April 2014

Transforming Corporate Reporting

 

IIRC Chair Mervyn King discusses his long involvement in corporate governance and his commitment to change the way we understand companies.

 
 

Ruth Prickett

 

Mervyn King is a busy man. One week he’s in Madrid, then Vienna, London, and Sydney before heading to Bangalore to advocate for integrated reporting. This demand indicates the attention organizations and countries are giving the topic — and the fact that they are paying it such attention shows how successfully King and his colleagues at the International Integrated Reporting Council (IIRC) have been telling the world why it’s a good, and necessary, idea.

 

A lawyer by training — at just 41, he was the youngest judge ever to resign — King then became a nonexecutive director of several listed companies, which he says gave him an unusual perspective on organizations. “I had worked on corporate governance issues first as a lawyer and then as a nonexecutive director,” he says. “When you see both sides of the coin, it gives you a better viewpoint and makes you think differently.”

 

His involvement with integrated reporting was a result of being asked to develop corporate governance guidelines for South Africa during the period immediately following the end of apartheid. The only report of that kind to come out before this was the U.K.’s Cadbury Report on corporate governance, which was published in December 1992. King believed that governance, strategy, and sustainability were inseparable and needed to be integrated into every aspect of a business.

 

In 1992, while South Africa was moving into a new democracy, the Institute of Directors in Southern Africa, and other large accountancy bodies, wanted guidelines to help direct and manage companies, because most of them hadn’t been in the mainstream economy before. “I agreed to do this, but I stipulated that we had to have a clean slate because we were a new nation being born,” King says. “I brought in people from all sectors to sit on the panel, from the president of the Johannesburg Stock Exchange to representatives from the union of the textile industry.”

 

This broad panel produced the first King Report on Corporate Governance in 1994 and, King explains, it became known worldwide as an example of how to move from an “exclusive” to an “inclusive” corporate governance approach. An exclusive model, he adds, focuses entirely on shareholders, price, and the bottom line — even if this has an adverse impact on society or the environment.

 

“We said that the board needs to identify key stakeholders in the business, understand their needs and the expectations of the company, and take these into account when making decisions in the best interest of the company in order to maximize total value,” he says. “The board must look at the positive and negative impacts of the organization — financially, socially, and environmentally.”

 

The panel that created the King Report never disbanded, so King was able to build on the collective experience to produce updated versions in 2002 and 2009. The King Report adopted the nonprescriptive “comply or explain” ethos now enshrined in 2010’s U.K. Corporate Governance Code (formerly the Combined Code). The principle of inclusive reporting garnered praise around the world, and in 2001, King was invited to chair the United Nations (UN) Steering Committee on Corporate Governance to rewrite the governance and oversight provisions for the UN and the World Trade Organization.

 

During the years King spent working on corporate governance codes, the world has changed. In the 21st century, we see global financial crises, climate change, radical transparency, ecological overshoot, population explosion, and greater expectations from stakeholders. These changes make his principles of inclusive reporting more relevant than ever.

 

“There’s no company today that doesn’t think about the expectations of its stakeholders,” King points out. “Shareholders are now the general public, through their pension funds and financial institutions, not just a few wealthy families. It’s the duty of the people who manage these funds to ask whether the company they invest in will be around in the long term. Is the company’s business sustainable in the 21st century?”

 

Whereas the people who directed companies used to think the world had limitless resources and an endless ability to absorb waste, everyone is now aware that this is not the case, he adds. The global population is expanding, and natural resources are finite and diminishing. “Directors
can no longer think they can carry on business-as-usual, and that is why big companies are changing the way they do business.”

 

At the same time, reporting has become far more complex since the days when financials were the only area on which organizations needed to report. This has led to increased pressure for a model that enables reporting across a broad spectrum of functions.

 

“Toward the end of the 20th century, analysis of listed companies was showing that market capitalization was nowhere near the book value according to international financial standards,” King explains. “As much as 80 percent of an organization’s value was not financial and we weren’t reporting on it, leaving stakeholders uninformed.”

 

In addition, he points out that financial reports reflect a snapshot of the company’s finances at a given time. “From that, you can hardly make an informed assessment about the stability and sustainability of the company longer term,” King says.

 

Concerns about the inadequacy of existing reporting provisions led to a meeting held by the International Federation of Accountants (IFAC) in 2009, where King addressed the topic of integrated reporting. This new concept also was included in the third King Report, published the same year.

