governance and corporate reporting world watch* · 29 transatlantic corporate governance cox calls...

World Watch*Governance and Corporate Reporting

Financial Reporting 4

Broader Reporting 17

Governance 27

Assurance 35

Diary Dates 40 Issue 2 2008

Credit Crunch Forum calls for action

Principles-based standards Let’s get on with it, says FRC

Non-GAAP measures How to report effectively

Sustainability To the heart of business

EDitoRiAl

David Phillips, senior corporate reporting partner PricewaterhouseCoopers

Richard Keys, global chief accountant PricewaterhouseCoopers

Where next after the NICE decade?Looking back today, highlights that we have all lived through an interesting period of economic history. It has been described by an eminent central banker, Mervyn King, as the NICE decade – one of no-inflation and consistent expansion. It was a period when the normal volatility of the business cycle declined substantially. In part as a result of globalisation, better monetary policy, inventory control...and perhaps we also got lucky.

We are now in a period of de-leveraging, as many of the world’s leading financial institutions repair their dented balance sheets. The multiplier effect kicks-in in reverse and is compounded by a shift in human behaviour caused by a lack of confidence. On a more optimistic note, most economic recessions only last for about 10 to 15 months.

Many business gurus believe that the next 15 months is the period when the future fortunes of many companies will be determined. It’s the actions and the investments that management teams make when growth slows or dips that differentiates the well run from the lucky.

So what does this mean for the stakeholders in our capital markets? Are there ways in which markets can be better informed about risks, management and performance (financial and operational, and including social and environmental impacts) that will reduce the excesses of market reaction but maintain the essential dynamic at the core of capitalism?

We should also consider the long-cycle issues and the challenges of the next millennium. Arguably these transcend the economic cycle as they are rooted in the bigger issue of human sustainability. We should not ignore the tell-tale signs of change present in the daily media – for example, energy and food security, water shortages and carbon emissions. While some companies remain sceptical about the issue and the urgency of the response needed, the majority recognise that it is critical and that sustainability and competitiveness are not mutually exclusive – they can in fact reinforce each other (see page 26).

The biggest hurdle appears to be prioritising the actions that will deliver meaningful change. This needs collaboration between governments, regulators and the corporate sector at a level not seen in the past (see, for example, pages 4, 14, 18, 29). If we get this agenda right the future could be truly NICE.

World Watch team

Editor: Sarah GreyConsulting editors: Richard Keys, David Phillips, Graham Gilmour, Jaap van Manen, Hans Dijkstra Thomas Scheiwiller, Erica Hauver, Diana HillierContributors: Emma Charlesworth, Lucy Crofts, Bethany Tucker, Raymond Taylor, Elizabeth Georgiades, Alison Thomas, Kinga Lodge, Ruth Walker, Liz Fisher, Ron Brown, Damon Bowles and PwC Staff

PricewaterhouseCoopers (www.pwc.com) provides industry-focused assurance, tax and advisory services to build public trust and enhance value for its clients and their stakeholders. More than 146,000 people in 150 countries across our network share their thinking, experience and solutions to develop fresh perspectives and practical advice.

© 2008 PricewaterhouseCoopers. All rights reserved. “PricewaterhouseCoopers” refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.

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Contact usPwC has a strong and effective network of people worldwide who can advise on the developments in reporting and the implications of local regulations, as well as international standards and global trends. If you would like to discuss any of the issues raised in this publication, please contact your local office, the people named in specific articles or the editor.

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Contents

Financial Reporting – News4 Credit crunch response

FSF analysis and actions to take

5 Corporate Reporting task Force Telling standard setters what investors want

5 Clarity for investors IOSCO demands accurate accounting information

5 Chinese accounting standards New publication to aid implementation

6 FASB reduced to five Amendments prepare for IFRS environment

7 Catering for global standard setting IASCF trustees review IASB accountability and capability

7 iFRS 3 impact on earnings Questions on the revised standard answered

7 Boost to EU market competitiveness US and Japanese accounting standards recognised

8 SEC push to improve financial reporting Pozen committee publishes proposals

8 iASB projects this year Papers and drafts for comment

9 iASB aims to reduce complexity Proposals to ease financial instruments problems

9 iFRS publications The agenda for extractive industries

10 Revenue recognition models IASB explores two balance-sheet driven models

10 Business combinations IASB finally completes second phase

11 Simplifying regulatory reporting SEC proposal to require XBRL reporting

11 Engaging with Australians National accounting boards still important says AASB

12 Korea milestone K-IFRS progress to align with international standards

12 Korea survey Waking up to the realities of IFRS

13 Brazil’s corporate law change Significant updates for financial statements

13 Japan convergence with iFRS Eliminating major differences by the year-end

13 iFRS for SMEs Pocket guide to the IASB’s proposals

14 CEos call for principles-based standards Key messages from the six largest firms

14 taiwan responds to iFRS ‘tide’ IFRS reporting ‘essential’ for international comparability

Financial Reporting – Opinion15 Principle-based standards – where next?

Put the vision into practice sooner rather than later

16 Pension changes Act now to influence the debate

Broader Reporting – News17 Executive pay

Building trust between executives and their shareholders

18 Carbon offsets UK launches new scheme and quality mark

18 Climate change CEOs call for government action

19 ESG indicators hit capital markets radar Importance of environmental, social and governance rises

19 Climate change Australian business leaders not up to speed

20 in Briefs Transparency awards for charitiesChina launches first social responsibility indexSwiss sustainability investment market growthPGGM commitment to microfinanceGood Egg Awards 2008

21 in Briefs Banking sector not integrating climate risksGaps in GRI guidelines for food processingGRI reporting – not enough strategiesBanco Itaú awardEthical trading rise

22 Carbon Disclosure Project Pertinent questions are getting answers

22 Argentina mandates sustainability reporting Buenos Aires governors pass new legislation

Broader Reporting – Opinion23 Good practice reporting

Getting to grips with non-GAAP measures

26 Sustainability Going right to the heart of business models

Contents

Governance – News27 Gender equality at director level

Norwegian law demands 40% female representation

28 Reading US directors’ minds Shareholders at front of executives’ thoughts

28 Guide to anti-money laundering Publication provides information on 50 countries

29 transatlantic corporate governance Cox calls for international cooperation

29 Consultation on Smith Guidance UK audit committees could change this year

30 turkey governance study ‘Cultural differences’ for emerging markets

30 Bulgaria code introduced A boost for domestic companies

31 Brazil governance upgrade Driving significant foreign investment

31 Australian focus on governance Audit committee forums bring stakeholders together

32 Risk management Is good decision making at risk?

32 Review of ‘excessive’ termination payments Senate ‘grills’ boards over outsize pay packages

33 investors want transparency Calls for better disclosure on alternative assets

33 EU governance developments Recommendation to improve shareholders’ rights

Governance – Opinion34 Good governance pays off

Sound structures and active shareholders improve performance

Assurance – News35 New requirements for overseas auditors

EC proposes transitional arrangements

36 Progress on Clarity Momentum grows towards IAASB 2008 goal

36 New iSA on related parties IAASB approves revised version of ISA 550

37 Clarifying iSA 501 Concerns that it is not principles-based

37 Building a global SAS 70 model ISA will be international equivalent of US standard

38 iSA 540 on fair values Contemplating additional guidance

38 independent audit regulators Heads together on hot topics

38 Annual transparency reports UK regulator makes new requirements

38 Action on auditor liability EC to recommend allowing limitations

Assurance – Opinion39 Big GAAS, little GAAS

Smaller entities don’t really need separate standards

Financial ReportingCREDit CRUNCH

Action stations on the credit crisis Eight months after the global credit crisis began, official reports have started to appear that seek to analyse the market turbulence and take action to limit its impact.

The most significant pronouncement was the report on enhancing market and institutional resilience issued by the Financial Stability Forum (FSF) in response to a request by the G7 finance ministers. This was prepared following extensive collaboration and fact-finding with different sectors involved in the credit crisis. The report details some 67 recommendations grouped under five headings:

Strengthening prudential •oversight of capital, liquidity and risk management

Enhancing transparency and •valuation

Changes in the role and uses of •credit ratings

Strengthening the authorities’ •responsiveness to risks

Robust arrangements for dealing •with stress in the financial system

The report is very action-orientated – responsibility for developing each of the recommendations is assigned to specific organisations, against a suggested timeline for action. The

FSF will be monitoring progress and will prepare a further report by the end of this year.

The financial reporting recommendations are challenging. The International Accounting Standards Board (IASB) is charged with following up on most of these (see box below). In a separate communiqué, the G7 finance ministers have strongly endorsed the FSF’s report, placing even greater emphasis on the need for swift action. They have urged the IASB to initiate improvements within 100 days.

The FSF report also recommends improved risk disclosures by banks and other market participants. It points to a separate report by the Senior Supervisors’ Group (a grouping of the banking regulators in France, Germany, Switzerland, UK and US) on Leading practice disclosures for selected exposures. This report looks at examples of disclosures by major international financial institutions in the last reporting season and highlights what the group considers to be good practices.

PwC financial instrument expert Pauline Wallace agrees that it is useful to share experience of how

banks provided information in their disclosures beyond that required by the standards. ‘In the IFRS world, we should certainly be looking at the types of disclosures highlighted in the Senior Supervisors Group report and in the US SEC’s recent “Dear CFO letter”, to see if these will aid transparency around risk.’

The FSF report also calls on the largest audit firms to share with the International Auditing and Accounting Standards Board the audit approaches that they have used to address assurance and reporting issues resulting from the current market conditions. The idea is that this experience could be used to help enhance audit guidance.

Peter Wyman, PwC UK regulatory partner, added: ‘We have already started the process of sharing our experiences of the last reporting season with the international standard setters and regulatory organisations. That does not mean that new audit standards are needed, but there may be areas where it is useful to reflect in guidance the practices we have been following.’

The Financial Stability Forum’s report can be found on www.fsforum.org

News & Opinion

FSF recommendations to the IASB on improving accounting standardsImprove the accounting and •disclosure standards for off-balance sheet vehicles on an accelerated basis and work with other standard setters toward international convergence.

Strengthen standards to •achieve better disclosures about valuations, methodologies and the uncertainty associated with valuations.

Enhance guidance on •valuing financial instruments when markets are no longer active. To this end, set up an expert advisory panel.

5World Watch Issue 2 – 2008

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The Corporate Reporting Users’ Forum (CRUF) gave standard setters a mixed report at the joint meeting of the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) in April. The group of professional investors and analysts raised questions about whether standard setters are focusing on the right issues and enhancing the efficiency of the capital markets.

The CRUF accepted an invitation to present to the joint board to give standard setters a practical insight into the challenges of valuing companies and suggest areas where standard setters could reduce some of the guess-work involved.

Peter Elwin, head of accounting and valuation at Cazenove, kicked off the session by providing some of the

CRUF’s basic principles for financial reporting. He stressed the importance of transactions and flows rather than balance sheet values. He also underscored the need for the data presented to be both consistent over time and comparable across companies – something that he believes has been hindered by an increasingly ‘through the eyes of management’ approach to standard setting.

Deutsche Bank’s capital goods analyst Peter Reilly drilled down into the impact of some specific areas of financial reporting standards on the day job of an analyst. He applauded the boards for their courage in standing fast against some vocal corporate opposition in their implementation of the stock options standard – an example of a market-driven standard, he said, that had ‘restored economic sanity.’

He was less convinced, however, about the decision to recognise intangibles on acquisition, describing them as ‘arbitrary numbers’ and ‘a case of extra cost with no upside’. He added that in his experience most analysts end up just stripping out any amortisation charge.

Mr Reilly was similarly cautious about the standard setters’ current plan to re-think revenue recognition. Any wholesale review of such a critical line in the accounts should not be entered into lightly, he warned, even if there are a few rough edges to the existing standard.

On the issue of cash, however, he called for a fundamental overhaul. ‘This is a major piece of unfinished business that we would love to see addressed.’

For further information on the CRUF see www.cruf.com

INVESTORS

Telling standard setters what they want

Call for clarity to help investorsThe International Organisation of Securities Commissions (IOSCO) has recently published a statement urging publicly traded companies to provide investors with clear and accurate information on the accounting standards used in the preparation of their accounts.

This recommends that companies preparing annual and interim financial statements on the basis of national

standards that are modified or adapted from IFRS should include at least the following:

A clear statement about the reporting •framework on which the accounting policies are based.

An unambiguous statement of the •company’s accounting policies on all material accounting areas.

An explanation of where the •accounting standards that underpin the policies can be found.

An explanation pointing out that •financial statements are in compliance with IFRS as issued by the IASB, if this is the case.

A statement that explains in what •way the standards and the reporting framework used differ from IFRS, as issued by the IASB, if this is the case.

IOSCO’s aim is to help mitigate the risk of investors making investment decisions without understanding the basis of the financial statements they are considering.

IOSCO

CHINESE ACCOUNTING STANDARDS

New publication aims to bring clarity It has been over a year (January 2007) since Chinese Accounting Standards (CAS) were aligned with IFRS, and the country’s 1,400+ listed companies immersed themselves in the challenges of a new and very different accounting regime.

To help organisations embed the new standards in their financial

reporting systems and daily activities, PricewaterhouseCoopers has published the 2008 version of China Accounting Standards – Summary, Changes and Comparison. Based on the original January 2007 publication, the new document offers a comprehensive, up-to-date tool for companies. Its aim is to help management and finance teams better

understand the impact of the changes that CAS has brought about, as well as the principle accounting treatments and presentation requirements of the new standards.

Copies of the publication are available from Baolang Chen at PricewaterhouseCoopers, email [email protected]

6 World Watch Issue 2 – 2008

The US Financial Accounting Standards Board (FASB) is to reduce its membership from seven to five, as significant changes to its governance and structure were pushed through by its oversight body, the Financial Accounting Foundation (FAF). In part, this is a response to the different role the FASB may have in the future as IFRSs become more accepted in the US.

The changes follow a lengthy public consultation of proposals put forward by a special committee of the FAF trustees in July last year.

Robert Denham, chairman of the FAF Board of Trustees, said the changes were intended to ensure that the FAF and its boards could continue to meet their responsibilities. ‘[The changes] demonstrate the trustees’ strong commitment to enhance the efficiency, effectiveness and independence of our standard-setting boards in a rapidly changing economic environment,’ he said.

The changes to the FASB include:

A reduction in the number of FASB •members from seven to five from 1 July 2008

Providing the FASB chairman •with the authority to set the board’s technical agenda

The current bylaw requirement •that FASB members should have investment experience has been broadened to emphasise the need for investor participation in the standard-setting process

By far the most controversial proposal put forward by the trustees was to reduce the number of board members to five, while retaining its simple voting majority. The trustees argued that reducing the size of the board would speed up its decision-making processes and make it more responsive to change. The proposal has been confirmed by the FAF in spite of opposition from a number of organisations. The FAF received 59 comments letters during the consultation process, but they have not been posted on its website.

The Financial Executives Institute’s committee on corporate reporting was one of the organisations that disagreed with the proposal, saying that reducing the number of members would not necessarily make it more nimble.

