principle 3 Act ethically and responsibly – Actively promote ethical and responsible decision-making; for example, by establishing a code of conduct.

Principle 4 Safeguard integrity in financial reporting – Have a structure to independently verify and safeguard the integrity of the company’s financial reporting. Establish an audit committee is one recommendation.

Principle 5 Make timely and balanced disclosure – Promote timely and balanced disclosure of all material matters concerning the company.

Principle 6 Respect the rights of security holders – Respect the rights of shareholders and facilitate the effective exercise of those rights.

Principle 7 Recognise and manage risk – Establish a sound system of risk oversight and management of internal control.

Principle 8 Remunerate fairly and responsibly – Ensure that the level and composition of remuneration is sufficient and reasonable and that its relationship to corporate and individual performance is defined.

© Copyright 2019 ASX Corporate Governance Council, Association of Superannuation Funds of Australia Ltd, ACN 002 786 290, Australian Council of Superannuation Investors, Australian Financial Markets Association Limited ACN 119 827 904, Australian Institute of Company Directors ACN 008 484 197,

Australian Institute of Superannuation Trustees ACN 123 284 275, Australasian Investor Relations Association Limited ACN 095 554 153, Australian Shareholders’ Association Limited ACN 000 625 669, ASX Limited ABN 98 008 624 691 trading as Australian Securities Exchange, Business Council of Australia ACN 008 483 216, Chartered Secretaries Australia Ltd ACN 008 615 950, CPA Australia Ltd ACN 008 392 452, Financial Services Institute of

Australasia ACN 066 027 389, Group of 100 Inc, The Institute of Actuaries of Australia ACN 000 423 656, The Institute of Chartered Accountants in Australia ARBN 084 642 571,The Institute of Internal Auditors Australia ACN 001 797 557, Financial Services Council ACN 080 744 163, Law Council of Australia Limited

ACN 005 260 622, National Institute of Accountants ACN 004 130 643, Property Council of Australia Limited ACN 008 474 422, Stockbrokers Association of Australia ACN 089 767 706. All rights reserved 2015.

Table 3.1

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Some of the recommendations associated with the eight principles include the following: » The board should have a majority of independent directors. » ‘Independent’ means a director cannot have been a substantial supplier or shareholder, or an employee

of the company or its professional advisers, within the last three years. » The chief executive officer (CEO) should not be the chair. However, there is no restriction on the CEO

being on other boards. » No limit exists on the number of directorships. » There should be an audit committee with at least one member with accounting or finance skills. » There should be separate nominations and remuneration committees.

Full details of the best-practice principles can be found at https://www.asx.com.au/documents/ asx-compliance/cgc-principles-and-recommendations-3rd-edn.pdf.

We now consider, in detail, the board of directors and the audit committee.

3.4 Board of directors In most countries, it is a legal requirement for companies to have a board of directors. As stated above, other types of entities, such as not-for-profit entities, also have governing bodies charged with a range of responsibilities. The role of the company board is to represent the interests of shareholders and its responsibility is to create value for shareholders. The board is accountable to the shareholders. It is responsible for reviewing the performance of the CEO and senior management, and for rewarding the senior executive team. It must also ensure that the company meets all its legal and statutory obligations, and that the major risks confronting the company are managed.

LO 3.4 Discuss the issues associated with the role of the board of directors and the audit committee in corporate governance.

Key concept 3.4: Board of directors

The board is an important corporate governance mechanism and its role is to represent shareholders and to create value for shareholders.

The following list outlines some issues in relation to company boards that have been addressed in the wake of high-profile company collapses. » Number of independent directors on boards. In the case of Enron, many of the directors were not really

independent as some of the non-executive directors had been previous auditors of the company. The argument supporting the use of independent non-executive directors is that they are more able to defuse agency conflicts between internal managers and absentee owners. However, others disagree and argue you need directors who understand the company’s business.

» Duality of leadership. Should the CEO be chair of the board or should the chair come from the non- executive directors? If the roles are combined, some argue that the board’s capacity to fulfil its duties is impaired.

» Size of the board. Some research suggests that the size of the board affects the performance of the firm. » Qualifications of directors. A board should consist of directors with the appropriate skills to allow the

board to discharge its duties. » Number of board memberships of directors. There is a view that some directors belong to too many boards

and do not have the necessary time to properly carry out their duties. » Length of service. Should directors be required to step down after a certain period of time to prevent

apathy, and also to prevent directors becoming too familiar with senior management?

