Corporate Governance and Information Gaps: Importance of Internal Reporting for Board Oversight

IN BRIEF

  • The existence and responsibilities of specialized committees on boards of directors have continued to evolve.
  • Questions arise regarding whether boards today are receiving and utilizing adequate information and support.
  • Courts and eminent legal authorities have repeatedly emphasized the significant responsibilities of boards for oversight of the management of public companies.

Introduction

The evolution of corporate governance and board of directors’ responsibilities continues. Recent years’ actions of shareowner activist groups and securities regulators—and reports of shareowner votes in corporate annual meetings thus far in 2017—provide many indications of ongoing growth in public expectations for the roles and performance of corporate boards of directors.

The existence and responsibilities of specialized committees on boards of directors have also continued to evolve. In addition to long-established types of board committees such as the audit, finance, compensation, risk management, and nominating and governance committees, we now see committees being formed to address such issues as science, technology and innovation, cybersecurity, health, safety and security, environment and sustainability, regulatory compliance and public policy, and other contemporary concerns. While these topics are all valid issues to consider in the oversight of today’s corporations, one wonders how many committees one board of directors can effectively administer and support. And how can numerous board committees successfully monitor corporate issues and developments and report on these matters in periodic board meetings?

In the face of growing expectations, further questions arise regarding whether boards today are receiving and utilizing adequate information and support to address their oversight responsibilities. It seems that nearly every week brings another news report about a breakdown in corporate ethics and controls as well as performance failures across a wide range of industries.

Recent events at Volkswagen and the public blowup at a well-known and seemingly successful “new economy” company, Uber, leading to the resignation of its co-founder and CEO, are two notable examples. The total fallout and remedies for these and other performance and governance failures are yet to be fully determined.

Upon reading about each new incident, one is prompted to ask, how could the directors in these companies not have been aware of serious problems? Did something go wrong in communications and information flows that let this happen?

Somehow, somewhere, it seems evident that there must have been some serious gaps in information supplied to the board, or possibly in board understanding and reactions to such information.

A deficiency in information supplied to boards calls into question whether boards today are in fact able to serve as an effective check and balance in the governance of public corporations.

Over the years, courts and eminent legal authorities have repeatedly emphasized the significant responsibilities of boards for oversight of the management of public companies. In the words of former Delaware Supreme Court Chief Justice E. Norman Veasey, stockholders should have the right to expect that “the board of directors will actually direct and monitor the management of the company, including strategic business and fundamental structural changes.”

Delaware Supreme Court Chancellor William B. Chandler also noted the significant oversight role of the board in his widely publicized opinion in the Disney Corporation Shareowner derivative suit concerning the hiring, compensation, and firing of Michael Ovitz. Chandler stated, “Delaware law is clear that the business and affairs of a corporation are managed by or under the direction of its board of directors. The business judgment rule serves to protect and promote the role of the board as the ultimate manager of the corporation.”

The “ultimate manager of the corporationthose are very strong words. Some might debate the terminology, preferring instead a phrase like “the ultimate overseer of the corporation.” But whether one uses “ultimate manager” or “ultimate overseer” as a designation, it is clear that a board of directors has significant responsibilities for the welfare of the corporation and its stakeholders.

Serving as an “ultimate manager” or “ultimate overseer” requires appropriate information flows to support that role. While there are different types of information flows, this article will focus on financial information supplied to boards of directors. We will also discuss two types of information gaps —quantity and quality—that can make it difficult for board members to carry out their oversight responsibilities.

Quantity of Information—How much is the right amount? Who decides?

In considering quantity, we must first ask these questions: how much information is needed for an oversight body to perform its functions, especially for a board or a board committee with a critical role in ensuring the welfare of the corporation and the interests of its shareholders? How much information is it realistic to expect a part-time body composed mostly of people from a range of industries, institutions, and professions, that typically meets four to six times a year, to absorb and act upon?

Who decides what data elements will be in the directors’ regular information package supplied for the board’s periodic meetings? And who decides when special circumstances warrant additional information, and what that information should be? How involved are board members in determining and specifying how much information they will receive for various purposes, when, and in what form?

Commonly, when a company is established, the founders and sponsors will work with the initial senior management to lay out a proposed structure for its board, including the board committees that will exist therein and the charters for those committees. The company’s management will develop and offer up what they believe to be an appropriate information package for periodic board meetings. Then as time progresses, board members and board committees will ask for whatever else they think they need to carry out effective oversight.

Issues that may subsequently arise include situations in which different directors may have different views on the amount of information they should receive, creating a need for agenda management, customized information support, or other measures. And changing circumstances, special events, and unexpected conditions may suddenly create a change in the quantity of information needed—as in the case of an unexpected (and possibly unwelcome) tender offer for the company’s stock, or when an unexpected corporate crisis occurs.

A sizeable amount of routine and ongoing financial information to be supplied to boards is mandated by regulators of public companies such as the Securities and Exchange Commission and the stock exchanges. Beyond these mandates, the issue of optimum quantity and optimum design of board information is to be determined by each organization. In answering the question, board committees today often utilize the services of outside counsel and other advisors to identify the information that they should be requesting to support their oversight obligations. They may also use external service providers to assist in performing assessments of internal board processes on a periodic basis.