‘We continue to believe that the board needs a sufficiently broad-based group to study and bring a variety of individual and industry perspectives and experiences to the analysis, and to have a comprehensive debate of the issues, in the development of well thought-out standards,’ said the committee in its response. ‘We believe that the dialogue, diverse views and expertise afforded among seven members allows for the creation of high-quality standards. A smaller board may not best represent the perspectives necessary to present a generally-accepted standard.’

Along with some other respondents, the FEI also felt that reducing the number of board members called for a super-majority voting system, particularly since the resulting standards would be ‘generally accepted’.

PricewaterhouseCoopers was among the respondents supporting the changes, although the firm asked the FAF in its response to be sure that the benefits of reducing the number of board members in terms of efficiency outweighs the disadvantages of reducing the breadth of expertise on the board. It also recommends that a mechanism be introduced through which any differences in FASB members’ views can be discussed and resolved. ‘The FASB’s role as a standard setter will change significantly with the anticipated move to IFRS in the US capital markets,’ said PwC partner David Kaplan. ‘We support the changes as long as the conditions we set out are met and the changes are implemented no sooner than when FASB begins transitioning to its new role.’

As well as the changes to the FASB, a number of changes have also been approved to the governance of the FAF trustees. Trustees will now serve one five-year term, as opposed to one three-year term with the possibility of a further three-year term. The board of trustees will be made up of between 14 and 18 members, rather than the current fixed quota of 16.

US

FASB reduced to five


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In April this year, the trustees of the International Accounting Standards Committee Foundation (IASCF) – the body that oversees the IASB – announced their plans and timetable for the forthcoming constitutional review of the organisation, which takes place every five years. On this occasion, the review coincides with a strategy review, as the trustees consider how to give the IASB the accountability and operational capability it needs to be a truly global standard setter.

The fact that many larger market economies (for example, Canada, India, Japan and Korea) have recently declared that they expect to converge with IFRS between now and 2012, represents a step-change in the use of the standards. It also has far-reaching implications for the dynamics of the relationship between the IASB/IASCF organisation and national regulators. ‘National government authorities are effectively putting their faith in the IASB to set accounting standards on their behalf,’ said PwC’s global chief accountant partner Richard Keys.

‘Adoption of IFRS in the US would further emphasise these issues of political accountability.’

The trustees have announced a two-stage process for the review. Their first consultation – to be launched in June – is on a proposal to form a monitoring group (MG) that will provide a further tier of political-level oversight above the trustees. This is likely to comprise senior representatives of regulatory and other bodies such as the IOSCO, the European Commission, the IMF and the World Bank. The proposals see the MG being responsible for the appointment of the trustees. It would also review the trustees’ procedures for appointing IASB members, and review the board’s strategy and its compliance with due process.

Speaking to a committee of the European Parliament to introduce the proposals, the IASCF chairman Gerrit Zalm explained: ‘The trustees are recommending the establishment of a monitoring group to end the practice of self-appointment and to create a formal link to public authorities. This link is

aimed at providing public authorities with greater comfort about our governance arrangements and operations.’

This first stage of the consultation process also includes a proposal to increase the size of the IASB to 16 members (from 14), and to introduce minimum geographical composition thresholds. It is argued that the board’s increasingly global constituency calls for greater geographical diversity in the membership. One formula being considered is to have four members from each region – North America, Europe and Asia/Oceania – with the remaining four members appointed from any area, subject to maintaining overall balance.

Early support for the MG and an enlarged IASB is thought to be crucial to obtaining buy-in for the changes to the constitution as a whole. Further detailed changes to the constitution will be consulted on in a second phase of the review, beginning in the final quarter of this year.

the iASCF’s announcements can be found on www.iasb.org

IASB

Catering for global standard setting

The EC has followed recent advice from the Committee of European Securities Regulators (CESR) on recognising US and Japanese accounting standards. So US and Japanese companies with a stock market listing in the EU can continue to file their financial statements under their local accounting standards, rather than be required to reconcile the accounting to IFRS.

In its comment letter PwC supported CESR’s pragmatic approach that results in robust GAAPs commonly used in the capital markets continuing to be recognised for use with listings in different jurisdictions – while pointing out that ‘equivalence’ should not be presumed to result in identical accounting outcomes.

This follows the US SEC decision last year that it would accept IFRS accounts from foreign entities listing in the US

without reconciliation to US GAAP. The EC decision is expected to boost EU stock exchanges and enable them to compete better with others.

The CESR also advised the EC to postpone a final decision on Chinese GAAP until there is more information on the application of new Chinese accounting standards. However, the EC has decided to allow Chinese companies to continue filing accounts using their home standards, but it will continue to review how this works in practice. More recently, CESR also issued draft advice on Canadian and South Korean GAAPs. The EC has already indicated that it will allow Canadian and South Korean companies to continue to file their financial statements under their local GAAPs until 2011, when both countries are expected to be fully converged with IFRS.

EQUIVALENCE

Boost to EU competitivenessEarnings questions answeredDealmakers and preparers of financial statements can get their questions on the impact of the revised business combinations standard answered in a guide issued by PricewaterhouseCoopers.

IFRS 3R: Impact on earnings aims to help communicate the consequences of a business combination on the current year’s financial statements and how a business combination may affect future years’ earnings.

The publication provides:

Background to IFRS 3 revised •

Its impact•

Questions and answers •

Summary differences with US GAAP•

the guide is available on www.pwc.com/ifrs


US

SEC push to improve financial reportingThe SEC committee set up last year to consider improvements in US financial reporting, chaired by Robert Pozen, has published a draft discussion memorandum setting out its proposals.

‘It is primarily focused on the US reporting model, and the role of the SEC and FASB,’ said PwC partner Dave Kaplan, ‘but the proposals are strategically important in understanding where US thinking is moving, particularly as convergence is now starting to colour the debate about the IASB’s governance, funding, processes and overall direction of travel.’

The report is approximately 100 pages long and has many proposals, but set out below are the principal recommendations:

Substantive complexity – here the main recommendation is that GAAP should be based on activities rather than industries, although an industry focus is acceptable where the economics are legitimately different.

The committee highlighted the need for better education around understanding the economic substance of transactions, rather than mechanical compliance with rules. It indicated that the committee may consider whether the FASB should develop a measurement framework to help determine the most appropriate measurement basis in a given situation, and refrain from issuing new standards that call for expanded use of fair value until such a framework is complete.

Standard setting process – the report comments that while the US system has been ‘quite effective’, it has evolved over many years with some of the basic principles becoming obfuscated by detailed rules, bright lines, exceptions and regulations, which reduce transparency and the usefulness of the resulting financial reporting. The main recommendations are:

Additional user/investor involvement•

The creation of a formal Agenda •Advisory Group, improved prioritisation of work, procedures for field testing and cost/benefit analyses

An objective-based approach to •the way standards are designed and implemented

The committee is also considering proposing that the SEC formally encourage improvement in the way standards are written – using an agreed

framework that promotes trust and confidence in efficient markets by encouraging professional judgements.

Audit process and compliance – this section principally considers financial restatements and the use of accounting and reporting judgements. Here the committee recommends that the SEC issue guidance to reinforce the following concepts:

Evaluation of materiality should •be based on the perception of a reasonable investor

Materiality should reflect how an •error has an impact on the total mix of information available to a reasonable investor

The determination of how to correct •an error should be based on the needs of current investors

The SEC should issue a policy •statement articulating how it evaluates the reasonableness of accounting judgements and include factors that it considers when making this evaluation

Delivering financial information – the committee agreed that information delivery must be provided in a way that will make it efficient, reliable and cost effective for each relevant investor group and will not significantly increase burdens on the reporting companies. It focused mainly on the electronic tagging of financial information (XBRL) and improved corporate website use.

Project output for review

timing of 2008 releases

Convergence projects

Debt/equity financial instruments DP Q1

Joint ventures IFRS Q4

Reducing complexity of financial instruments

DP Q1

Income tax ED Q2

Consolidation DP Q3

Fair value measurement guidance RT Q2

Financial statement presentation DP Q2

Revenue recognition DP Q2

Post-retirement benefits (including pensions)

DP Q1

Project output for review

timing of 2008 releases

Conceptual Framework

Phase A: Objectives and qualitative characteristics

ED Q1

Phase C: Measurement DP Q4

Phase D: Reporting entity DP Q1

other projects

Small and medium-sized entities IFRS Q4

KeyDP – Discussion paper RT – Round-table discussion

ED – Exposure draft IFRS – Final standard

Note The Financial Stability Forum has asked the IASB to address various issues, see page 4

Source: IASB work plan

IASB projects for comment this yearThe table shows IASB projects that are expected to have an output this year that company management, regulators and others may want to comment on or monitor. The table does not cover revisions to old standards.


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IFRS PUBLICATIONS

What’s on the agenda for extractive industries

FINANCIAL INSTRUMENTS

IASB aims to reduce complexity

The International Accounting Standards Board (IASB) has released a discussion paper that analyses the main causes of complexity surrounding the reporting of financial instruments, along with suggestions for tackling the problems.

The IASB’s paper, Reducing Complexity in Reporting Financial Instruments, represents the first step in the board’s project to replace IAS 39 with a simpler ‘principles-based’ standard that reflects economic reality.

In the paper, the IASB acknowledges that the current reporting requirements surrounding financial instruments are difficult to understand and apply, and analyses the main reasons behind the complexity. The long-term solution, it argues, is to measure all types of

financial instruments within the scope of the standard in the same way, and in the paper the board says that ‘fair value seems to be the only measure that is appropriate for all types of financial instruments’.

The board acknowledges, however, that there are pros and cons to this approach. Many concerns will have to be addressed before fair value measurement could be a requirement for all financial instruments, such as the volatility of earnings arising from changes in fair value and the presentation of unrealised gains and losses in earnings. There are also concerns that using fair value may result in greater complexity in financial instrument reporting, rather than less.

Short-term fix

Because resolving all the issues could take a great deal of time, the IASB proposes some intermediate approaches that could reduce complexity in the short term. These are:

Amending the measurement •requirements, for example by reducing the number of categories of financial instruments

Replacing the existing requirements •with a fair value measurement principle and some optional exceptions to fair value measurement

Simplifying the current hedge •accounting requirements

Contentious topic

The IASB is well aware that financial instruments remains one of the most contentious topics on its agenda, and has effectively challenged its detractors to support the project, or come up with a better idea. Rather than saying definitively that it is aiming for a single measurement approach, it leaves the question open-ended and asks for as many views as possible.

‘We are determined to simplify and improve IAS 39 by creating a principles-based standard,’ said IASB chairman Sir David Tweedie. ‘Those who believe in reducing complexity in accounting standards now have the opportunity to shape the way ahead.’

Comments on the discussion paper are requested by 19 September.

Need to Know: The future of IFRS for the extractive industries is a short publication from PwC that raises IFRS questions for oil, gas, mining and utility companies, such as: Is IFRS ‘broken’? What might replace IFRS 6? What accounting models are being considered? When will this financial reporting start?

The IASB is currently considering all models of accounting for reserves and resources, including the fair valuation of reserves on balance sheet. A new standard could be published as early as 2011 (effective from 2013), which indicates that the industry will need to participate in discussion now if it wants to influence the outcome.

The leaflet is available at pwc.com/energy (see publications) and acts as a preface for two comprehensive new IFRS publications for the industry – Financial reporting in the oil & gas industry and Financial reporting in the utilities industry. For more information, please email [email protected] or [email protected]


the international Accounting Standards Board (iASB) is exploring two balance-sheet driven models for revenue recognition and is expected to publish a paper imminently. For many years the iASB has pursued a balance-sheet approach to accounting – define assets and liabilities, measure them, and profit or loss emerges. it was perhaps only a matter of time before this thinking would be applied to revenue itself.

‘Revenue seems to epitomise the income statement like nothing else,’ said PwC technical partner Peter Holgate. ‘It is, with luck, the largest number in the income statement. Recognition of revenue therefore is surely based on a notion of earning revenue – the cash that comes in the door, adjusted for movements in debtors – as goods are sold or services are provided. That, at least, has been the traditional view.’

The first model being considered by the IASB potentially leaves the amount and timing of the revenue numbers unchanged from current practice, but rationalises them in a different way. Where cash is received in advance of a service being provided, it gives rise to something currently called deferred revenue – an income statement notion of revenue that we have not yet earned. If this is viewed from a balance sheet perspective, it becomes a liability to perform services in future. The amount is the same, but we have moved to a balance sheet perspective.

The other method being considered is more radical. It involves initially measuring the liability to perform services at fair value, that is, at the amount that a hypothetical market participant would charge – ie, what the entity would have to pay a third party to be relieved of the obligation to perform the service. If that amount is less than the amount charged to the customer,

there is an immediate gain that would be recognised. Moreover, if the amount of the liability – the price that a market participant would charge – changes, it is re-measured, so creating a gain or loss. And this is done even though there will generally be no intention of passing the work to a third party.

‘This second model is all very well in theory (perhaps),’ commented Peter Holgate, ‘but in most contexts, there will be no active market in such services, so determining the value of the liability takes us again into the “mark-to-model” territory, which has been problematic recently in the context of financial instruments.

‘Revenue is currently used as such a major indicator of performance that company management may want to follow this consultation closely and from the start so that they can make their views known to the IASB at an early stage.’

IASB

Exploring revenue recognition models

The IASB completed the second phase of its business combinations project earlier this year, after considerable delay. The development of the standard has been controversial, and questions have been raised about how quickly this will be endorsed in the EU. The topic is considered critical, as business combinations are such a prominent feature of the capital markets – their annual value is equivalent to around 10% of the worldwide market capitalisation of listed securities.

The revised standard – IFRS 3 (revised) – will increase the use of fair value through the income statement and cement the ‘economic entity’ view of the reporting entity. The changes will take effect on 1 July 2009, although they can be adopted earlier.

‘Investors and their advisers have a difficult enough job assessing how the activities of the acquirer and its acquired business will combine,’

said IASB chairman Sir David Tweedie. ‘But comparing financial statements is more difficult when acquirers are accounting for acquisitions in different ways. Now the accounting requirements in IFRSs and US GAAP will be substantially the same.’

However, many commentators objected to the IASB’s proposals. The IASB pressed ahead, making only limited changes and, for the first time, published a feedback statement summarising public comments and seeking to explain how they influenced the final standard. Commentators can now consider whether this statement adequately explains the board’s rationale for rejecting adverse comment and whether this new process strengthens the board’s accountability to stakeholders.

One of the key challenges for companies will be explaining a different and more volatile income statement to

users of financial statements. Provisions in the standard that will affect the income statement at the time of acquisition and afterwards include:

Transaction costs to be expensed•

Pre and post consolidation interests to •be fair valued through income

Changes in estimates of earn-out •payments are income or expense

Mary Dolson, leader of PwC’s global business combinations IFRS team, said: ‘Companies should look at their acquisition structures and model post-acquisition earnings under the new standard. They may want to re-consider payment structures to mitigate undesirable income statement volatility.’

