Looking beyond the bottom line Cover Story

  • Date:01 Jul 2005
  • Type:CompanyDirectorMagazine
Seeking to create shareholder wealth, boards have traditionally put much of their time and effort into ensuring short term financial performance meets market expectations.

Looking beyond the bottom line

Seeking to create shareholder wealth, boards have traditionally put much of their time and effort into ensuring short term financial performance meets market expectations. But, as John Arbouw reports, this may no longer be enough as boards come under pressure to examine the non-financial indicators of the long-term health of corporations

When the board papers arrived there was always one thing you were certain of: the bulk of the information provided had to do with the financials of the company. And it was the discussion on how this money was generated; the profit that could be expected and the cost of earning this money that normally provided the main agenda item.

After all, financial performance is universally acknowledged as the key indicator of the health of the corporation.

However, in recent times, another item is gaining prominence in the board papers and vigorously discussed - what else is going on in the company that may or may not have an impact on the board.

The saying that you don't know what you don't know is not necessarily the get-out-of-jail-free card when things go pear-shaped within a corporation. The money trail can only tell you so much and directors are finding that they have to dig deeper into the non-financials if they are fulfil their duty - and avoid legal scrutiny.

It is the enhanced emphasis on non-financials that is also a catalyst for the debate on the role of directors. And this debate has been stirred to no small extent by recent legal judgments that appear to expand director roles and the legal liability attached to these new definitions.

The result is that the role of the board, the role of directors and the role of the chairman have come under greater scrutiny as governments, shareholders, stakeholders, the media and the public want answers and accountability for corporate failures.

One obvious fall-out in lumping added responsibilities onto a board is that the board becomes a de facto executive arm of the company. This is a far more involved role than merely acting as the representatives of the shareholders and, through individual skills and expertise, monitoring the financial performance of the company.

Certainly the community, the media and to a large extent the government believe that boards have a much broader function than simply ensuring shareholder wealth is being created.

James Hardie is a case in point. In the view of the community, James Hardie concentrated on maximising its profits without due regard to the effect its business was having on its employees, stakeholders and the community

The Australian Government through CAMAC is currently looking at the roles of directors while boards are now engaged in an ongoing evaluating not only of their collective role but also the individual performance of directors (see story Page XX).

Last month, Senator Grant Chapman, chair of the parliamentary joint committee on corporations and financial services, announced that the parliamentary committee would conduct an inquiry into corporate responsibility.

The committee will inquire into corporate responsibility and triple-bottom-line reporting, for incorporated entities in Australia, with particular reference to:

  • The extent to which organisational decision-makers have an existing regard for the interests of stakeholders other than shareholders, and the broader community;
  • The extent to which organisational decision-makers should have regard for the interests of stakeholders other than shareholders, and the broader community;
  • The extent to which the current legal framework governing directors' duties encourages or discourages them from having regard for the interests stakeholders other than shareholders, and the broader community;
  • Whether revisions to the legal framework, particularly to the Corporations Act, are required to enable or encourage incorporated entities or directors to have regard for the interests of stakeholders other than shareholders, and the broader community. In considering this matter, the committee will also have regard to obligations that exist in laws other than the Corporations Act;
  • Any alternative mechanisms, including voluntary measures that may enhance consideration of stakeholder interests by incorporated entities and/or their directors;
  • The appropriateness of reporting requirements associated with these issues; and
  • Whether regulatory, legislative or other policy approaches in other countries could be adopted or adapted for Australia.
The committee will consider both for-profit and not-for-profit incorporated entities under the Corporations Act.

But what other factors besides financial performance should boards be monitoring, especially when increasing regulation is already diverting attention away from financial performance to compliance?

Recent surveys of directors and corporations worldwide illustrate a struggle to come to terms with what is meant by non-financial information and how a board of part-timers can gather this or be responsible for it.

A survey (In the dark: What boards and executives don't know about the health of their business) by Deloitte and The Economist intelligence unit in April 2004 revealed a "critical fault between rhetoric and reality in the boardroom of the world's leading companies. Non-financial factors are widely regarded as extremely important drivers of success for a company, yet they receive considerably less attention than the financial data from the board and senior managers".