Quality of Information Supplied to the Board—Issues in Measuring Financial Performance

A next question is “what kind of information is needed?” In regard to quality of information, one must consider the nature of the information being supplied, what matters are covered, and how understandable the information is. The timeliness of information is also important. On one hand, board members will want to receive information sufficiently in advance of a meeting to review and absorb it properly. On the other hand, sometimes last-minute developments can affect information previously provided, and there will be a need to ensure that directors receive up-to-date information.

Common components of board information include information about an organization’s market and business strategy, risk management, measures of financial and operational performance, control structures, management processes, and human resources issues. All of these components of information are important. In particular, providing the right kind of financial information is an essential part of overseeing a company’s performance and prospects.

The design and use of financial and operational measures can be complex. For a publicly held company, a first obvious requirement for financial information to be supplied to the board is the company’s external financial statements and disclosures reported to investors, for which board review is mandated by securities regulators. These financial statements and disclosures are prepared in accordance with generally accepted accounting principles (GAAP) and supplemented by additional information required by regulators. The information mandated by GAAP and regulators is both voluminous and complex.

GAAP financial statements are widely used, important, and necessary, but they are not sufficient to oversee and manage a specific business effectively.

GAAP financial statements are the end product of elaborate and lengthy national and international standards-setting processes that are designed to achieve consensus among professional accountants, investors, and other stakeholders on how best to portray the value and performance of reporting entities across companies and industries. The resulting body of knowledge utilizes a very broad spectrum of concepts, principles, and rules.

GAAP accounting standards represent the eminent thinking and careful deliberation of many experts. The standards are important for broad cross-company use, as they seek to provide a uniform benchmark for external comparisons by investors. Yet despite the rigor underlying their preparation, GAAP financial statements are inadequate for understanding and running a particular business at a particular point in time, because they are static and often complex and inflexible.

Economic theory tells us that the division of labor is specific to an organization at a point in time. Similarly, corporate governance structures and processes, and operational needs and priorities, are specific to a firm at a point in time. The oversight responsibilities of boards of directors constitute an important check and balance in an organization’s ongoing governance structure and operational control system, and such a control system must consider more than GAAP financial statements. Boards require information that is relevant to addressing their oversight responsibilities, and information that is clear and understandable.

Boards regularly receive information provided to them by management. If this information primarily takes the form of GAAP financial data, it is likely that they are not obtaining a full picture of the business. In order to oversee, understand, and run a business effectively, one needs to look at performance measures in addition to GAAP. This need has led to custom-tailored internal financial reporting measures used by management and directors of an enterprise. Such internal reporting can be a flexible system, portraying not only standard recurring measures used by management but also selected aspects of operations of particular importance at one time or another. Internal reporting can make certain adjustments to results to consider unit-controllable results and thereby provide additional context and insight into the performance of both business units and the total company. Internal unit reporting may focus on actual versus budgeted cash flows more than unit gross profit or accounting net income.

Non-GAAP Measures in External Reporting

Because adjusted “Non-GAAP” results can be illuminating and useful to management and directors, some measures may be reported externally to the public and investors, as well as inside the business. However, Non-GAAP measures used in external reporting have at times been challenged by regulators as misleading to investors, on the basis that such measures were portraying only “good news” and/or were obscuring less favorable performance. There is a substantial body of information from the U.S. Securities and Exchange Commission providing guidance on proper use of Non-GAAP measures in external reporting and also describing SEC enforcement actions for misuse. On the international front, the International Organization of Securities Commissions, a worldwide body of securities regulators in both developed and emerging markets, has also issued pronouncements about Non-GAAP reporting. Entry of “Non-GAAP” in the search boxes on these organization’s websites, www.sec.gov and www.iosco.org, will bring up a host of documents providing guidance about what is and is not considered acceptable for public reporting of such measures.

This article will not attempt to cover the subject on Non-GAAP further beyond making these two statements: (1) Non-GAAP measures have a useful and legitimate place in reporting about a business, both internally and externally, but care must be taken so they do not mislead investors and other users. (2) A company’s board of directors would be well-advised to understand how a company’s Non-GAAP measures are developed and used, and why they are viewed as meaningful in assessing corporate performance. In particular, it is advisable for a board to understand any corporate use of measures that have been challenged by regulators, such as “free cash flow” or “net income excluding the effect of one-time charges,” when used in external reporting to investors. The latter has at times been challenged because the label “one-time” is debatable if such charges have occurred repeatedly, as is sometimes the case with restructuring charges.

Using Internal Reporting Design and Cash Flow Monitoring to Understand and Manage Effectively

Ideally, an organization’s internal reporting should identify and illuminate the relevant elements of financial and operational performance that are important to the company’s success. A good design for internal reporting can also be used to encourage the behaviors and actions that contribute to company success. However, there is an important caveat to be observed when using internal reporting for performance incentive purposes: a design for internal reporting and incentives that fails to consider risks that exist and controls that need to be present can have disastrous consequences.