The feedback statement on IFRS 3 (revised) is available on the IASB’s website www.iasb.org

IFRS

Business combinations


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the SEC has formally proposed using technology to get important information to investors faster, more reliably and at lower cost. the proposed rule will require all US companies to provide financial information using ‘interactive data’, beginning next year for the largest companies and within three years for all US companies.

A wide variety of methods have been used for voluntary ‘tagged’ filings to date, with mixed cost savings. Of some 60 companies that voluntarily used eXtensible Business Reporting Language (XBRL) to communicate their performance to the SEC in the past year, 40% are thought to have used the widely and freely available ‘add-ins’ to manually tag completed company reports. Most of the remaining companies are opting to either outsource their tagging processes or to use software solutions providing automatic tagging of completed company reports, for example through XBRL tagging websites.

Time and cost savings are expected to remain limited until companies push the application of XBRL from the end of the reporting processes back into their underlying, internal report writer, assembly, review and aggregation processes. ‘If business reports were cars,’ said PwC partner Mike Willis, ‘company reporting processes are in the pre-Henry Ford era, when each car was

custom made by dedicated craftsmen – and too expensive for everyday use.’

One company realising the potential for more automated reporting processes is United Technologies Corporation, which has used their consolidation system to generate XBRL-tagged content – financial statements, notes and narrative, including the MD&A – and to produce internal review draft documents using Wikipedia-style collaboration. Cost and time savings from these XBRL-enabled processes are estimated by the company to be 25%.

In The Netherlands, using XBRL to generate savings in the administrative burden on companies is being taken a step further with the development of an XBRL compliance taxonomy that enables a ‘business-centric’ filing model. This allows multiple government agencies to source their data on companies from one XBRL-formatted filing. The Dutch government cites a 90% reduction in the number of data elements required from companies, and believes this saves companies 25% in reporting costs.

‘Financial executives should monitor XBRL adoption by relevant regulators and evaluate tools and features available from vendors,’ Mr Willis concluded. ‘Leveraging XBRL to improve internal reporting processes may also help visionary executives deliver significant improvements in the timeliness, cost and quality of information used by management and their stakeholders.’

XBRL

Regulators want smart communication

XBRL adoption

Country organisation Programme/application

Japan Tokyo Stock Exchange (TSE), NTO, BoJ, METI

Mandatory TSE registrant financial report filings

US Securities and Exchange Commission FFIEC/FDIC/FRS/OCC

XBRL voluntary filer programme Mandatory ‘call report’ filings

UK Companies House HM Revenue and Customs

Accounts filings Company tax filings

China China Securities Regulatory Commission

Mandatory interactive data filing for financial statements

Australia Australian Treasurer Standard Business Reporting

Netherlands Ministry of Finance/Justice Business centric model

Singapore Accounting & Corporate Regulatory Authority

Mandatory filing for all registrants

Korea Financial Supervisory Service/DART Mandatory filing for all registrants

Note The IFRS XBRL Taxonomy 2008 is expected to be final by the end of June.

AUSTRALIA

Engaging with the boardsNational accounting boards still have an important role to play in engaging with their local community even though the International Accounting Standards Board (IASB) has assumed standard-setting responsibilities for IFRS countries around the world, according to Professor David Boymal, chairman of the Australian Accounting Standards Board (AASB).

‘The main reason we seek comments from entities,’ he told World Watch, ‘is to ensure that all relevant issues are on the table when we discuss IFRS proposals at our board meetings and roundtable events. We encourage people to attend our board meetings and participate in our roundtables, we even encourage them to just telephone – it really doesn’t matter how we get their comments, it is just so important that we do get them.’

One of the companies that is actively engaged with both the Australian and international boards about their proposals is the QBE Insurance Group, Australia’s largest international general insurance and re-insurance company. ‘QBE has always taken the view that it should get involved and be active in the regulatory and accounting standard-setting process,’ said Neil Drabsch, CFO of QBE. ‘I think it is important that all companies take an active interest in the accounting standards. It is better that concerns about an accounting proposal form a common voice, rather than a lone one, and it doesn’t matter whether you are a large company or a small one – your voice will be heard.’

Mr Drabsch believes the boards are listening. ‘I think over time they are getting better at listening and appreciating what corporate entities have to do to apply the standards. I understand that regulators must look at trying to establish “best practice” to develop standards that meet a common overall aim, and unfortunately that process is not going to satisfy everyone.’


One year on from the announcement that Korea will adopt IFRS from 2011, Korean companies are ‘waking up’ to the realities of the change, according to a recent survey of CFOs and finance personnel conducted by PricewaterhouseCoopers in Korea.

The majority of respondents acknowledged that transition to IFRS will enhance transparency and comparability of Korean company reporting in the global capital markets. Half the respondents expected IFRS to bring long-term benefits to their company, while 67% expected it will bring long-term benefits to the Korean economy.

However, many respondents were concerned about the challenges and complexities that the transition to IFRS presents. More than 64% of respondents said consolidation was the most significant challenge in making the change to IFRS. This is perhaps not surprising, as currently separate financial statements are the main source of financial information, and consolidated financial statements are supplementary. Under IFRS, this will be reversed. The matter is exacerbated by the fact that companies will have to revise the scope of their consolidations and subsidiaries, which is expected to increase volatility in reported earnings.

Another significant concern was the challenge of embedding IFRS into the day-to-day operations of their

organisation, including their people, systems and processes. Many respondents to the survey indicated that their systems and processes will require a significant overhaul.

Educating people about the changes within their organisations was another cause for concern. While almost 90% of financial personnel interviewed were aware that their company faces mandatory IFRS transition on 1 January 2011, there was less awareness outside the finance function – 64% of CEOs, 50% of board directors and 47% of audit committee members had knowledge of the new regulations. There was even less awareness among other employees, and respondents had significant concerns about the training that would be needed and the costs involved.

Inconsistencies between domestic regulations and IFRS were also a worry, despite some developments in harmonisation. Respondents called for Korea’s regulatory body to harmonise domestic regulations with IFRS to smooth the transition process.

‘Korean companies are realising the extent of planning, preparing and resources that they need to complete the change to IFRS,’ said Kevin Kab Jae Lee, PwC’s IFRS leader in Korea. ‘I expect that IFRS transition will remain one of the hottest topics for CFOs in Korea over the next few years.’

KOREA SURVEy

Waking up to the realities of IFRS

KOREA

Korea’s move toIFRSA significant milestone was reached at the end of last year when the Korean International Financial Reporting Standards (K-IFRS) were released, which are a word-for-word translation of the full IFRS issued by the International Accounting Standards Board (IASB). This demonstrates significant progress since Korea’s official announcement of the ‘roadmap to IFRS’ in March last year.

The translation fulfils the due process set out in the IASB’s copyright agreement and includes the IFRS framework, all the standards and the interpretations. The IFRS basis for conclusions and application guidance are also being translated into Korean and are due for release later this year.

The Korean Accounting Standards Board (KASB) and large Korean corporations are now familiarising themselves with the IASB’s standard-setting process and are contributing to the funding of international standards.

Korean listed companies will be required to apply K-IFRS from 2011, although all companies except financial institutions can voluntarily adopt IFRS from 2009. Many have already started IFRS conversion projects in readiness for adoption.

Companies have significant concerns about making the change to IFRS (see Korea survey article) and the large volume of IFRS conferences, seminars, training events and other meetings is an indication of this.

The Korean securities regulator (Financial Supervisory Service) has also established the IFRS International Advisory Committee in January 2008 to support the conversion process, and the Korean government is expected to release revised laws and regulations to endorse IFRS shortly.


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Fundamental changes in Brazilian corporate law (Law 11.638), which became effective at the start of the year, have introduced new content and a different format for Brazilian companies’ financial statements.

The new law has given the Brazilian Securities Commission (Comissão de Valores Mobiliários – CVM) the mandate to develop accounting standards that comply with IFRSs. To fulfil its mandate, the commission has engaged an independent professional body, the Accounting Pronouncements Committee (Comitê de Pronunciamentos Contábeis – CPC), which represents preparers, users and auditors of financial statements as well as academics. The CPC intends to finish all new accounting standards that are needed to allow full convergence with IFRS by the end of 2009. Few standards

have already been issued, but the agenda is full for 2008 and includes financial instruments, business combinations and intangible assets.

‘The changes in accounting principles are being introduced to converge Brazilian GAAP with IFRS,’ said Fábio Cajazeira, a partner at PwC Brazil. ‘The new principles will segregate tax accounting from the financial statements for the first time, which is fundamental to improving the quality of financial statements and achieving full harmonisation with IFRS.’

Many more Brazilian companies will need to prepare audited financial statements. The new accounting principles will have to be applied by all companies with total assets over R$240m (€92m) or gross revenue over

R$300m (€115m), which are now subject to full audit.

The CVM had already announced a requirement for IFRS consolidated financial statements to be prepared as additional information by public companies by 2010 (2009 comparatives). When the changes introduced by the new law are fully implemented, this requirement will be extended to individual companies and large, private companies.

The changes are expected to increase transparency in the financial markets and further improve the competitiveness of Brazilian companies, both locally and against global players. 2007 was an extraordinary year for the country’s capital markets, with 64 IPOs, 2.5 times more than in the previous year (26). Approximately one third of the shares issued were acquired by foreign investors.

‘The changes are welcome,’ Mr Cajazeira concluded. ‘This is a significant step in Brazil’s evolution to become a major player in the global capital markets, now that it has achieved investment grade status.’

BRAZIL

Corporate law change moves closer to IFRS

Japan is on target to eliminate major differences between Japanese generally accepted accounting principles (GAAP) and IFRS by the end of 2008, according to reports from the recent meeting of standard setters from both the international and Japanese Boards in Tokyo.

The Accounting Standards Board of Japan (ASBJ) and the International Accounting Standards Board (IASB) met in April for the second time since their ‘Tokyo Agreement’ in August last year, when they decided to accelerate convergence between Japanese and international standards. IASB chairman Sir David Tweedie reported that discussions at the recent meeting covered key projects that the boards hope to complete before mid-2011, as well as the way in which Japan will converge its standards with IFRSs.

At the meeting, the ASBJ representatives discussed the implications of the credit crisis and updated delegates on progress since the December meeting on both the short-term and longer-term projects, including: consolidation; revenue recognition; insurance contracts’ interaction with other projects; liability and equity; and financial statement presentation.

‘We are pleased that we and the IASB share the understanding of steady progress in line with our project plans,’ said ASBJ chairman Ikuo Nishikawa. ‘We will address the issues to ensure credibility and transparency of the international financial and capital markets.’

The next joint meeting is scheduled for September this year in London.

JAPAN

Convergence with IFRS on targetIFRS for SMEs PwC’s pocket guide on IFRS for SMEs (proposals) provides a summary of the recognition and measurement requirements in the proposed IFRS for small and medium-sized entities (SMEs) published by the International Accounting Standards Board in February 2007.

The definition of SMEs is based on the nature of the entity not its size. The standard will apply to entities that publish general-purpose financial statements for owners and the local tax authorities, not for entities with securities traded in a public market or that hold assets in a fiduciary capacity.

The guide is written for those who have little or no knowledge of full IFRS, but who have a reasonable understanding of basic accounting concepts and terminology.

IFRS for SMEs (proposals) – Pocket Guide 2007 is available on www.pwc.com/ifrs


BIG FIRMS

CEOs call for more principles-based accounting standardsThe discussion paper on principles- based accounting standards that was released jointly by the six largest accounting firms has stimulated significant discussion in the last few

months, as was intended (see opinion article on page 15). The paper proposes a framework for discussion that highlights the importance of accounting standards that align with economic reality, are responsive to users needs and recognise the necessity of using appropriate professional judgement.

The paper was released earlier this year at the fourth Global Public Policy Symposium, in New york when 250

senior executives discussed how collaboration will help maintain healthy global capital markets.

The CEOs recognised in the paper that the behaviour of all market constituents will have to change to deliver less complex and more principles-based standards. To this end, they have encouraged market participants to challenge standard setters through the public comment process.

Too complex

A focus on principles-based standards will help in the effort to reduce unnecessary complexity in accounting standards. Business transactions are complex, but today’s financial statements have reached the point that even the largest companies struggle to get them right and make them meaningful, and even sophisticated investors struggle to fully understand them.

Reflect economic reality

Principles-based standards, the paper says, should also encourage preparers, auditors and standard-setters to achieve financial reports that more closely reflect economic reality. Some argue that reflecting economic reality will cause more income statement volatility. The fact is that economic

volatility is a market reality. Rather than using detailed rules to obscure this volatility, investors and all stakeholders will ultimately be better served by having access to clearer information about volatility that actually exists. If investors come to accept volatility as normal, it could create a shift in mind-set that de-emphasises short-term earning measures and puts greater emphasis on the underlying fundamentals that drive the business value.

Transparency is essential

Financial reports prepared using principles-based standards require transparent disclosure to ensure investors understand and have confidence in management’s judgements. Financial statements must also be prepared with the end user – the

investor – in mind and should include information that they need to compare companies, such as: the underlying cash flows of transactions (to help users to predict future cash flows); the fair values of assets and liabilities (and how they change); key judgements.

Embrace judgement

Preparers and auditors of financial statements must put more emphasis on the exercise of professional judgement to faithfully report the economic consequences of transactions. They must feel confident that fundamentally sound and well-documented judgements will not be subject to unwarranted second-guessing.

www.globalpublicpolicy symposium.com

It is time for multinational companies in Taiwan to begin preparing IFRS financial statements because ‘the IFRS tide has become irresistible’, according to Joseph Chou, PricewaterhouseCoopers partner in Taiwan. He argued in the Taiwan Commercial Times earlier this year that IFRS reporting is essential to be internationally comparable and be able to attract financing in international capital markets.

Currently, Taiwan uses the IFRS framework for setting its new accounting standards, but it has not fully adopted IFRS. It is in the process of bringing its accounting closer to IFRS in several areas, including:

Expensing stock-based compensation•

Gradually adopting consolidated •financial statements

Changing the method used to •value inventories

Updating the accounting for all •insurance contracts

Revising the treatment of all •financial instruments

However, it appears that significant differences emerge in practice for several reasons. First, IASB interpretations are not necessarily adopted in Taiwan because they fall outside the scope of national standards. Second, government regulations can make application inconsistent with IFRS, for example on accounting for employee bonuses. And finally,

different corporate practices give rise to differences – purchase price allocation in a business combination, for example, is normally dealt with internally in Taiwan, which tends to yield different results to elsewhere.

According to Mr Chou, Taiwan-based companies that have already converted to IFRS, have found that the largest differences to national GAAP were in consolidated statements, revenue recognition, corporate M&A, financial instruments and disclosures. ‘Taiwanese companies may have no choice but to go along with adoption of IFRS to maintain their competitive edge,’ said Mr Chou. ‘It is time to follow international trends and not be left on the sidelines.’

TAIWAN

Will companies go with the ‘irresistible tide’?

Key messages in the CEOs’ whitepaper


OPINION

Principle-based standards – where next? Emotive terminology may have delayed progress on simpler standards that really work for companies and for their investors, argues UK regulator Ian Wright. Let’s get on with putting the vision into practice before it’s too late

Many column inches have been written asserting that IFRSs are principle-based standards and that their US counterparts are rule-based. The reality, you may be surprised to learn, is rather different. Both sets of standards start with very similar fundamental principles about the provision of relevant,

reliable information to support economic decision making. yet even this proposition could be considered a rule that identifies one purpose for financial statements above all others.