While nearly 73 percent of directors surveyed said their companies were under increasing pressure to measure non-financial performance, the reality is that financial results and non-financial performance are disconnected in many companies.

"It is intuitively obvious that the balance sheet profit and loss account, cashflow statement are the result of non-financial drivers, yet this is rarely, if ever, reflected in the way companies are run," the survey said.

"This mismatch between financial and non-financial indicators has been neglected because the latter tend to be harder to measure and less reliable, and because capital markets are structured to reward financial results consistently and non-financial ones only rarely."

The survey found that the biggest obstacles to enabling boards and senior management to track non-financial vital signs is the lack of reliable measuring tools and scepticism as to whether this is bottom line relevant.

This is hardly surprising. The Australian market fixation with financial performance short-termism makes it very difficult for boards and companies to think beyond the accepted financial performance indicators.

Increased global competition, customer relations, shareholder communication, employee retention and product innovation are accepted drivers of non-financial performance and the reality is that this does impact the financial performance over time.

But if these drivers of non-financial performance are fairly clear, the emergence of corporate social responsibility (CSR) however ill-defined at present is becoming an even more potent factor in the way companies are being measured.

The company or the board of the 21st century may certainly place CSR alongside profits as the main indicators of corporate health but trying to "sell" this story to a market interested only in sales, costs and earnings makes this evolutionary rather than revolutionary.

But there is progress. The fifth international survey of corporate responsibility conducted by KPMG and released last month shows the growing importance within the business community of corporate responsibility as the key indicator of non-financial performance, as well as a driver of financial performance.

According to the survey, the important business drivers for corporate responsibility for companies are:

  • to have a good brand and reputation
  • to be an employer of choice
  • to have and maintain a strong market position
  • to have the trust of the financial markets and increase shareholder value
  • to be innovative in developing new products and services and creating new markets.
Interestingly, the KPMG survey shows that in the decade or more that the firm has been conducting this type of survey, the number of companies that now produce CSR reports as part of the reporting process has tripled.

"Corporate responsibility (CR) reporting in industrialised countries has clearly entered the mainstream," says the report. "We have observed an increasing professionalism in the form of new global reporting standards, standards that can be used to provide assurance on corporate responsibility reports.

"We also see that corporate responsibility performance of companies has definitely caught the eye of the financial sector as is reflected in recent developments like the Equator Principles, the Dow Jones Sustainability Index (DJSI) and the FTSE4Good Index on the stock markets, and the emergence of socially responsible investment funds".

The major survey findings are:

  • CR reporting has been steadily rising since 1993 and it has increased substantially in the past three years. In 2005, 52 percent of G250 (the top 250 of the Fortune 500 companies) and 33 percent of N100 companies (the top 100 companies in 16 countries including Australia) issued separate CR reports, compared with 45 percent and 23 percent, respectively, in 2002. If we include annual financial reports with CR information, these percentages are even higher: 64 percent (G250) and 41 percent (N100).
  • A dramatic change has been in the type of CR reporting which has changed from purely environmental reporting up until 1999 to sustainability (social, environmental and economic) reporting which has now become mainstream among G250 companies (68 percent) and fast becoming so among N100 companies (48 percent).
  • Although the majority of N100 companies (80 percent) in most countries still issue separate CR reports, there has been an increase in the number of companies publishing CR information as part of their annual reports.
  • At national level, the top two countries in terms of separate CR reporting are Japan (80 percent) and the UK (71 percent). Reporting has increased considerably over the last three years in most of the 16 countries in the survey, with the highest increases seen in Italy, Spain, Canada and France.
  • The typical industrial sectors with relatively high environmental impact continue to lead in reporting. At the global level (G250), more than 80 percent companies are reporting in electronics and computers, utilities, automotive and oil and gas sectors, whereas at the national level (N100), over 50 percent of companies are reporting in the utilities, mining, chemicals and synthetics, oil and gas, oil and gas and forestry, paper and pulp sectors. Most remarkable is the financial sector which shows more than a two-fold increase in reporting since 2002.
The picture that emerges on a global level including Australia is that while boards are still struggling to come to terms with definitions and measurements there is a common acceptance that holistic responsibility must include a range of factors.