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Researchers have also been actively studying many questions concerning corporate governance. A number of studies have attempted to test whether companies with good corporate governance perform better in terms of profitability and share market performance. Many studies show a positive relationship between the ownership of shares by the CEO and firm performance and some show mixed results. Studies have also shown that it is easier for the CEO to control and influence the board’s decisions. For example, in 2017 CPA Australia was embroiled in controversy which eventually saw the CEO sacked and the entire Board resign. It was alleged that the CEO wielded too much influence over the board.

An audit committee is a subcommittee of the board of directors and is another important corporate governance mechanism. The audit committee may be charged with various duties including: » overseeing the appointment of and relationship with the external auditor » overseeing the appointment of and relationship with the internal auditor » reviewing compliance with regulations and accounting standards » reviewing internal control procedures » overseeing the company’s risk management practices » reviewing the company’s financial statements and recommending them to the board for approval. The

board has to sign off on the financial statements and certify that they represent a true and fair view of the company. It is one matter to require the formation of an audit committee and another to specify its role and powers.

The above roles are extensive and are not necessarily carried out by all, or even some, audit committees. An important issue for all audit committees is whether the audit committee should have its own funding so it is not reliant upon management. If it is reliant upon management for funding it may not be able to effectively conduct its duties.

Key concept 3.5: Audit committee

An audit committee is a subcommittee of the board of directors and part of the corporate governance of a company. Its roles vary according to the company but, in general, the role of the audit committee is to ensure that the financial statements have been reliably prepared and verified.

The major thrust for the creation of audit committees is to add credibility to the financial reporting process. The critical issue relates to how independent the audit committee is, as this influences its effectiveness. Ian Ramsay (2001) prepared a report for the federal government of Australia following the problems with HIH, One.Tel and others. In his report, Ramsay made the following comments about audit committees. » An effective audit committee must not only exist and be independent, it must actually meet and be active. » Audit committee members must be independent. » Each member should be financially literate or should, within a reasonable period of time after

appointment, become financially literate.

3.5 Enforcement of corporate governance The response of government to company failures has been somewhat different in the USA and Australia. The USA adopted what is described as a ‘black letter law’ approach through the passing of the Sarbanes-Oxley Act in 2002. This is an extensive legislative response to corporate failures and has many requirements including: » the establishment of a Public Company Accounting Oversight Board with responsibility for overseeing

the work of audit firms » significant new rules relating to auditor independence

LO 3.5 Identify the approaches to enforcing corporate governance requirements in australia and the USa.

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» a ban on the provision of many non-audit services to audit clients » the requirement that the lead audit or coordinating partner and the reviewing partner rotate off the

audit every five years » the external auditor reporting directly to the audit committee » the condition that the CEO, controller, CFO, chief accounting officer or person in an equivalent position

cannot have been employed by the company’s audit firm during the one-year period preceding the audit. In Australia, the legislative response to company failures came through the federal government’s

Corporate Law Economic Reform Program (CLERP). CLERP 9 (so named because it is number nine in the series) resulted in a number of changes (but not on the scale of the Sarbanes-Oxley Act) including the following: » Audit committees are compulsory for the top 500 companies. » Requirements are stipulated in relation to auditor independence. » The employment and financial relationships between an auditor and client are subject to increased

restrictions. » The provision of non-audit services is subject to increased disclosure requirements. » Auditing standards were made legal, similar to accounting standards. » There is an automatic rotation of the audit partner every five years. This means that a partner in an

accounting firm cannot be in charge of the audit of the same client for more than five years. As stated earlier in this section, the approach in Australia has been largely based on a ‘best

practice’ approach. A ‘best practice’ approach really places the onus on companies to adhere to good corporate governance principles, as issued by bodies like the Australian Securities Exchange (ASX). Companies should disclose their compliance with the principles in their annual report or explain why they do not follow ‘best practice’ if they do not. Companies now make extensive disclosures about corporate governance and how they comply with the ASX principles. For an example see page 32 of

the 2018 annual report for Woolworths Limited at www. woolworthslimited.com.au.

While research generally does not support a strong link between board composition and financial performance, some studies support a link between governance practices and investment risk. Other studies show a relationship between board composition and social and environmental performance. The problem for investors is how to measure governance practices across a large number of companies operating in many countries in a cost-effective way. As an outcome of this demand, a number of agencies have emerged offering ratings on the corporate governance of companies in many different countries. The Institutional Shareholders Services (ISS) located in the USA, Governance Metrics International (GMI) and Reputex in Australia offer such services.

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Stop and think 3

Outline the approaches taken in Australia in relation to corporate governance as a result of high-profile company failures that have occurred here.

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Study tools

Summary LO 3.1

Discuss what is meant by sustainability reporting and explain the Global Reporting and Integrated Reporting initiatives. Sustainability reporting is a report which discloses information about an organisation’s environmental, social and financial activities. The most common names for such reports are Triple Bottom Line (TBL) or integrated reports. It is sometimes described as reporting about people, planet and profit.