So what is the real debate about – are we all at cross purposes and missing the point?

Principle-based and rule-based are in fact code for the historical outcomes of the standard-setting process. IFRS standards have higher-level rules for a relatively wider group of transactions and balances, compared to US GAAP, which has far more detailed rules, many of which apply to relatively narrow types of transactions.

One consequence of this difference is the size of the pile of literature. IFRS fanatics point out that the whole of IFRS can be captured in a single book (albeit with ever-reducing paper thickness), while their US friends don’t actually know the thickness of the full pile of paper – there are so many different sources of what has become US GAAP.

Less emotionIf we were to use the ‘higher-level rules’ and ‘more-detailed rules’ language to describe our visions, might we reduce some of the emotion that surrounds the difference in style and approach between the US and non-US worlds? I hope so. The initiative by the CEOs of the major audit firms when they published a joint treatise on principle-based standards (see page 14) could be a turning point because it is acting as a catalyst for more detailed discussion. But what is missing is a clear vision of what should be happening next!

That paper talked primarily about outputs consistent with higher-level rules – standards that apply to a broad range of similar transactions with few exceptions, if any. But in one regard there may be some confusion and we may not yet have a meeting of the minds. The CEOs called for principle-based standards that require the use of judgement, but this doesn’t quite capture what will benefit the market most. you might think that more detailed rules mean that there is less need for judgement because everything is spelled out. However, this is not the experience in the US,

where the complexity of rules means that experts spend huge amounts of time assessing ‘when’ to apply which rule, rather than ‘how’ to apply them, because there are so many rules that apply to a narrow set of circumstances. This, if you like, is the wrong kind of judgement – it is better to have higher-level rules and for the judgement to be around ‘how’ best to apply them.

More simplicityFaced with a choice of a simple high-level rule or a complex requirement to assess many factors, I suspect that the vast majority of finance directors and investors would choose the former without hesitation. We need to remind ourselves that the most common purpose of accounting standard setting is to help companies raise capital at a reasonable cost and for investors to identify the most rewarding investment providing a reasonable return. If these two parties quickly agree that a simple rule can do the trick, it would seem bizarre for any other parties to stop this happening.

Of course business transactions are often highly complex and similar economics can be captured in different legal structures, so it is highly unlikely that a simple rule (which many will describe as a principle) will be available every time. For example, what we know from experience is that we can’t write a simple rule that can be applied to determine whether a company controls another entity and so should be consolidated. So we need to agree a vision for how and when it is necessary to abandon a search for a simple rule and instead to describe the characteristics that need to be evaluated using judgement brought to bear by experienced management and auditors.

All this may seem somewhat academic, but actually it is deadly serious. The prospect of the US market moving to IFRS has become a reality, and many now characterise the debate as being about ‘when’ rather than ‘if’ that happens. US stakeholders are likely to have difficulty in understanding the culture that has been embedded in the vast majority of IFRS standards (IAS 39 being a notable exception) and we need to get agreement on the style of future standards before an excessive amount of US GAAP history gets adopted as if it is IFRS guidance.

If the major firms could produce a few high-level examples of their vision for principles-based standards within the next few months, there is the potential to progress this debate before more detailed rules get locked into future IFRSs – it will be really hard to recover lost ground at a later date.

Ian Wright is the director of corporate reporting at the Financial Reporting Council, the UK regulator. He was formerly a partner at PricewaterhouseCoopers.

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OPINION

It could pay to keep up on pension changes Expect a heated debate on accounting for pensions. The IASB has kickedoff with proposals for significant change, and if you want to influence the discussion you need to get involved now, argue Richard Keys and Richard Davis

There are some problems in accounting that refuse to go away. There have been arguments about what to do with deferred tax, goodwill and the impact of changing prices for decades, and accounting for pensions is another subject one might include in that illustrious list. Post-retirement benefits, including pensions, are on the IASB agenda and in March the board issued a discussion paper representing its first proposals for significant change in this area.

At this stage, the IASB’s aim is to eliminate some of the deferred recognition and smoothing mechanisms permitted or required by the current standard, IAS 19, and to address perceived problems in respect of plans that have features of both defined benefit and defined contribution.

Deferred recognition to go?Some would argue that getting rid of the deferred recognition options allowed under IAS 19, in particular the ‘corridor approach’ to recognising actuarial gains and losses, is an overdue and much-needed fix to ensure a meaningful balance sheet. The approach of recognising actuarial gains and losses immediately was adopted in the UK some time ago. At the time, many plans were falling into deficit after a prolonged period of surplus, which made the new standard unpopular with the corporate community. Immediate recognition was introduced into IAS 19 in 2005, but only as an option, with the result that most European companies and a minority of UK companies include some other number in their balance sheet that bears little discernable resemblance to the current surplus or deficit in the pension plan.

Smoothing considered inappropriateEqually, many would say that recognising an assumed rate of return on plan assets in the income statement, irrespective of the actual return, does not reflect reality. When equity markets fell in the aftermath of the dotcom boom, there were many examples of companies recognising an expected return on plan assets that was greater than their disclosed profit (or loss) for the year. Furthermore, if estimates prove to be on the high side, the bad news gets reflected in equity and does not impact on the income statement.

Where should the expense go?The next question addressed in the discussion paper is where the resulting pension expense should be recognised – an expense that is potentially large and highly volatile. Various models are being considered, ranging from recognising everything in the income statement to recognising only certain items. A common feature of all of the proposals, however, is that more of the components of pension expense would be reflected in the income statement. Whether this would increase or reduce profit or loss would depend on

market movements and how good actuaries’ predictions have been.

Is it fair to fair value?Finally, the IASB proposes a radical new approach to pension plans that have features of both defined contribution and defined benefit plans. So called ‘contribution-based plans’ entitle a member to benefits that are expressed in relation to a contribution, for example a percentage of current salary plus some form of indexation or return, such as the return on a pool of assets or a stock market index.

The discussion paper proposes that obligations in respect of such plans should be measured at fair value. This could have significant practical implications. If fair value means exit price – and there have been indications from other IASB projects that that is a likely direction of travel – then this might be equivalent to the cost of buying an annuity from an insurance company. In many countries, the mortality assumptions used by insurance companies are more conservative, or perhaps less optimistic, than those used by pension funds, and the yields underlying annuity contracts are seldom as high as the high-quality corporate bond yields. So the value placed on a pension liability from a contribution-based plan could be considerably higher than the value placed on the same pension payable from a defined benefit plan.

What next?These proposals represent the first phase in the IASB’s project. An important topic not yet addressed is the measurement of defined-benefit obligations. A discussion paper issued in January by the European Financial Reporting Advisory Group (EFRAG) and certain European standards setters – under the auspices of the Pro-active Accounting Activities in Europe (PAAinE) – has suggested that pension obligations should be measured using a risk-free rate rather than the corporate bond rates currently used.

Some actuaries estimate that this change could add as much as 25% to pension plan liabilities and significantly increase reported deficits. But if the fair value model proposed for contribution-based plans was to be applied to all defined benefit plans, the impact could be even greater.

Although the IASB’s discussion paper represents only the first step on what could be a very long road towards a new accounting standard, those who want to influence the debate will need to get involved now.

Richard Keys is the global chief accountant at PricewaterhouseCoopers. Richard Davis is a pension specialist in the Global Accounting Consulting Services group at PwC.

News & Opinion

Reporting of executive pay can be a battleground between companies and shareholders. Many remuneration reports are framed to disclose no more than the law requires. However, research on this topic by PwC suggests that mere compliance with regulatory reporting requirements is unlikely to build trust between companies and their shareholders, or provide insight into the business drivers of executive remuneration.

It is not only shareholders who challenge this state of play. In the US, SEC chairman Christopher Cox commented that investors ‘should not need a machete and a pith helmet to go hunting for what the CEO makes’. He added that the compensation disclosure and analysis provided is often ‘as tough to read as a PhD dissertation’. This has become an area of international concern. Some argue the problem stems from the fact that it is often unclear who owns the remuneration report – is it the CFO, HR director, company secretary or chair of the remuneration committee?

Clarity around how remuneration policies align executives’ interests with those of the shareholders is also often lacking. Findings from recent PricewaterhouseCoopers’ research of the FT Global 500 companies illustrate the gaps in this alignment. The top global companies in the US, Europe, Australia and Canada commonly report on executive pay, but there is only a limited link between

the measures used to assess executives’ performance and the key performance indicators used to track progress against strategic objectives. In Japan and developing markets these links are seldom provided (see chart).

Practical ideas for addressing these issues are available in ‘Generico’, a fictitious annual report developed by the multi-stakeholder Report Leadership group. The group sees executive remuneration as the next key area for improvement.

The same group has published the executive remuneration report, which focuses on disclosure and presentation, and continues a core theme using the company’s strategy to underpin its reporting, through alignment of executive pay components to strategic goals and the KPIs used to assess progress towards those goals.

Presentation of information is made clearer, says the report, by taking a three-level approach:

At a glance – high-level •messages in the letter from the remuneration committee’s chair, with a synopsis of key qualitative and quantified information.

Remuneration explained – •the company’s approach to remuneration, key building blocks, current year performance and expected future changes.

Remuneration in detail – •comprehensive disclosures required by local regulations combined with best practice disclosures

‘If the thinking in the paper is taken to heart, we believe fewer institutional investors will be inclined to vote against remuneration reports in the future,’ said PwC’s Sean O’Hare. ‘There may even be an added bonus – public company pay packages to rival those in private equity’.

Contact: [email protected]

REMUNERAtioN

The ‘hunt’ for executive pay

Broader Reporting

Companies’ executive remuneration and reporting of key performance indicators (KPis) by region

There are wide regional variations in reporting executive remuneration, and in links between executive performance measures and KPIs

US

Japan

Europe, Australia & Canada

Developing Markets

All FT Global 500

0 20 40% of companies

60 80 100

Executive remuneration performance measures same as KPIs

Different executive remuneration performance measures

No KPIs reported

No executive remuneration reporting

Base: 483


SURVEy

CEOs want government action on climate changeDespite the ongoing and highly visible debate over global warming, it appears it is not an issue keeping many CEOs up at night. Of the 1,150 CEOs in 50 countries interviewed for PricewaterhouseCoopers’ 11th Annual Global CEO Survey, only 34% say that climate change is a cause for concern, with the remainder believing it was not a threat to their business. In addition, only 37% of the respondents said their organisation was investing significant resources to address the risks and opportunities presented by climate change; however, this number increased to 56% among large organisations with a turnover of more than US$10 billion a year.

While the majority of companies interviewed might not be heavily proactive in helping to tackle climate change, four-fifths were supportive of greater government regulation to address the problem – a stark difference to their usual cry for less government regulation on other issues. Support for increased government intervention was highest among CEOs in Asia, at 90%, and lowest in North America, at 64%.

CEOs also favoured collaborative efforts to alleviate climate change. Overall, 73% of CEOs believed that businesses need to collaborate more effectively with industry peers and business partners to mitigate climate change. This number rose to 82% in Asia Pacific and declined to 58% in North America. There was also a strong push for developed countries to adopt more of the responsibility and greater share of the

costs to reducing climate change than developing countries, with three quarters of the respondents agreeing to the statement.

‘I feel it’s wrong to expect developing countries to take the lead,’ said Akhil Gupta, managing director of one of India’s leading business groups Bharti Enterprises. ‘Since energy is an expensive commodity, I think there is plenty of incentive for every company in every industry to use it more efficiently.’

Views on regulation

Only 26% of CEOs believe that •their governments are creating a business-friendly environment.

Most CEOs agree or strongly •agree that governments should drive convergence of global tax and regulatory frameworks – only 17% oppose the idea. The UK significantly bucks this trend with 37% against the idea.

CEOs are almost evenly divided on •whether the regulatory framework is designed on the assumption that companies will act without integrity.

57% of CEOs believe that •governments have not reduced the regulatory burden and only 18% think they have.

To find out more about how CEOs around the world are viewing climate change as well as other key global business issues, visit www.pwc.com/ceosurvey.

UK

New code of practice for carbon offsets

In February, the UK Department for Environment, Food and Rural Affairs (DEFRA) announced a voluntary Code of Best Practice for carbon offsetting, with a new quality mark to be launched later this year.

DEFRA ruled that, for the time being, only Kyoto-compliant credits issued under the Clean Development Mechanism and Joint Implementation will meet the quality mark. This was in spite of heavy lobbying by many involved in carbon markets during the consultation process, who suggested that the code should include a broader set of voluntary offset standards rather than focus on the compliance grade credits. However, DEFRA has left the door open for voluntary credits by agreeing to review their decision when there is more experience in the market and industry consensus around a rigorous standard for offset projects.

‘We fully support DEFRA’s goal of building confidence in the voluntary market – the voluntary carbon market is an important market in its own right,’ said Richard Gledhill, PwC climate change partner. ‘Public and media concern about the rigour of the projects that underpin this market is justifiable – there is a real risk that low-quality projects will undermine public confidence in the use of both voluntary and compliance carbon markets to achieve reductions in greenhouse gas emissions.

‘However we are not persuaded by the case for a national standard in what is already an international market, and we are concerned that the focus on compliance grade credits may exclude many worthwhile, smaller projects, particularly in the poorer countries that face some of the biggest challenges from climate change.’


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AUSTRALIA

Executives not yet up to speed on climate change

ENVIRONMENTAL SOCIAL AND GOVERNANCE

ESG indicators hit capital markets radar

Australian business leaders admit that they have not taken steps to address climate change risks to their business, according to a PwC survey of senior executives. This is particularly significant in the context of significant developments taking place in Australia that are expected to happen quickly.

Businesses will have to keep pace with developments such as:

Mandatory emissions and energy •consumption reporting

2020 emissions targets, underpinned •by detailed environmental and economic analysis

Consultation with government on the •design of an emissions trading scheme

Nick Ridehalgh, PwC partner, told World Watch: ‘I expect this year to be a watershed for Australian businesses who are entering the emerging carbon economy and laying the foundations now for their carbon management strategy. This is happening against a background of rapid change both globally and locally.’

According to the survey – Carbon Countdown: A survey of executive opinion on climate change in the countdown to a carbon economy – 98% of the 303 Australian leaders managing businesses

with turnovers greater than A$150m admitted they are yet to implement a strategic response to address the risks of climate change to their business.

This was due to the fact that very few were clear on what the risks really were. More than 70% said they do not understand their company’s climate change obligations, while 78% have yet to formally assess the climate change risks that will impact on their business.

For more information visit www.pwc.com/au/climatechange or contact Nick Ridehalgh by email: [email protected].

The importance of environmental, social and governance (ESG) indicators for our capital markets is becoming increasingly evident. This is reflected by growing pressure from major superannuation funds and investment funds through mechanisms such as the UN Principles of Responsible Investment and the Carbon Disclosure Project, as well as increased recognition that understanding key ESG indicators can give significant insight into how a company is performing.