 

The idea garnered attention and led to a meeting in London at St. James’s palace, brought together by the convening powers of Prince Charles. King and Sir Michael Peat, who was then the prince’s principle private secretary, invited the chairs of the International Accounting Standards Board, U.S. Financial Accounting Standards Board, and IFAC; the world chairmen of the Big Four accounting firms; and the chairmen of the International Organization of Securities Commissions, the World Bank, and the World Business Council for Sustainable Development. Everyone accepted the invitation, and within an hour, they agreed that the future lay in integrated reporting — and the International Integrated Reporting Council was born.

 

However, agreement is one thing — identifying how to implement integrated reporting in practice and changing the way organizations think and act about sustainability is another.

 

For a start, King says, organizations need to change the way they communicate. “For about 80 years, we’ve been reporting in International Financial Reporting Standards speak, but the general public — who are our consumers, labor, depositors in banks, contributors to pension funds, and society in general — did not understand it,” King says. “We’ve been communicating in an incomprehensible language, and new financial reporting standards established to protect us after scandals such as Enron have just made it more complex.” When sustainability reporting was established, it just meant that organizations produced two reports, “both incomprehensible to the average stakeholder,” he says.

 

This matters, King argues, because the way in which companies report influences the way they behave. The size and complexity of most annual reports also ensures that even the directors rarely read them cover-to-cover.

 

To address this, the IIRC, chaired by King, has released a framework laying out the principles of integrated reporting and guidelines on how to put it into practice. The council, of which The IIA is a member, has been working with large organizations around the world to run pilot studies implementing its principles and learning from their experiences.

 

“The collective mind of the board has to understand all the material factors in the reports and work as one collective mind,” King says. “It has to be clear, concise, and understandable. To be accountable you have to be understood.”

 

The new framework isn’t mandatory, but King says that major asset owners around the world are supportive, and countries are writing up regulations and codes that are supportive of integrated reporting. But frameworks and guidelines are only as good as the people who implement them. The pressures of investor concern and the danger of bad publicity when something goes wrong can prompt even reluctant executives to pay attention, and internal audit will be crucial to making it work.

 

“Internal audit is the glue in modern governance and the right arm of the nonexecutive board,” King says. “Internal audit also could stand for independent assurance. When I started my career, internal auditors were seen as the people in the back room who ticked boxes. Now they are critical to adequate and effective controls of the risks inherent in the way the company makes its money.”

 

No strategy is any good if it’s not controlled, he warns. And the only person who really knows whether a company’s strategy is controlled effectively is the head of internal audit.

 

“External auditors look mainly at the financials, which is understandable, but internal auditors look at everything across the company,” King says. “The internal audit team, therefore, needs to be better resourced than the external audit team because its remit is far broader.” Internal audit also needs to be independent, with a straight communication route via the audit committee to the board. It’s important that internal audit can criticize the executive without fear, King says, and this usually happens only if internal auditors report to the audit committee, not the CEO.

 

Heads of internal audit also should attend strategy meetings. “They need to be able to say “No, you can’t implement this strategy because it can’t be controlled” or “I can’t control this with existing resources,’” he adds. They do not develop strategy but advise senior management on the controls needed for a proposed strategy.

 

Internal audit develops a risk-based internal audit plan that dovetails with the risk-based external audit plan, King explains. Putting this into action for integrated reporting may require more specialist resources on the internal audit team. For example, he says, you may need an environmental lawyer. “We’re moving on from the days when internal audit was drawn from a pool of accountants and now need to draw on people from a broader range of backgrounds.”

 

Board directors’ duties haven’t changed significantly, despite changes to corporate governance principles; but their purview has become wider, partly because of emerging risks in areas such as social media. King says this means directors need a strong audit function more than ever. “I would never be part of a company that didn’t have an excellent internal audit department,” he says. “I’d be mad to take on the risk. I would want to meet the head of internal audit as part of my due diligence before accepting the appointment. It’s critical.”

 

So what is the next step for King and integrated reporting? There certainly will be more developments, and the IIRC probably will issue a second version of the framework at some point, he says. The King Report committee still meets every quarter, as it has since 1992, so it will probably revise the report further, too. “Continuity of knowledge is vital, even if individual members move on,” King says.

 

As for the constant travel, King says he feels like he’s really making a difference in the quality of reporting and ensuring that businesses are sustainable. “This has been my vision since 2000, and I’m seeing it happen in my lifetime. Nothing can be more rewarding,” he says.

 

Ruth Prickett is editor of Audit & Risk magazine.

 

*A version of this article first appeared in Audit & Risk, March/April 2014, the magazine of the Chartered Institute of Internal Auditors. Reproduced with permission. 

 

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