The most widely cited benchmark in the determination of what should be included in a sustainability report is the Global Reporting Initiative (GRI) – an institution based in the Netherlands. The GRI was established through the United Nations Environment Program with the objective of enhancing the quality, rigour and utility of sustainability reporting. In 2002, the GRI released the Sustainability Reporting Guidelines. The latest version of the guidelines are the GRI Standards, which were released in 2016. The GRI identified a series of trends that added momentum to the need for techniques that enhanced an organisation’s ability to more consistently and comprehensively report on the economic, environmental and social dimensions of its activities, products and services.

Integrated reporting involves organisations reporting on all activities relevant to value creation. Such reporting includes financial information but also includes information on strategy, as well as environmental, social, governance and other value-relevant activities in an integrated report.

LO 3.2 Identify the factors that should help determine appropriate ethical behaviour for accountants. Accountants also have a professional code of ethics, and this should help them deal with ethical dilemmas and guide them with regard to what constitutes appropriate ethical behaviour.

LO 3.3 Explain what is meant by the term ‘corporate governance’ and identify the eight ASX Corporate Governance Council principles. Corporate governance consists of mechanisms (such as boards of directors and audit committees) that provide some assurance to absentee owners that the management team of a company is accountable for its actions, and to minimise agency costs in relation to that management.

The eight ASX Corporate Governance Council principles are: » Principle 1: Lay solid foundations for management and

oversight » Principle 2: Structure the board to add value » Principle 3: Act ethically and responsibly » Principle 4: Safeguard integrity in financial reporting » Principle 5: Make timely and balanced disclosure » Principle 6: Respect the rights of shareholders » Principle 7: Recognise and manage risk » Principle 8: Remunerate fairly and responsibly.

LO 3.4 Discuss the issues associated with the role of the board of directors and the audit committee in corporate governance. The board is an important corporate governance mechanism and its role is to represent shareholders and create value for shareholders.

Issues addressed in relation to boards of directors in the wake of the company collapses include: » the number of independent directors on boards » duality of leadership » size of boards » qualifications of directors » the number of board memberships of directors » length of service.

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An audit committee is a subcommittee of the board of directors and is another important corporate governance mechanism. Duties assigned to audit committees include: » reviewing the company’s financial statements and

recommending them to the board for approval » overseeing the appointment of and relationship with the

external auditor » overseeing the appointment of and relationship with the

internal auditor » reviewing matters in relation to compliance with

regulations and accounting standards » reviewing internal control procedures » overseeing the company’s risk management practices.

LO 3.5 Identify the approaches to enforcing corporate governance requirements in Australia and the USA. Government’s responses to company failures differ in the USA and Australia. The USA has adopted what is described as a ‘black letter law’ approach, which represents the mandatory requirements, by passing the Sarbanes-Oxley Act in 2002. Australia made some changes to law through CLERP 9. However, the main approach has been that of best practice, with the ASX Corporate Governance Council’s Principles of Good Corporate Governance.

Review questions 1 What challenges face business in relation to ethical

behaviour? Are they different for accountants? 2 Is there a conflict between self-interest and ethical

behaviour? 3 What is the role of a board of directors? 4 What issues are important for boards of directors in

relation to their corporate governance role?

5 What is sustainability reporting? 6 What is a triple bottom line report? 7 What is an integrated report and how does it differ from

a TBL? 8 What is the role of an audit committee? 9 Do governance issues apply to not-for-profit entities? 10 What is a professional code of ethics for accountants?

Take it further 1 Visit the website for a major Australian company and see if you can locate a sustainability report. Check out www.woodside. com.au or www.woolworths.com.au, where you will find a sustainability report for each company.

Take it further 2 Select two companies from different industries and critically review their reports on the environment, society and governance.

problems for discussion and analysis 1 Visit the Woolworths website (www.woolworths.com.au) and critically review the statement on corporate governance.

What do you consider are the strengths and weaknesses of corporate governance at Woolworths? 2 Should there be a legal requirement for organisations to produce a sustainability report or should it continue to be a

voluntary practice? 3 The following are two definitions of triple bottom line (TBL) reporting:

– In the purest sense, the concept of TBL reporting refers to the publication of economic, environmental and social information in an integrated manner that reflects activities and outcomes across these three dimensions of an organisation’s performance. (Group of 100, 2003)

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– The external reporting on the economic, social and environmental performance and impacts of an entity can have four potential purposes: i to improve the efficient operation of entities in achieving their legal purpose, e.g. highlighting areas of an entity’s

negative economic, social and environmental impacts and also increasing transparency and strengthening accountability for users

ii to help meet the preferences of present and future investors, consumers, employees, creditors, suppliers and insurers iii to inform stakeholders with no direct ownership, investment or consumption interests iv as a significant public policy tool to maximise human welfare over time (Institute of Chartered Accountants in New

Zealand, 2002).