PwC’s global research tells us that the capital markets have in the past been sceptical of governance, CSR

and sustainability reports because companies have not properly aligned the additional information with their corporate strategy nor explained its medium-to long-term value effectively to their key stakeholders.

Now, the strength of the debate on climate change and the potential impact of a carbon-constrained economy has become a catalyst for a closer review of a company’s longer-term sustainability practices, and improved management, monitoring and reporting of key non-financial data that act as lead indicators to the company’s longer-term sustainability.

In Australia, specialist research organisations are becoming increasingly focused on more in-depth analysis of the ESG performance of the top 200 Australian companies. Regnan, for example, was originally established by BT Investment Management in 2002 and now is partnered by eight of the largest superannuation funds to undertake such ESG research. Their work assists superannuation funds, fund managers and analysts to better understand the longer-term implications of key ESG indicators on the sustainability of corporate earnings.

Major investment houses such as Goldman Sachs JB Were also have

dedicated ESG analyst teams, which use ESG research directly in their valuation models or as input to their risk assumptions.

ESG reporting framework

In an effort to improve the quality of ESG reporting, PwC Australia has developed a proposed framework for a fictitious company, Generico, to help organisations better explain how their ESG performance is integrated into overall corporate reporting. The framework, published in Best Practice Environmental, Social and Governance (ESG) Reporting, is based on the following four premises:

Clear alignment of key ESG metrics to •corporate strategy

Long-term targets and measurement •of performance over time (trends)

Transparent and candid reporting •against ESG milestones

Quantification of financial returns, •where possible, from ESG activities through integrated corporate reports

The best practice ESG report can be downloaded from www.pwc.com/au/corporatereporting. You can find out more about Regnan’s research at www.regnan.com.au.


AUSTRALIA

Transparency awards for charities

China launches its first social responsibility index

The Good Egg Awards 2008

PGGM makes commitment to microfinance

Swiss sustainable investment market continues to grow apace

The Juvenile Diabetes Research Foundation (JDRF) in Australia is the winner of the inaugural Australian Transparency Awards, introduced to help encourage measurable accepted benchmarks and consistency in reporting across the not-for-profit sector. A relatively young organisation, the Australian Community Support Organisation (ACSO), was named as runner-up.

The awards were set up by PricewaterhouseCoopers in collaboration with the Institute of Chartered Accountants in Australia (ICAA), because now, more than ever, not-for-profit organisations need to present a clear and complete picture of their performance and future prospects if they are to raise public and private funding to support their stated cause. Currently, these organisations are in a challenging environment. They lack a consistent reporting framework for their sector, cope with fierce competition for donations, and face an economic climate that is putting pressure on interest rates and discouraging discretionary spending.

The judging process included an extensive review by PwC and the ICAA reporting experts as well as consideration by a four-member judging panel and final deliberations by an external jury.

For more information, including the full Jury Report on trends and reporting issues across the Australian NFP sector, visit www.pwc.com/au/transparencyawards2007

Shenzhen Securities Information (an affiliate to Shenzhen Stock Exchange), in partnership with Tianjin TEDA have signed an agreement of cooperation to launch the TEDA Environmental Protection Index. The Index is made up of 40 ‘A-share’ companies, representing ten industries that are regarded as leaders in terms of social or environmental performance. The

Index is listed alongside other indices on the Shenzhen Stock Exchange.

The aim is to allow domestic and foreign investors to monitor performance of Chinese companies with proven records of energy conservation and environmental responsibility, against mainstream indices.

‘A good egg’ – formerly a rather old fashioned English expression for a reliable person – has now taken on a more modern spin. ‘Good eggs’ today are companies focused on making a difference to the welfare of laying hens by switching to cage-free eggs.

The biggest award winners at the ‘Good Egg’ awards this year were multinationals McDonald’s and Unilever with other major winners including Sodexo Belgium, Carrefour Belgium and Restaurant Associates in the UK (part of Compass Group). In the public sector category, the European Parliament also won an award.

Is this an indication of where future corporate transparency will go?

www.thegoodeggawards.com

PGGM, the €88bn ($139bn) asset manager of the Dutch healthcare pension fund, is making one of the world’s largest institutional commitments to microfinance, announcing an investment of €200m with specialist fund managers over the

next two to three years. The aim is to advance economic development through small-scale entrepreneurship in developing countries. The initial allocation will make investments in microfinance projects in Africa, Asia, Latin America and Eastern Europe.

The market for sustainable investments in Switzerland continued its strong growth in 2007 according to research by onValues. In spite of financial market turbulence, the total market volume increased by 67% in the period between end of 2006 and end of 2007, reaching a volume of CHF30 billion (CHF34 billion if assets managed in

Switzerland on behalf of foreign clients and subsidiaries are included). Assets managed in sustainable funds and other collective vehicles grew 92% in the same period, while the total Swiss fund market saw its volume decrease by 1%.

www.onvalues.ch


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Banking sector not yet integrating climate risks

Gaps in GRI guidelines for the food processing sector

Banco Itaú launches award for journalists and academics

Ethical trading on the rise

Too many stories and not enough strategies

According to a report published by Ceres earlier in the year, the banking sector has been slow to address the challenges posed by climate change. The Ceres’ analysis of the top 40 largest banks found that ‘...only a handful have begun integrating climate risks into their core business of lending by pricing carbon into their finance decisions or setting targets to

reduce greenhouse gas emissions in their lending portfolios’.

The financial institutions were scored between 0-100 against good practices criteria. The top three scorers were: HSBC (with 70 points), ABN Amro (66) and Barclays (61).

www.ceres.org

The Global Reporting Initiative (GRI) is to develop a Food Processing Sector Supplement after research on trends in sustainability reporting among food processing companies revealed a number of sector-specific issues that regularly appear in reports, but are not currently covered in the GRI Guidelines.

The GRI-led study, which included an overview of 60 food processing reports

for 2006, identified that sourcing and supply chain issues, environmental aspects of agriculture, food safety, health and nutrition, animal welfare, packaging and transportation were all high-frequency themes covered in the sector’s sustainability reports. The supplement is expected to be launched in 2010.

www.globalreporting.org

The Itaú Award for Sustainable Finance initiative aims to reward the production of news stories and academic papers on sustainable finance to stimulate focused debate. It is supported by the SustainAbility and the Instituto Ethos The winner of each category will receive a cash prize.

www.sustainability.com

Currently, fair-trade sales are worth £400m a year in the UK, and the initiatives of ethical trading are continuing to grow, with an increasing number of companies taking it up on a large scale. For instance, the UK’s sugar conglomerate Tate & Lyle has announced that it is going to move its entire retail cane-sugar range to fair-trade by the end of 2009. According to Ethical Performance magazine, this will be the largest switch to the ethical labelling programme by any major UK food or drink brand. The company has estimated that this scheme will create a return of at least £2m ($4m) in fair-trade premiums for cane farmers around the world.

The UK’s Co-operative supermarket, which has already gone fair-trade on coffee and it own-brand chocolate, is to switch all of its own-brand hot drinks to fair-trade. At present the company is selling 180 fair-trade products. Another large UK food retailer, Sainsbury’s has announced it will change its own brand of tea and coffee to fair-trade over the next three years.

Companies using the GRI reporting framework are failing to articulate how sustainability strategies are likely to affect their business performance, according to Sean Gilbert, the GRI technical development director. The GRI guidelines require all companies to ‘provide a high-level, strategic view of the organisation’s relationship to sustainability’ through their sustainability statement, but in practice some companies are not doing this.

The aim of the statement is to provide an insight on strategic topics rather than simply summarise the content of the report. Mr Gilbert told Ethical Performance magazine in April that companies should ‘focus on the issues of long-term importance and those fundamental to enabling them to operate, and to make a connection between the value that a company creates and its environmental, social and governance activities’.


As the issue of climate change remains in the public eye, an increasing number of companies are turning to the Carbon Disclosure Project (CDP), which gathers information from leading companies, for assistance with improving their sustainability. The CDP makes the information it gathers from corporations publicly available, which helps to catalyse the activities of policymakers, consultants, accountants and marketers.

Questions askedIts latest initiative was to send out a questionnaire to thousands of companies in February this year. The final results of the survey are due in September and are expected to give significant visibility and accountability to all those taking part, as well as important information for investors. Response rates are already high, which indicate that an increasing number of companies are feeling the growing pressure to treat

climate reporting as part of their normal business practices.

Collating information for the CDP questionnaire provides newcomers to this kind of reporting with a good starting point to make the initial assessment and to begin the process of collecting relevant data on the carbon emissions. For those already participating, it enables them to take a step further and consider the strategic implications. The questionnaire contains quantitative as well as qualitative information, and so enables companies to take a holistic look at climate-related risks, opportunities and management strategies.

Pressure won’t let up‘We can expect the pressure for more, and better, disclosure by businesses to continue,’ said PwC sustainability partner Thomas Scheiwiller. ‘The political

and media focus on this topic is not going to let up.’ This pressure is increasingly being applied in emerging markets – this year, for example, the CDP’s request for information has gone for the first time to China’s 100 largest companies. There are also plans for the CDP to launch new operations in South Korea and Latin America.

The fact that Merrill Lynch has recently agreed a three-year global partnership with the CDP to support its development in China and elsewhere, indicates that investors want this kind of information and are taking it seriously. CDP CEO Paul Dickinson said: ‘This global partnership will help the CDP to build on its current success in creating a unified business response to climate change. As regulations on greenhouse gas emissions tighten, CDP data will become increasingly useful to help guide investment models.’

CARBON DISCLOSURE PROJECT

Pertinent questions on carbon are getting answers

The CDP is an independent, not-for-profit organisation that aims to create a lasting relationship between shareholders and corporations around the implications of climate change for shareholder value and commercial operations. Its activities help give insight into areas where there is scope for reducing emissions. Companies also use the process of responding to

its questionnaires as a tool for benchmarking themselves against their competitors.

On behalf of institutional investors such as AXA, ANZ and HSBC, CDP seeks information from the world’s largest companies on the business risks and opportunities associated with climate change and greenhouse

gas emissions. It has collected data from over 3,000 companies and is seen by some as the ‘gold standard’ for carbon disclosure methodology and process. Its website is the world’s largest repository of corporate greenhouse gas emissions data.

For further information see: www.cdproject.net

What is the Carbon Disclosure Project?

ARGENTINA

Buenos Aires mandates sustainability reportingThe new governors of the City of Buenos Aires have passed new legislation (not yet implemented) mandating sustainability reporting. This new piece of legislation, referred to as Law 2.594, will require companies with more than 300 employees and a legal address in the capital to publish an annual sustainability report based on their social, economic and financial sustainability.

As a minimum, companies will have to report in line with the Instituto Ethos guidelines, a leading Brazilian CSR

organisation. In addition, they will be encouraged to draw on the Global Reporting Initiative G3 indicators in the preparation of these reports. It has been estimated that approximately 100 companies will be affected, including: Telecom Argentina, BBVA Banco Frances, Cresud and MetroGas.

Smaller companies (those with fewer than 300 employees) will be encouraged to voluntarily adhere to the reporting guidelines. In return for their transparency they will be eligible for financial benefits, such as promotional

soft loans and technological investment incentives. The Production Ministry of the City of Buenos Aires has been tasked with implementing the new CSR law and monitoring progress with help from other ministries such as those for the environment, urban planning, and finance.

This development follows in the footsteps of the recent announcements by both the Swedish and Chinese governments that have both mandated sustainability reporting for state-owned companies in their territories.


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Getting to grips with non-GAAP measures

For companies to report just the GAAP information required by regulators simply doesn’t cut it in today’s markets. Companies recognise this and frequently report a variety of non-GAAP numbers to try to meet investors’ and other stakeholders’ need for a clear understanding of what the business has been doing.

To help companies evaluate the effectiveness of their current non-GAAP reporting, we have summarised some current practices and what investors have to say about it, as well as shared a couple of live examples of good practices.

What companies do with their non-GAAP reporting

The majority of company executives support the use of non-GAAP numbers in their financial statements, according to PwC’s research last year – Performance statement: coming together to shape the future. Corporate respondents also support the idea that certain ground rules should be followed, such as providing clear definitions of non-GAAP information, explanation of why it is relevant and reconciliation back to GAAP numbers.

When we looked at non-GAAP income measures that companies included in their 2005 financial statements, we found that 44% of companies in Europe’s largest capital markets reported additional income measures excluding depreciation and/or amortisation (EBITDA and similar measures) somewhere in their financial statements. There were clear national trends: 59% of companies in Germany, for example, reported these measures, while only 32% in the UK did so.

There are also strong industry variations for EBITDA and similar measures, indicating that companies are already responding to investor demands for international comparability within industry sectors. For example, 70% of information/ communications companies in Europe reported these measures, but only 12% of FS companies (see chart page 24). Across eight European countries, 10% of the companies surveyed included these measures on the face of the income statement.

There is considerable variation between companies in what they include on the face of the income statement.

Embrace non-GAAP measures in your corporate reporting, David Phillips advises, but it is increasingly important to follow certain ground rules so that the information sheds light and not ‘noise’

What investors and analysts think‘I like non-GAAP measures: they help me increase my understanding of the underlying performance of the business’

‘Not that many companies would use non-GAAP measures to portray a negative impression of a company’

‘We need standard definitions for EBITDA’

‘I think companies should be required to be consistent in their non-GAAP measures’

‘It is incredibly important to get a bigger sense of what’s going on in the marketplace’

‘I think the annual report should be management communicating to shareholders and other stakeholders what the business has been doing – you will never do that satisfactorily in pure GAAP measures’


The number of line items in Europe in 2005 varied between 8 and 48, while the range of subtotals showing revenues plus or minus certain items varies from 2 to 8. In the US last year, the majority of company executives did not think non-GAAP numbers should be allowed on the face of the primary statements, while those from the rest of the world are ambivalent.

Visual presentation of non-GAAP measures tends to vary by country as well. A significant minority of companies present non-GAAP measures in additional columns or boxes – this is most common in the UK where 24% use separate columns and 20% use boxes and sub-analysis on the face of the income statement.

What do investors think about non-GAAP information?

The use of non-GAAP information is perceived by investors to be pervasive in the communication of corporate performance, and there is considerable support for its use. It is seen as a valuable mechanism for addressing the inherent tension between GAAP reporting and a company’s particular facts and circumstances.

Very few respondents from the investment community think non-GAAP numbers should be banned. However, there is strong support for ground rules on their use – with particular value placed on reconciliations to GAAP. A majority also think non-GAAP numbers should be marked as non-GAAP and as unaudited where that is the case. They would also like to see definitions given.

The majority of US investors and analysts surveyed, just like the company executives, think non-GAAP numbers should not be

Diploma, the international group of specialised distribution businesses, leverages innovative communication techniques to explain better its financial performance.

In this example, the group’s alternative performance measures are clearly identified in box-outs on the face of the primary statements.