This is certainly borne out in the quarterly survey of directors by Mckinsey (The View from the Boardroom) that shows directors are tired of being defensive.

The survey shows that while short term financial performance is still a primary focus directors also want to "expand their reach into issues that shed light on the long term health of their companies".

Creating a balance between the short and long term health of the company is recognised as vital, but how does a board that meets once a month deal with the detail of these issues?

"In seeking to balance short and long term performance, board might start by agreeing on a core set of metrics tailored to the specifics of a company's industry, maturity, culture and current situation. For example, two oil companies, one focusing on operation efficiencies and the other on exploration - might choose quite different metrics. Similarly companies concentrating on a fast turnaround might, understandably, be less focused on their long term health," says the Mckinsey survey.

"Boards seem eager to shake off the perception that they are defensive and lethargic. So far they responded satisfactorily to the call for higher standards and strong compliance with new accounting rules. Now, they apparently want to become more active in of the companies they govern. Boards and management alike can benefit from such a new relationship but only if both understand its complexity and mitigate the tensions it sure to create."

The pressure on boards to think beyond the bottom line is not only coming from government or the media. With superannuation choice in action this month, super funds, the elephants of the investment world, are paying far more attention to the kind of companies their investors say they want their money invested in.

Last month five of Australia's largest called on directors to pay more attention to business ethics such as unfair business practices, such as price fixing, bid rigging, insider trading, giving of secret commissions or kick-backs to business associates.

The super funds, which between them invest almost $7 billion in Australian equities, said that in order to manage the long-term interests of investors they were duty bound to ensure the companies in which they invest had systems in place to avoid potential regulation, litigation and reputation costs to shareowners.

In research they conducted of S&P/ASX 200 companies they found that:

  • More than half of all companies did not publicly disclose information on their processes to protect against violations of consumer privacy;
  • Nearly half (46 percent) of companies made no mention of staff or contractor training with regard to product safety or the handling of materials hazardous to public health;
  • Forty-six percent of companies did not publicly disclose policies protecting whistleblowers; and
  • Appropriate codes of conduct among 52 percent of companies did not address the company's adherence to responsible marketing and promotion issues such as fair trading and truth in advertising.
In the US, the Conference Board recently launched its Corporate Governance Handbook 2005 - Developments in Best Practices, Compliance, and Legal Standards by Carolyn Kay Brancato and Christian A. Plath.

In the introduction to the study the rationale for the publication was simple:

"In boardrooms across the country, directors are asking themselves: Is our board managed as effectively as the company is managed? What processes do we need to put in place to make us more aware of 'red flag' in company operations? How do we fulfill our proper monitoring role and yet rely on management and external experts such as accountants, attorneys, and consultants? How can corporate governance processes be used to help keep our company viable and restore public confidence in the capital markets? How will instituting corporate governance best practices reduce corporate risk?"

These are questions Australian directors are also asking. But whether it is done voluntarily through appropriate procedures and processes or reluctantly as part of a compliance requirement resulting from government regulation, the need to look beyond short-term financial performance to actively considering the other factors impacting on the long term health of the company is becoming a fact of life.

Many boards have already embarked on this process. For some this has been a reality since start-up. For others it will require a cultural change.

One thing is certain. The maxim of creating wealth will have a far broader definition than at present and the bottom line will have implications for a wider constituency than just the shareholders.

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The purpose of this database is to provide a full-text record of all articles that have appeared in the CDJ since February 1997. It is aimed to assist in the research and reference process. The database has a full-text index and will enable articles to be easily retrieved.It should be noted that information contained in this database is in pre-publication format only - IT IS NOT THE FINAL PRINTED VERSION OF THE CDJ - therefore there might be slight discrepancies between the contents of this database and the printed CDJ.