Required

a Compare and contrast the two definitions. b Critically evaluate both definitions.

4 Discuss the major differences between a triple bottom line report and an integrated report. Which one do you believe provides more useful information for shareholders? Other stakeholders?

5 In fewer than 100 words, detail your understanding of the word ‘ethics’. 6 It is difficult to get hard facts about the cost of corporate fraud but estimates range from $1 billion to $5 billion per annum

in Australia. Is it possible to regulate against fraud? 7 You have been hired by Jim’s Towing Service, a sole proprietorship, to prepare the tax return for the business. Upon

checking the bank statements and the cash books of the business you discover that Jim has not included in the revenue any cash received when customers paid cash. Only the amounts received from insurance companies have been included in the revenue. Discuss what you should do.

8 Michael P. Cockley is a young accountant who has just commenced practising in the Perth suburb of Nedlands. He is currently trying to build up his practice which specialises in giving taxation advice and preparing clients’ taxation returns.

One of Michael’s clients is Leslie Raby, a rather testy ex-navy officer. Captain Raby has only just come to Michael after falling out with another accountant. Amanda Trefrey, the former accountant, merely mentioned that there had been ‘personality clashes and communication problems’.

As he looks at Raby’s taxation assessment, Michael notices that it differs materially from his estimate and the difference is very much in his client’s favour. In checking Raby’s file, it becomes clear to Michael that the Taxation Office has made an error. Further, there is a strong likelihood that this error will result in a permanent advantage to his client. Raby’s tax return was a full and proper disclosure and had been correctly prepared. It is unlikely that the error made by the Taxation Office will ever be discovered. In discussions with his client, it becomes apparent to Michael that Raby is aware of the error and the monetary gains that will accrue to him if this error is overlooked.

Discuss the following questions. a What should Michael do under the circumstances? b If nothing is said about the client standing to gain from the error made by the government department and he keeps

the money, is the ‘oversight’ any different from stealing? c What responsibility does Michael have? Should he act independently of the captain’s wishes?

(Adapted from Paul H. Northcott, Ethics and the Practising Accountant: Case Studies, Australian Society of Certified Practising Accountants, 1993.)

9 Jan Skully is the founder and chairperson of Extraordinary Products Ltd. The company has performed well in the past, but over the last year the share price has steadily declined. As Skully owns a majority of the shares, she decides to do something to protect her investment. She secretly channels $200 million from other companies she owns into the purchase

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of additional shares in Extraordinary. These new shares are used by the other companies as security for the loans taken out to raise the necessary cash to purchase the shares in Extraordinary. A year later Jan Skully dies and the transactions are uncovered and revealed in the press, and the price of Extraordinary’s shares plummet.

Discuss

a whether the transactions were unethical b how the scheme could have been prevented.

10 Should corporate governance practices be enshrined in legislation or is it best to allow companies to self-regulate and choose their own appropriate corporate governance structures?

11 Discuss the advantages and disadvantages of having a majority of independent directors on a board. Why do you believe a requirement for independent directors to hold separate meetings is being seriously considered?

12 Why is it important for audit committees to have their own funding independent of management? Should any members of the management team attend meetings of the audit committee? Give reasons.

ethics case study The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry in Australia in 2018 had some startling revelations about many issues. One activity which caused an enormous backlash in the community was the admission by AMP that they charged fees for no service including to accounts of clients who had died.

Required

a Discuss the ethical issues surrounding such transactions. b If found guilty of such activities, should the penalties be only fines or should there be some who serve a prison

sentence? c On the AMP website it is stated that, ‘We understand that having access to quality financial products and services

can have a profound impact on lives. AMP therefore has a duty to ensure it delivers a positive customer experience’. https://corporate.amp.com.au/about-amp/corporate-sustainability/environmental-management.

How can one reconcile this statement with the charging of fees for no service?

Cool Value Cinemas Go to the online case and answer the questions related to Chapter 3.

1 There can be many reasons ranging from other companies are doing it, good for business through to wanting to be a responsible organisation.

2 Students should demonstrate an understanding of the issues involved with ethics and appreciate the real costs of being unethical.

3 Australia has made some legislative changes through CLERP 9, but the main approach has involved best practice regulations with the ASX Corporate Governance Council’s Principles of Good Corporate Governance and Best Practice Recommendations.

Suggested answers to stop and think exercises

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