Diploma annual report 2007

GOOD PRACTICE (CONTINUED)

EBitDA and similar measures in financial statement by industry

Technology

Infocom

Entertainment & media

Real estate

Financial services

Energy, utilities & mining

Services

Retail/wholesale

Production/construction

%0 10 20 30 40 50 60 70 80 90 100

Base: 1,300 companies in 2005

Source: Presentation of income under IFRS: flexibility and consistency explored, PwC 2007

2007 2006Note £m £m

CASH FLOWS FROM OPERATING ACTIVITIES

Cash flow from operations 19 23.0 20.9

Finance income received 1.1 1.0

Tax paid (8.0) (7.1)

NET CASH FROM OPERATING ACTIVITIES 16.1 14.8

CASH FLOWS FROM INVESTING ACTIVITIES

Acquisition of subsidiaries (net of cash acquired) 18 (31.1) (7.0)

Deferred consideration paid 18 (0.5) (1.0)

Proceeds from the sale of property, plant and equipment 0.6 11.0

Purchase of property, plant and equipment 11 (1.6) (1.3)

Purchase of other intangible assets 10 (0.6) (0.1)

NET CASH (USED IN)/FROM INVESTING ACTIVITIES (33.2) 1.6

CASH FLOWS FROM FINANCING ACTIVITIES

Dividends paid to shareholders 7 (5.4) (4.7)

Dividends paid to minority interests 17 (0.3) (0.3)

Purchase of own shares (1.3) (0.1)

NET CASH USED IN FINANCING ACTIVITIES (7.0) (5.1)

NET (DECREASE)/INCREASE IN CASH AND CASH EQUIVALENTS (24.1) 11.3

Cash and cash equivalents at beginning of year 36.7 25.7

Effect of exchange rates on cash and cash equivalents (0.2) (0.3)

CASH AND CASH EQUIVALENTS AT END OF YEAR 16 12.4 36.7

ALTERNATIVE PERFORMANCE MEASURES (note 2)2007 2006

£m £m


Add: Dividends paid to shareholders 5.4 4.7

Dividends paid to minority interests 0.3 0.3

Acquisition of subsidiaries (net of cash acquired) 31.1 7.0

Deferred consideration paid 0.5 1.0

FREE CASH FLOW 13.2 24.3

Consolidated Cash Flow StatementFor the year ended 30 September 2007

The notes on pages 34 to 53 form part of these financial statements.

33 DIPLOMA PLC ANNUAL REPORT 2007

2007 2006Note £m £m

CASH FLOWS FROM OPERATING ACTIVITIES

Cash flow from operations 19 23.0 20.9

Finance income received 1.1 1.0

Tax paid (8.0) (7.1)

NET CASH FROM OPERATING ACTIVITIES 16.1 14.8

CASH FLOWS FROM INVESTING ACTIVITIES

Acquisition of subsidiaries (net of cash acquired) 18 (31.1) (7.0)

Deferred consideration paid 18 (0.5) (1.0)

Proceeds from the sale of property, plant and equipment 0.6 11.0

Purchase of property, plant and equipment 11 (1.6) (1.3)

Purchase of other intangible assets 10 (0.6) (0.1)

NET CASH (USED IN)/FROM INVESTING ACTIVITIES (33.2) 1.6

CASH FLOWS FROM FINANCING ACTIVITIES

Dividends paid to shareholders 7 (5.4) (4.7)

Dividends paid to minority interests 17 (0.3) (0.3)

Purchase of own shares (1.3) (0.1)

NET CASH USED IN FINANCING ACTIVITIES (7.0) (5.1)


Cash and cash equivalents at beginning of year 36.7 25.7

Effect of exchange rates on cash and cash equivalents (0.2) (0.3)

CASH AND CASH EQUIVALENTS AT END OF YEAR 16 12.4 36.7

ALTERNATIVE PERFORMANCE MEASURES (note 2)2007 2006

£m £m


Add: Dividends paid to shareholders 5.4 4.7

Dividends paid to minority interests 0.3 0.3

Acquisition of subsidiaries (net of cash acquired) 31.1 7.0

Deferred consideration paid 0.5 1.0

FREE CASH FLOW 13.2 24.3

Consolidated Cash Flow StatementFor the year ended 30 September 2007

The notes on pages 34 to 53 form part of these financial statements.

33 DIPLOMA PLC ANNUAL REPORT 2007


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Unilever 2006 annual report and accountsUnilever, the international consumer goods group, provides a long-term target for return on invested capital (ROIC) as a key element of its strategy.

The group then provides a section in its annual report on non-GAAP measures, including ROIC. This explains the rationale for using these measures, sets out a definition of each measure and provides reconciliations to relevant GAAP measures.

allowed on the face of the primary statements, while the majority of respondents from the rest of the world think they should.

Investment professionals do not agree on management’s motivation for using non-GAAP numbers so widely. Some interpret their use as management’s effort to ‘spin’ the company’s performance; others consider it a valid attempt to overcome the limitations of GAAP in explaining performance. But even where it is perceived as ‘spin’, non-GAAP information is viewed as a signal about the company’s management and how it views the world. Many say that it is increasingly important because revaluations make it harder to gain a clear view of operating performance.

What developments can we expect?

Reconciling non-GAAP back to GAAP•

Clear definitions of terms used•

Labelling of the non-GAAP numbers•

Companies will continue to report non-GAAP measures in their financial statements that investors find useful, and definitions are likely to become clearer and more consistent.

I expect convergence around the choice and presentation of non-GAAP measures along industry lines to grow, particularly as companies re-evaluate the effectiveness of their non-GAAP reporting to the market in an IFRS environment and compare themselves with peers in the same industry sector.

Convergence will be slower where companies are limited by regulation from responding to market demands. Generally, regulators have acknowledged that non-GAAP measures may be useful, but they tend to have different views about exactly what is appropriate in practice. Further cooperation between regulators, therefore, is clearly needed to avoid enforcing different national preferences or prohibitions and to allow market forces to influence convergence.

Further good practice examples and copies of the surveys mentioned can be found at www.corporatereporting.com. For PwC’s 11 Reporting Tips with a full set of real examples, please e-mail [email protected]

David Phillips is a senior corporate reporting partner at PricewaterhouseCoopers.

Unilever Annual Report and Accounts 2006 5

ReportoftheDirectors

(continued)

About Unilever

Description of businessUnilever is one of the world’s leading suppliers of fast movingconsumer goods across Foods and Home and Personal Carecategories. Unilever’s portfolio includes some of the world’s bestknown and most loved brands.

Strategy and long-term financial targetsAt the heart of Unilever's strategy is a concentration of resourceson areas where we have leading positions and on high growthspaces, especially in personal care, in developing and emergingmarkets and in Vitality. While the focus is on developing thebusiness organically, acquisitions and disposals also have a role to play in accelerating the portfolio development.

To execute this strategy the business has been reorganised tosimplify the management structure and to improve capabilities in marketing, customer management, and research anddevelopment. The result is better allocation of resources, betterexecution, faster decision-making and greater focus on efficiency.The new organisation, augmented by the successful 'OneUnilever' project, allows us to leverage our scale both globally and locally.

Unilever's long-term ambition is to achieve top-third totalshareholder return and our targets reflect this. Over the period2005-2010 we target ungeared free cash flow of €25-30 billion.Disposals made in the past two years, with no significantacquisitions to date, have reduced the cash generation over theperiod by just over €1 billion. Return on invested capital istargeted to increase over the 2004 base of 11%. We expectunderlying sales growth of 3-5% per annum and an operatingmargin in excess of 15% by 2010 after a normal level ofrestructuring of 0.5 to 1 percent of sales.

Key performance indicatorsUnderlying sales growth, operating margin, ungeared free cashflow, return on invested capital and total shareholder return arekey performance indicators for the Group.

In the Operating review on pages 13 to 22 and the Financialreview on pages 23 to 32 we explain why we regard these asimportant indicators of our progress against our strategicobjectives, describe how we calculate them, and report on theresults of these measures for the current and preceding years.

RegionsThree regional teams are responsible for managing Unilever’sbusiness in the regions, and for market operations. They areprimarily responsible for winning with customers and deployingbrand events and innovations effectively. The regions are fullyaccountable for the profit performance of our business, as well as growth, short-term cash flows and the in-year development of market shares.

The Europe region includes our operations in Western Europe and in Central and Eastern Europe, and in 2006 accounted forapproximately 38% of our business on a turnover basis. The Americas region includes our operations in North Americaand Latin America and represented around 35% of our business.Our Asia Africa region accounted for 27% of our business, andincludes our operations in the Middle East, Turkey, Africa, Asiaand Australasia.

CategoriesTwo category teams cover Foods and Home and Personal Care,and are responsible for each category and the brands therein.They are fully responsible for brand development and innovation,including research and development. Categories also lead thestrategic elements of the supply chain and are accountable forlong-term value creation in the business, as measured by marketshare development, category growth, innovation metrics andbrand health.

For more information about our two categories and theirinnovation activities during 2006 please refer to pages 20 to 22.

FunctionsOur five support functions (Finance, HR, IT, Communications and Legal) provide value-adding business partnership, strategicsupport and competitive services to the whole business (especiallythe regional and category organisations). They are organisedaround the model of business partners, shared services andexpertise teams.

Operating environmentWe have a wide and diverse set of competitors in our consumergoods businesses. Many of our competitors also operate on an international scale, but others have a narrower regional orlocal focus.

Competition is a normal part of business. We aim to compete and give value to our consumers, customers and shareholders in three ways:

• by continually developing new and improved products;• by sharing our innovations and concepts with our businesses

all around the world; and• by striving to lower the cost of our sourcing, manufacturing

and distribution processes while still maintaining, andimproving, the quality of our products.

We support efforts to create a more open competitiveenvironment through the liberalisation of international trade. We support the full implementation of the Single European Marketand inclusion in the European Union of other countries that fulfilthe agreed criteria for membership.

Unilever’s products are generally sold through its sales force andthrough independent brokers, agents and distributors to chain,wholesale, co-operative and independent grocery accounts, foodservice distributors and institutions. Products are distributedthrough distribution centres, satellite warehouses, company-operated and public storage facilities, depots and other facilities.

Financial review (continued)

Unilever Annual Report and Accounts 2006 25


(continued)

CautionUnilever cautions that, while UFCF and ROIC are widely used astools for investment analysis, they are not defined terms underIFRS or US GAAP and therefore their definition should be carefullyreviewed and understood by investors. Investors should be awarethat their application may vary in practice and therefore thesemeasures may not be fully comparable between companies. In particular:

• We recognise that the usefulness of UFCF and ROIC asindicators of investment value is limited, as such measures are based on historical information;

• UFCF and ROIC measures are not intended to be a substitutefor, or superior to, GAAP measures in the financial statements;

• The fact that ROIC is a ratio inherently limits its use, andmanagement uses ROIC only for the purposes discussed above.The relevance and use of net profit for the year (being the mostrelevant comparable GAAP measure) is clearly more pervasive;and

• UFCF is not the residual cash available to pay dividends butrepresents cash generated by the business and broadly availableto the providers of finance, both debt and equity.

Underlying sales growth USG reflects the change in revenue from continuing operations atconstant rates of exchange, excluding the effects of acquisitionsand disposals. It is a measure that provides valuable additionalinformation on the underlying performance of the business. In particular, it presents the organic growth of our business yearon year and is used internally as a core measure of salesperformance.

The reconciliation of USG to the GAAP measure turnover is asfollows:

2006 2005vs 2005 vs 2004

Underlying sales growth (%) 3.8 3.4Effect of acquisitions (%) 0.1 0.0Effect of disposals (%) (0.8) (1.5)Effect of exchange rates (%) 0.3 1.4Turnover growth (%) 3.2 3.3

Ungeared free cash flowUngeared free cash flow (UFCF) expresses the generation of profitby the business and how this is translated into cash, and thuseconomic value. It is therefore not used as a liquidity measurewithin Unilever. The movement in UFCF is used by Unilever tomeasure progress against our longer-term value creation goals asoutlined to investors.

UFCF is cash flow from group operating activities, less capitalexpenditure, less charges to operating profit for share-basedcompensation and pensions, and less tax (adjusted to reflect an ungeared position and, in 2006, for the impact on profit on sales of frozen foods businesses), but before the financing of pensions.

In 2006, UFCF was €4.2 billion (2005: €4.0 billion). Thereconciliation of UFCF to the GAAP measures net profit and cash flow from operating activities is shown on page 26.

The tax charge used in determining UFCF can be either theincome statement tax charge or the actual cash taxes paid. Our consistently applied definition uses the income statement tax charge in order to eliminate the impact of volatility due to thevariable timing of payments around the year end. For 2006 theincome statement tax charge on this basis is materially impactedby the tax effect of non-cash charges for the provision forpreference shares and certain other non-cash items. UFCF basedon actual cash tax paid would be €4.5 billion (2005: €3.7 billion).

Return on invested capitalReturn on invested capital (ROIC) expresses the returns generatedon capital invested in the Group. The progression of ROIC is usedby Unilever to measure progress against our longer-term valuecreation goals outlined to investors.

ROIC is profit after tax but excluding net interest on net debt andimpairment of goodwill and indefinite-lived intangible assets bothnet of tax, divided by average invested capital for the year.Invested capital is the sum of property, plant and equipment andother non-current investments, software and finite-lived intangibleassets, working capital, goodwill and indefinite-lived intangibleassets at gross book value and cumulative goodwill written offdirectly to reserves under an earlier accounting policy.

In 2006, ROIC was 14.6% (2005: 12.5%). The reconciliation ofROIC to the GAAP measure net profit is shown on page 26.

ROIC reported in 2005 and 2006 has been based on totalbusiness profit, including profit on disposals. The impact on profitafter tax of material disposals was €1 170 million (2005: €458million). ROIC excluding this impact is 11.5% (2005: 11.3%).

26 Unilever Annual Report and Accounts 2006


(continued)


€ million € million € millionUngeared free cash flow 2006 2005 2004

Net profit 5 015 3 975 2 941Taxation 1 332 1 301 836Share of net profit of joint ventures/associates and other income from non-current investments (144) (55) (95)Net finance costs 725 618 631Depreciation, amortisation and impairment 982 1 274 2 063Changes in working capital 87 193 547Pensions charges in operating profit less payments (1 038) (532) (472)Movements in provisions less payments 107 (230) 574Elimination of profits on disposals (1 620) (789) (308)Non-cash charge for share-based compensation 120 192 218Other adjustments 8 (23) (10)

Cash flow from operating activities 5 574 5 924 6 925

Less charge for share-based compensation (120) (192) (218)Add back pension payments less pension charges in operating profit 1 038 532 472Less net capital expenditure (934) (813) (869)

Less tax charge adjusted to reflect an ungeared position (1 336) (1 440) (964)

Taxation on profit (1 332) (1 301) (836)Taxation on profit on sales of frozen foods businesses 159 – –Tax relief on net finance costs (163) (139) (128)

Ungeared free cash flow 4 222 4 011 5 346

€ million € million € millionReturn on invested capital 2006 2005 2004

Net profit 5 015 3 975 2 941Add back net interest expense net of tax 365 424 431Add back impairment charges net of tax(a) 15 245 536

Profit after tax, before interest and impairment of goodwill and indefinite-lived intangible assets 5 395 4 644 3 908

Year-end positions for invested capital:Property, plant and equipment and other non-current investments 7 142 7 333 6 966Software and finite-lived intangible assets 608 642 623Inventories 3 796 4 107 3 756Trade and other receivables 4 667 5 185 4 410Trade payables and other creditors due within one year (8 513) (8 782) (8 232)Elements of invested capital included in assets and liabilities held for sale 15 200 –Goodwill and indefinite-lived intangible assets at gross book value 20 705 21 621 19 854

Total 28 420 30 306 27 377

Add back cumulative goodwill written off directly to reserves 6 427 6 870 7 246

Year-end invested capital 34 847 37 176 34 623

Average invested capital for the year 36 850 37 012 36 444

Return on average invested capital 14.6% 12.5% 10.7%

(a) Excluding write-downs of goodwill and indefinite-lived intangible assets taken in connection with business disposals.24 Unilever Annual Report and Accounts 2006


(continued)


Demographic assumptions, such as mortality rates, are set havingregard to the latest trends in life expectancy, plan experience andother relevant data. The assumptions are reviewed and updatedas necessary as part of the periodic actuarial valuation of thepension plans. Mortality assumptions for the four largest plans are given in more detail in note 20 on page 104.

