Directors must be ready to use their muscle

BACK in the day — 40 years ago — when a series of financial scandals first persuaded the business world that there was a need for standards to lay down some rules about what went into company accounts, there was a joke about auditors. Ask what was the answer to three plus three and he or she would reply: “What would you like it to be?”

In a speech last year at the annual conference of the European Accounting Association, International Accounting Standards Board chairman Hans Hoogervorst spoke gloomily about how the world had not moved on.

True, there were now volumes of accounting and auditing standards and a foot-high pile of corporate governance code but, he said, firms still routinely used their annual accounts and reporting season to lie about how well they were doing. It remained a daily struggle to keep capitalism honest.

The American rules framework is called GAAP, for Generally Accepted Accounting Principles. Looking to the US, Hoogervorst said that “more than 88% of the S&P 500 now currently disclose non–GAAP metrics in their earnings release”. He added: “Of those, 82% show increased net income and are clearly designed to present the results in a more favourable light… The popular metric, core earnings was on average 30% higher.”

He also hinted that he knew why this might be. “Most management remu- neration packages adjusted earnings.”

Now, it is tempting to blame the accountants for this, but as the Institute of Business Ethics points out in a hardhitting paper published today, it is the directors who are responsible for the preparation of the accounts so it is the board’s responsibility. The auditors are there to try to ensure they do it properly, and while you might argue that they do this less effectively than they might, they nevertheless are not there to do the directors’ job for them. The auditors are not there simply so the board can sidestep its duties.

The author of the paper is Guy Jubb, who until his recent retirement was the global head of governance and stewardship at Standard Life Investments and, as such, is one of the most influential people in the British investment world.

He has seen at first hand the lengths to which companies will go to put a favourable gloss on their figures. His paper is a call to arms, a powerful reminder to non-executive directors that it is their responsibility to prevent the preparation and publication of figures which might mislead.

If they feel the paper asks too much

are based on of them, given that executive managers may deliberately seek to keep them in the dark, it also provides a powerful manual on what they should look out for and how they should behave in order to get it right.

Jubb agrees with Hoogervorst that the root cause of attempts to put a favourable gloss on numbers comes down to management — the chief executive or members of his team — wanting to be seen in a good light, usually but not always, because their pay and promotion prospects depend on it.

Pressure on teams to meet unrealistic objectives is the strongest factor in compromising ethics, Jubb suggests. He points out too that the willingness or not to fake it should tell non-executive directors a lot about the culture of the business and the tone which is coming from the top. Understanding this, and being on top of it, is therefore central to the non-executives’ ability to do their job properly.

The ver y essence of company accounts should be truthfulness and integrity. But this means non-executive directors have to satisfy themselves that everything is true and not, as more often happens, simply leave it to the auditors. The presentation should be fair and objective, meaning they have to temper the natural optimism of management who will always believe everything will turn out better than it usually does. The accounts should be neutral between one year and the next, and prudent, so there should be no attempt at “smoothing” — moving money from one year to the next.

Indeed, one of the key warning signs is a company which delivers steadily rising profits year-in, year-out, because business is just not like that. Accounts should be consistent, so profits cannot be inflated artificially by changing depreciation policies or any other factors.

They should be complete and should say so if something has happened just after the year-end which tot ally changes the picture. And in addition to all this they should be in language normal people can understand.

The temptation to flatter to deceive will be stronger when companies are resisting a takeover — or trying to do one themselves; when the dividend looks to be in danger; or when management faces the embarrassment of missing its profit forecasts.

Directors should also be aware of changing public attitudes to what used to be seen as acceptable tax avoidance — again for what it says about corporate culture but also for the severe risk of reputational damage. As the era of unquestioned shareholder supremacy comes to an end, and companies are instead seen to be servants of wider s o c i e t y, financial repor ting has to respond.

Finally, non-executive directors have to realise that their job does not stop with the accounts. One of the great skills of the public relations industry — when it is not stirring up racial hatred in South Africa — is to make a silk purse out of a sow’s ear.

PRESS releases are usually written in a way which exaggerates all the good points and buries the bad. Theirs is a world where the sun always shines, if it rains it is only occasionally on Sunday after dark and it absolutely never snows. Lazy or overworked journalists and investment analysts all too often find it easier to believe them.

But, says Jubb, it is important that these communications uphold the principles of responsible financial reporting, just as much as the financial statements themselves. It is therefore also the responsibility of non-executives to make sure these presentations are balanced and reasonable.

And that is the cue for a gasp of shock from everyone with any experience of how the system works. If this paper gets traction, it really will change the way the financial world behaves.

‘One of the key warning signs is a company which delivers steadily rising profits year-in, year-out’