The design of a company’s internal reporting system to managers and directors is inherently unique to each company. Guidance can be gleaned from benchmarking and understanding the approaches used in peer companies and others and from business publications, but ultimately each company must find its own best design to assess and understand performance. And a best design often needs revision over time, in light of changing needs and circumstances.

Cash Flow Monitoring—A Key Measure of Performance

An important part of performance measurement that sometimes receives insufficient attention in internal reporting to a company’s board of directors is cash flow monitoring. Cash flows are the lifeblood of a business. Not for nothing do we often hear the phrase “cash is king.”

Understanding how to interpret cash flows and monitoring cash closely is essential for overseeing and managing a business. Whether a business is a large, multinational, mega-billion-dollar corporation, a mid-size public or private company or partnership, or a small owner and founder-run enterprise, failure to track and manage cash flows effectively can seriously disrupt or even bankrupt a company. Cash flows can be effectively measured in a timely manner, and a comparison of budgeted to actual receipts and disbursements can often give a much clearer financial picture than reported revenues and expenses and net income on a GAAP income statement. Discussions on the causes of cash flow variances can uncover problems and opportunities without need for approximations or adjustments. The cash flows either did or did not occur within the particular time period.

Operational and capital cash flows are concrete results not easily subject to manipulation. Thus, they can serve as a safeguard against efforts to manipulate income through revisions in accruals or reclassifications of operating expenses to capital expenditures. They also can avoid misunderstanding of results that include unbudgeted one-time charges or have been adjusted to exclude such charges. Accurate cash flow information can also help to highlight possible weaknesses in controls and negative developments not readily apparent in income statement measures, as in a case where a strong corporate emphasis on customer sales growth, combined with a relaxing of the company’s product financing and credit-granting controls, may be increasing risk to an unacceptable level, for example.

Company CFOs, treasurers and controllers should work together to devise appropriate internal processes and teams for budgeting and measuring cash flows and analyzing anomalies - and for explaining cash flow information to the board in an understandable manner. Relevant board committees such as the Finance Committee, Audit Committee, and Nominating and Governance Committee will have a significant interest in receiving such information in their check-and-balance and governance roles. Internal audit and the external auditor may also provide input to enhance controls and accuracy.

Cash flow information can be very complex; for example, the Statement of Cash Flows that is presented in GAAP is viewed by some as arcane and difficult to understand. However, through effective internal measurement and reporting, companies can develop effective methods for presenting cash flow data and interpreting it for the board. For a more detailed discussion on cash flow monitoring and reporting, including a model for presenting such data, the reader is referred to an earlier article on this subject by one of the authors—see “Cash Flow Monitoring as a Governance Tool” in THE CORPORATE BOARD, March/April 2010.

Corporate and Director Obligations for Public Reporting and Disclosure

Since the passage of the Sarbanes-Oxley Act and the later Dodd-Frank Act, many obligations have been created for public company reporting to investors, and also for board of directors’ review of such reporting. Extensive and explicit documentation of such requirements exists in regulatory pronouncements and business and professional publications. Less explicitly defined are the requirements pertaining to board review of financial information that could influence an investor’s decision to buy or sell stock in a company—what is termed “material information” by the SEC and other regulators– as that information arises. For example, what are the obligations of a director who becomes aware of material information in board meeting discussions that the company’s executives do not feel is yet ready to be disclosed to the public? Consultation with corporate counsel may be needed in such situations.

Appropriate and timely reporting to investors is the direct obligation of a public company’s management. However, board oversight of this important obligation also requires a degree of knowledge about what should be done and when. A detailed discussion of this subject is beyond the scope of this article; however, it is a matter for which directors can request explanations from a company’s CFO, auditors, and general counsel.

Conclusion

Today’s boards of directors live in a time of growing oversight responsibilities and expectations. The likelihood of meeting these expectations can be enhanced if board members have a clear understanding of a company and its financial performance, cash flows, and prospects. Gaps in financial information can undermine a board’s ability to perform its role as an important check and balance in the governance and operation of the company. A well-designed internal reporting system for measuring and reporting financial performance, coupled with vigilant and active board interest, supports board effectiveness in carrying out oversight responsibilities. Well-designed internal financial reporting processes and cash-flow monitoring are important components of an effective board information system.

ABOUT THE AUTHORS

New York City, NY

H. Stephen Grace Jr.

Dr. Stephen Grace is President and Founder of H.S. Grace & Company, Inc., a litigation support, expert testimony and business consulting firm serving corporate officers and directors and their counsel…

New York City, NY

S. Lawrence Prendergast

Larry Prendergast is Chairman of the Turrell Fund and serves on the advisory boards of several investment funds, including JPMorgan. He is a member of the Board of Advisors for H.S. Grace & Company…

New York City, NY

Susan Koski-Grafer

Susan Koski-Grafer is a Consultant and Senior Advisor on business performance and strategy, employee development, financial reporting, and international securities regulation.  She is a member of the…

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