ProvisionsProvision is made, amongst other reasons, for legal matters,disputed indirect taxes, employee termination costs andrestructuring where a legal or constructive obligation exists at thebalance sheet date and a reliable estimate can be made of thelikely outcome.

Advertising and promotion costsExpenditure on items such as consumer promotions and tradeadvertising is charged against profit in the year in which it isincurred. At each balance sheet date, we are required to estimatethe part of expenditure incurred but not yet invoiced based onour knowledge of customer, consumer and promotional activity.

Deferred taxFull provision is made for deferred taxation at the rates of taxprevailing at the year-end unless future rates have beensubstantively enacted, as detailed in note 1 on page 76. Deferredtax assets are regularly reviewed for recoverability, and a valuationallowance is established to the extent that recoverability is notconsidered likely.

Reporting currency and exchange ratesForeign currency amounts for results and cash flows are translatedfrom underlying local currencies into euros using annual averageexchange rates; balance sheet amounts are translated at year-endrates except for the ordinary capital of the two parent companies.These are translated at the rate prescribed by the EqualisationAgreement of 31⁄ 9p = €0.16 (see Corporate governance on page 39).

Non-GAAP measuresCertain discussions and analyses set out in this Annual Report andAccounts include measures which are not defined by generallyaccepted accounting principles (GAAP) such as IFRS or US GAAP.We believe this information, along with comparable GAAPmeasurements, is useful to investors because it provides a basisfor measuring our operating performance, ability to retire debtand invest in new business opportunities. Our management usesthese financial measures, along with the most directly comparableGAAP financial measures, in evaluating our operatingperformance and value creation. Non-GAAP financial measuresshould not be considered in isolation from, or as a substitute for,financial information presented in compliance with GAAP. Non-GAAP financial measures as reported by us may not becomparable to similarly titled amounts reported by othercompanies.

In the following sections we set out our definitions of thefollowing non-GAAP measures and provide reconciliations torelevant GAAP measures:

• Underlying sales growth; • Ungeared free cash flow;• Return on invested capital; and• Net debt.

We set out ‘Measures of long-term value creation’ as anintroduction to the following section, in order to explain therelevance of the above measures. At the end of this section on non-GAAP measures, we summarise the impact on TotalShareholder Return (TSR) which is our key metric.

Measures of long-term value creationUnilever’s ambition for the creation of value for shareholders ismeasured by Total Shareholder Return over a rolling three-yearperiod compared with a peer group of 20 other companies.Unilever believes that the contribution of the business to thisobjective can best be measured and communicated to investorsthrough the following measures:

• The delivery, over time, of Ungeared Free Cash Flow (UFCF),which expresses the translation of profit into cash, and thuslonger-term economic value; and

• The development, over time, of Return on Invested Capital(ROIC), which expresses the returns generated on capitalinvested in the Group.

Unilever communicates progress against these measures annually, and management remuneration is aligned with theseobjectives. The UFCF over a three-year period is incorporated as a performance element of Unilever’s management incentive scheme.

UFCF and ROIC are non-GAAP measures under IFRS and USGAAP. We include them in this respect since they are the way in which we communicate our ambition and monitor progresstowards our longer-term value creation goals and in order to:

• Improve transparency for investors;• Assist investors in their assessment of the long-term value

of Unilever;• Ensure that the measures are fully understood in the light of

how Unilever reviews long-term value creation for shareholders;• Properly define the metrics used and confirm their calculation;• Share the metrics with all investors at the same time; and• Disclose UFCF as it is one of the drivers of management

remuneration and therefore management behaviour.

As investor measures, we believe that there are no GAAPmeasures directly comparable with UFCF and ROIC. However, in the tables on page 26, we reconcile each as follows: UFCF tocash flow from operating activities and also to net profit; ROIC to net profit.

24 Unilever Annual Report and Accounts 2006


(continued)


Demographic assumptions, such as mortality rates, are set havingregard to the latest trends in life expectancy, plan experience andother relevant data. The assumptions are reviewed and updatedas necessary as part of the periodic actuarial valuation of thepension plans. Mortality assumptions for the four largest plans are given in more detail in note 20 on page 104.

ProvisionsProvision is made, amongst other reasons, for legal matters,disputed indirect taxes, employee termination costs andrestructuring where a legal or constructive obligation exists at thebalance sheet date and a reliable estimate can be made of thelikely outcome.

Advertising and promotion costsExpenditure on items such as consumer promotions and tradeadvertising is charged against profit in the year in which it isincurred. At each balance sheet date, we are required to estimatethe part of expenditure incurred but not yet invoiced based onour knowledge of customer, consumer and promotional activity.

Deferred taxFull provision is made for deferred taxation at the rates of taxprevailing at the year-end unless future rates have beensubstantively enacted, as detailed in note 1 on page 76. Deferredtax assets are regularly reviewed for recoverability, and a valuationallowance is established to the extent that recoverability is notconsidered likely.

Reporting currency and exchange ratesForeign currency amounts for results and cash flows are translatedfrom underlying local currencies into euros using annual averageexchange rates; balance sheet amounts are translated at year-endrates except for the ordinary capital of the two parent companies.These are translated at the rate prescribed by the EqualisationAgreement of 31⁄ 9p = €0.16 (see Corporate governance on page 39).

Non-GAAP measuresCertain discussions and analyses set out in this Annual Report andAccounts include measures which are not defined by generallyaccepted accounting principles (GAAP) such as IFRS or US GAAP.We believe this information, along with comparable GAAPmeasurements, is useful to investors because it provides a basisfor measuring our operating performance, ability to retire debtand invest in new business opportunities. Our management usesthese financial measures, along with the most directly comparableGAAP financial measures, in evaluating our operatingperformance and value creation. Non-GAAP financial measuresshould not be considered in isolation from, or as a substitute for,financial information presented in compliance with GAAP. Non-GAAP financial measures as reported by us may not becomparable to similarly titled amounts reported by othercompanies.

In the following sections we set out our definitions of thefollowing non-GAAP measures and provide reconciliations torelevant GAAP measures:

• Underlying sales growth; • Ungeared free cash flow;• Return on invested capital; and• Net debt.

We set out ‘Measures of long-term value creation’ as anintroduction to the following section, in order to explain therelevance of the above measures. At the end of this section on non-GAAP measures, we summarise the impact on TotalShareholder Return (TSR) which is our key metric.

Measures of long-term value creationUnilever’s ambition for the creation of value for shareholders ismeasured by Total Shareholder Return over a rolling three-yearperiod compared with a peer group of 20 other companies.Unilever believes that the contribution of the business to thisobjective can best be measured and communicated to investorsthrough the following measures:

• The delivery, over time, of Ungeared Free Cash Flow (UFCF),which expresses the translation of profit into cash, and thuslonger-term economic value; and

• The development, over time, of Return on Invested Capital(ROIC), which expresses the returns generated on capitalinvested in the Group.

Unilever communicates progress against these measures annually, and management remuneration is aligned with theseobjectives. The UFCF over a three-year period is incorporated as a performance element of Unilever’s management incentive scheme.

UFCF and ROIC are non-GAAP measures under IFRS and USGAAP. We include them in this respect since they are the way in which we communicate our ambition and monitor progresstowards our longer-term value creation goals and in order to:

• Improve transparency for investors;• Assist investors in their assessment of the long-term value

of Unilever;• Ensure that the measures are fully understood in the light of

how Unilever reviews long-term value creation for shareholders;• Properly define the metrics used and confirm their calculation;• Share the metrics with all investors at the same time; and• Disclose UFCF as it is one of the drivers of management

remuneration and therefore management behaviour.

As investor measures, we believe that there are no GAAPmeasures directly comparable with UFCF and ROIC. However, in the tables on page 26, we reconcile each as follows: UFCF tocash flow from operating activities and also to net profit; ROIC to net profit.


OPINION

Take sustainability to heartWhile corporate responsibility has been overwhelmingly driven by external pressures and expectations, sustainability goes right to the heart of the business model – raising significant questions and challenges for the corporate reporting model, says Erica HauverIn the last decade we’ve seen a whole raft of social and environmental issues gain and maintain a central position in the public consciousness. Climate change, poverty, and HIV/AIDS are only the most high-profile of a list that ranges from obesity, to child labour, to ethical sourcing.

For major multinational companies the consequence has been a new and unprecedented level of global scrutiny. The NGO community in particular is increasingly media-savvy, and increasingly adept at using that expertise to exert both positive and punitive pressure. The carrots have come in the form of high-profile awards and indices for corporate responsibility (or CR); the sticks make themselves felt in a degree of external pressure that has seen sector after sector targeted on specific social and environmental practices.

For many companies the most obvious consequence has been the striking rise in corporate responsibility reporting in the course of the last decade. The number of reports being issued has quadrupled in that time. A PwC survey last year found that 83% of FTSE350 companies now have a section in the annual report dedicated to their CR activities.

But even if most large companies now have CR policies and principles, many of these have been driven by the need to put something in the CR report, and can bear little relevance to what actually happens in the business day-to-day. In such a context it’s hardly surprising that many CR reports have been reactive and defensive, with little hard data on real impacts, especially in so-called ‘soft’ areas such as social development and human rights.

In the last 18 months, the profound challenge of sustainability became a mainstream concern for governments, the media, and consumers alike. Climate change impacts and adaptation, water scarcity, natural resource depletion, energy and food supply and demand are just a few of the interrelated issues that are focusing minds on how we live within our means.

Slow progress

While there are some very important signals that indicate the market is turning its attention to these challenges, progress is slow. Even in the wake of the Stern Review and the Intergovernmental Panel on Climate Change report, sustainability objectives still rarely form part of a company’s strategic and commercial objectives. And the growing number of sustainability reports are quite often a re-branding of the old-style CR report.

Initiatives like the GRI framework have attempted to address some of these concerns by providing companies with a more rigorous and consistent framework against which to report. However, even the largest businesses can find this apparatus resource-intensive and unwieldy, and many find it insufficiently flexible for the very different sustainability issues faced by

different industry sectors. As a result, all but the most technical readers may struggle to discern the big picture from the plethora of detail.

The other major trend of the last few years has been the move to an issues-based approach to reporting (animal testing policies for pharma, Equator Principles reporting among banks, sustainable sourcing practices for the food industry). This has some undoubted advantages, but there is still a need for new metrics and new methodologies, which can assess real and meaningful performance improvements.

Will investors drive development?

One of the key – and thus far largely silent – parties here is the investment community. We have always expected that institutional investors would drive the development of a more effective sustainability reporting model, but so far the demand for such a model has been, at best, patchy. Investors who focus on Sustainable and Responsible Investment (SRI) are one obvious exception, as are those funds that follow sectors where sustainability issues are already having positive or negative financial consequences.

That said, there is more and more evidence that the real momentum for change will come from inside business, rather than outside. The cleverer companies are already starting to shift from the tactical management of dozens, or even hundreds, of different CR metrics to the deeper and more difficult task of integrating the principles of sustainability into corporate strategy and operational performance. This will not be easy in itself, and those who attempt it will want a new reporting model that can quantify and communicate what they have achieved.

Tough questions

This raises some tough questions that companies, investors, regulators and NGOs will need to find answers to:

How can we create an integrated reporting model that •communicates what is important in an effective way?

How can you demonstrate the link between a responsible •and sustainable approach to business, and long-term financial success?

How do you decide which are the right key performance •indicators for your particular sector?

And how do you manage the balance between robust data •and the need for a clear understanding of the wider picture?

As the effort to find some answers to these difficult questions progresses, I will keep you updated in future World Watch articles.

Erica Hauver is UK lead partner for sustainability at PricewaterhouseCoopers.

News & Opinion

Norway has made gender equality a boardroom necessity following legislation in January requiring all companies listed on the Oslo Stock Exchange to appoint women in 40% of director roles.

The country’s gender equality initiative began in 2004, when government-owned companies were required to have boards with at least 40% representation of each gender. It has now been rolled out to include all publicly-owned enterprises and companies in the private sector.

As a result, Norwegian companies have had to recruit some 1,000 female directors, with some businesses reporting difficulties in finding candidates with experience both at board and industry level. One outcome is that suitable female directors are often sitting on a large number of boards, causing investors to have some concern that their attention could be spread too thinly. However, the Confederation of

Norwegian Enterprise has launched a programme to train additional women for board and leadership positions.

In spite of these early difficulties, all the publicly traded companies in Norway that need to meet the minimum requirements have now done so. It’s interesting to note that in its 2007 report, Women Board Directors of the Fortune Global 200, Corporate Women Directors International highlighted Norwegian company Statoil as second in its list of top ten companies for female director representation.

At a recent seminar in Zurich, Norway was again singled out for praise – along with Sweden, Finland, Denmark and the UK – as one of the most progressive countries in Europe for its

track record on female representation at director level. Professor Morten Huse of the Norwegian School of Management Bl and Tor Vegata University, Rome said that the changes were sometimes organic – as in the case of the UK – and other times the result of alterations to laws or regulations. In Spain, for example, gender equality plans require that 40% of listed firm directors be female by 2016.

Professor Huse added that there is a need to understand the argument for minimum levels of female directors from a number of points of view: first, by asking ‘what is best for society?’; second, by considering ‘what is best for the companies?’; and third, by enquiring ‘what is best for the individual women?’.

Although this is an area for future research, there is some evidence already which shows that greater female participation at senior level has real benefits for business. For example, in 2002, a Conference Board of Canada study found that corporations with female board directors have better governance practices, particularly on oversight and control of audit and risk. Meanwhile, a joint study of European enterprises by McKinsey and Amazone Euro Fund, with mixed reviews, concluded that companies whose management teams strongly represented both genders outperformed their peers by as much as 10% on return on investment.

NoRWAY

Women at the top

Governance News


GUIDE

Anti-money launderingThe anti-money laundering Know Your Customer quick reference guide, produced by PwC, provides those in the global financial sector with accessible information on anti-money laundering regulations in nearly 50 countries. It provides a generic question sheet

which, once downloaded, can be lined up against the corresponding answer sheet for each individual country.

The guide covers a range of information, including: whether the local regulator will allow the use of a risk-based approach to anti-money laundering; how politically exposed people should be treated; whether you can do business with shell banks; and who you can contact locally.

‘The wide range of different requirements across the world sometimes makes it difficult for global organisations to get global policies in place,’ said Andrew Clark, PwC anti-money laundering partner. ‘This Quick Reference Guide is going to be useful for anybody in the financial services sector who operates in more than one territory.’

For copies of the guide see www.pwc.com/anti-money_laundering

SURVEy

Reading US directors’ minds Shareholders are at the forefront of US directors’ minds, according to the sixth annual survey – What directors think – from PricewaterhouseCoopers and Corporate Board Member magazine. This reflects the ongoing concerns about high levels of risk and increasing shareholder scrutiny.

The survey, which sought the views of over 1,000 corporate directors in the US, investigated board members’ views on their growing responsibilities, directors’ boardroom risk and the changing relationship between directors and shareholders.

Directors consider shareholders to be their most important constituency, ranking them above institutional investors, customers and creditors. As the demand for accountability to shareholders continues to rise, directors are more inclined to interact with them directly. An overwhelming 96% are publicly prepared to address a shareholder’s request for their opinion.

Risk is still a significant issue for directors, but seems to be one that they are taking more in their stride. Some 62% consider their risk to be just as high as the previous survey (2006), but fewer directors are feeling the pressure of increased risk.

The vast majority of boards (88%) now conduct a regular board evaluation – more than double the level in 2002. 79% consider this the most important tool for improved director effectiveness, but a significant number do not appear to be making the most of the process – 38% of

directors said that their board’s evaluation process was only ‘somewhat effective’.

‘The survey has confirmed what our conversations with directors had indicated,’ said Catherine Bromilow, US corporate governance partner at PwC. ‘For example, we can now see a clear trend that more companies are using evaluations as a tool to boost board processes and directors’ abilities to fulfil their fiduciary duties.’

Board directors found that some of their most demanding and time-consuming responsibilities related to the audit committee. More than half of those who were audit committee members spent between three and four hours in each meeting. ‘Audit committees continue to work diligently

to address the past expansion of their core responsibilities,’ said Ms Bromilow. ‘They are spending time not only to oversee the integrity of the financial statements and the audit processes, but also to monitor the risk management and compliance functions that are so critical to companies’ ongoing success.’

‘Overall, the results indicate that directors are concentrating on activities that help maintain a high standard of corporate governance,’ concluded Ms Bromilow. ‘Board evaluations, continuing education and attention to important issues, such as CEO succession, can help directors mitigate their personal risk as they attempt to discharge their most important duty: protecting the interests of shareholders.’

90% of directors deem ongoing •education as important, but 60% of boards have no formal budget for it.

Directors rate regular executive •sessions with the CEO as the leading hallmark of good governance.

81% say that asking for resignation •is the most appropriate action against a director who has leaked information to the press.

Directors perceive that majority •voting rules will cause very little change on company boards

Earnings restatement is rated as •the most important signal that they should take a more active role in the company.

Succession planning is seen as •important, but 35% of directors were unhappy with the way this is handled.

Controlling the size of CEO •pay was seen as a problem by two-thirds of the directors surveyed – one third said that pressure by institutional investors and stockholders is the most likely way to control CEO pay growth, but 92% did not want shareholders to have a vote on this. 41% said boards and companies’ compensation committees should stand firm to bring about change in this areas.

Further survey findings include:


TRANSATLANTIC CORPORATE GOVERNANCE

Time to identify regulatory common ground On the big issue of promoting global peace and prosperity, international co-operation on corporate governance regulation and integration of capital markets is just as important as foreign diplomacy. Such was the opening gambit of Christopher Cox, chairman of the US Securities and Exchange Commission (SEC) in his keynote speech at the fourth conference on Transatlantic Corporate Governance Dialogue in Washington.

Sponsored by the European Corporate Governance Institute (ECGI) and the American Law Institute (ALI), the event in October focused on ‘corporate governance standards and capital market competitiveness’.

He went on to add that while ‘regulation is not the fuel that drives our markets, it undoubtedly is the oil that greases the gears’. Regulators need to strike a balance, he told delegates, between ‘under-regulation, which carries with it the risk of fraud, abuse, and a loss of investor confidence, and over-regulation, which saps the economic vitality of otherwise vibrant markets’.

He added that variations in national regulatory systems can be accommodated, the disparities often

stemming from historic backgrounds. It is up to the regulators to diagnose and deal with the different situations arising from different market structures. ‘Just because capital now flows across borders more easily, and businesses routinely operate on a worldwide basis, it doesn’t mean that a one-size-fits-all approach to securities regulation is wise,’ he said.

As markets evolve, regions find that they have more in common than they used to. The fact that one country’s regulators work with another’s to resolve problems that have arisen in the market show that regulatory objectives have much in common.

Ensuring that investors are properly informed is central to the trans-Atlantic dialogue, Mr Cox continued, highlighting disclosure, transparency, and the cost of obtaining and processing information required by corporate governance regulations as the key elements. The costs of obtaining such information can be a barrier, and this is one of the reasons why the SEC is looking at improving financial reporting through interactive data, such as eXtensible Business Reporting Language (XBRL). International Financial Reporting Standards (IFRS) are another initiative

that moves towards consistency of information for investors. But, to be successful, IFRS must be ‘applied faithfully and consistently across jurisdictions,’ he added.

‘Many of us, as securities regulators, are similarly like-minded and we share common regulatory objectives. We should relentlessly seek to make common ground…[and] work closely together to eliminate unnecessary and redundant regulations, to recognise how different regulatory approaches may achieve our shared objectives, and to learn from each other about what works and what doesn’t.’

For more information, visit www.ecgi.org

UK

Consultation on Smith Guidance for audit committeesGuidance for audit committees in the UK could change this year following the Financial Reporting Council’s (FRC) consultation on the Smith Guidance for Audit Committees.

Amendments are proposed to the Smith Guidance for two reasons. The first is to reflect any consequential changes that might arise from the FRC’s recent review of the Combined Code. This included a recommendation that, for smaller companies, the company chairman may be a member of, but not chair of the audit committee, as long as he or she was independent on appointment. However, his or her membership must be in addition to the minimum number of independent non-executive directors.

This follows hot on the heels of recommendations by the Market Participants Group (MPG), which was set up by the FRC over a year ago to advise on possible actions that market participants could take to mitigate the risks arising from the structure of the audit market in the UK. This is the second reason for proposed changes to the guidance.

In relation to audit committees, these MPG recommendations included:

A requirement for disclosure of •information in the annual report on the auditor selection decision. This would involve disclosing any contractual obligations to appoint certain types of audit firms.

Reviewing the independence •section of the Smith Guidance to ensure that it is consistent with the relevant ethical standards for auditors.

A requirement for the audit committees •of major public interest entities to assess periodically the risks associated with the possible withdrawal of their external auditor from the market and to consider whether any mitigating action is appropriate.

A revised version of the Smith Guidance is expected later this year.

the FRC proposals on the Smith Guidance are available on the FRC’s website www.frc.org.uk.

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TURKEy

Corporate governance – a cultural divide

BULGARIA

New code enables international competition

the process of implementing new corporate governance regulations by leading companies in turkey has uncovered a cultural difference between emerging and developed markets, a study has established.

The findings came to light during the November 2007 International Research Conference on Corporate Governance in Emerging Markets, held in Istanbul. Here, much of the discussion focused on progress that companies in the Istanbul Stock Exchange 50 were making in implementing governance-related disclosure requirements.

According to Bengi Ertuna and Ali Tukel of Bogazici University, who undertook the research, companies are making an effort to implement the regulations – recently introduced for the benefit of

shareholders – but face difficulties in interpreting the spirit of the principles.

They go on to state that corporate governance principles were formed in developed markets, which are characterised by a separation of ownership and control. In contrast, the conditions in emerging markets tend towards highly concentrated ownership structures, with a significant number under family control. The biggest issue, they stated, is monitoring the controlling owners and related conflicts of interest.

Mr Ertuna and Mr Tukel looked at three mechanisms of board composition and control – the existence of independent board members; the compensation of executive and non-executive board members; and the formation of board committees. They concluded that, for

these three items of disclosure, the 50 companies investigated had complied acceptably in this transition period, but that there was still a way to go in complying with the substance of the principles.

‘The entire corporate governance process is a relatively recent concept for Turkish companies, and they are making efforts to understand and interpret its implications,’ they added. ‘For the time being, companies’ primary emphasis seems to be on making their present governance structures look like they are in compliance instead of making the necessary changes to comply with the substance of the regulations. The principles addressing the relevant conflicts of interests remain largely untouched.’

Following Bulgaria’s accession to the EU, the country has taken a crucial step forwards in supporting domestic companies by launching its National Corporate Governance Code (NCGC).

One of the main driving forces behind the NCGC is the Bulgarian Stock Exchange – Sofia (BSE-Sofia), which is seeking to encourage the use of corporate governance principles by public companies, both to enable them to compete more effectively on the world stage and to raise the confidence of domestic and international investors. Some 40 Bulgarian companies have signed up to the NCGC since its launch in October last year.

The NCGC replaces the Corporate Governance Code, which had only been applied to some of the companies trading on the BSE-Sofia. Now, not only are all listed companies required to adopt the new code, but some parts of the NCGC will be enshrined in Bulgarian legislation, making key elements obligatory for non-listed companies as well. The rules and provisions of the code will be reviewed every 18 months.

‘The code was much needed for Bulgaria to support the business community’s efforts to compete in the EU and international markets,’ says Professor Bistra Boeva, co-chair of the

task force that developed the code. ‘It will give those companies that want to apply better governance practices an opportunity to distinguish themselves.

‘The Bulgarian Corporate Governance Code is a first step in the right direction, and Bulgaria should vigorously continue its effort in improving the corporate governance framework. This should include full disclosure of significant beneficial ownership, related-party transactions and increased director professionalism.’

For further information, visit www.bse-sofia.bg


More rigorous corporate governance standards and greater transparency are driving significant foreign investment into Brazil with a subsequent surge in companies listing on the Sao Paolo Stock Exchange (BVSP).

The Novo Mercado – ‘New Market’ – is the listing segment with the most demanding corporate governance standards within the BVSP, and is designed on the premise that stock valuation and liquidity are positively affected by shareholders’ rights and the quality of company information.

With rules mirroring those in the US and Europe, it has proved a magnet for overseas investors who have bought up 74% of shares in the listing and now account for 30% of all exchange transactions in Brazil.

Over 100 companies have chosen to list on the Novo Mercado, with 75% of businesses going public last year opting to comply with its more demanding standards. Highlights of these include the requirement that companies must have one class of shares – voting shares; that

company boards must have at least five members; and that at least 20% of directors must be independent.

These are a significant departure from a system where non-voting shares are commonly used to allow companies to raise capital while maintaining the voting power of the controlling shareholder. A major attraction of the Novo Mercado among foreign investors has been its greater protection for minority shareholders.

In terms of financial reporting, the listing also requires that the annual balance sheet be disclosed according to the standards of US Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). In fact, Brazilian companies are expected to adopt IFRS by 2010, thus improving the understanding of financial information by foreign investors.

See www.bovespa.com.br/indexi.asp for more information

BRAZIL

Higher standards boost foreign investment

AUSTRALIA

Audit committees focus on riskA series of Audit Committee Forums have been held across Australia by the leaders of the professional accounting bodies, major accounting firms, top 100 company CFOs, the Commonwealth Treasury, and the Australian Securities and Investments Commission (ASIC).

The purpose of the forums was to bring together audit committee chairmen and other key stakeholders to discuss frankly how corporate governance was working in Australia and the challenges facing members of audit committees.

Each forum was organised around a panel session with a prominent audit committee chair, one or more advisers to audit committees, an external auditor and Lee White, chief accountant at ASIC.

The challenge of prioritising risks while managing so many matters was a hot topic for both the panel and attendees. Other key areas included:

Current financial market volatility•

The approach to managing •continuous disclosure requirements

The role and responsibility of the •internal audit

How the audit committee deals with •myriad reports and recommendations on internal control issues

In relation to risk, discussion centred on the importance of prioritising and managing risk effectively, and whether audit committees should be responsible for risk. Quite diverse views were expressed, including that risk is the domain of the whole board, that having

both audit and risk in one committee could mean insufficient time is given to relevant issues, and that having separate audit and risk committees could lead to a fragmented approach to important matters.

The type of industry and the size and sophistication of the company were generally considered to be relevant factors to working out whether a separate risk committee was needed. For some with separate committees, directors often sat on both committees and joint meetings were also held.

‘The value of the forums was to bring relevant stakeholders together and get issues out in the open,’ said PricewaterhouseCoopers governance specialist Liz Stamford. ‘The challenge is to continue the momentum.’

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Risk management is often viewed as a back-office function, leading companies to miss out on the broad benefits it can provide, a PwC study suggests. The study of UK financial directors across a range of commercial sectors – In Control – indicated that risk management has become synonymous with risk mitigation, which has a relatively narrow focus.

Results indicate that while the majority of companies have invested in strengthening their risk management process, few consider that it is an integral part of good

decision making. The majority continue to operate risk management, business planning and performance management in separate silos.

‘This can have negative effects,’ said PwC director Geraldine Rutter. ‘Not only does it leave companies vulnerable to unforeseen or misjudged risks, but, by taking too little risk, they may also be missing beneficial opportunities.’

The following summary represents the study’s collective results of the

companies surveyed. A ‘satisfactory’ rating (green) in all areas would give companies real insight into what risks might stop them achieving their strategic objectives.

The full report aims to give finance directors, particularly in the non-financial sector, useful insights into how they can manage their risk better.

Copies of the report and further information are available from Leila Cogan, email [email protected]

The House Oversight and Government Reform Committee of the US Senate has recently grilled board members of three American financial companies over the ‘outsize’ pay packages received by their CEOs. However, it is not only the beneficiaries of these packages that have testified; the board members that approved the packages and their advisors have also been required to provide testimony.

The oversight committee has spent several months gathering background information for the hearing. Minutes of board meetings and internal emails have been unearthed that caused observers to question how these boards discharged their responsibilities around executive pay.

One of the key findings related to the use of external advisers. For example, it transpired from the committee’s research that the CEO of one company hired a second compensation consultant when the first compensation consultant appointed by the board opined that his pay was inflated. The second compensation consultant developed a more lucrative package for the CEO than his predecessor (with higher bonus opportunity and less downside risk). Emails between the compensation committee and the consultant confirmed that he was acting as an independent adviser to the committee. yet other emails between the CEO and the consultant appear to indicate that he was acting as a personal adviser to the CEO at the same

time. This raised questions of corporate governance probity within the company.

‘Companies with a secondary listing in the US might be in the oversight committee’s sights and may wish to consider how their engagements with advisers will stand up to public disclosure,’ said PwC remuneration partner Sean O’Hare. ‘It is worth remembering that some jurisdictions, such as the UK, require disclosures about independent advisers to the remuneration committee and details of other work they perform. The purpose of this is to highlight circumstances in which an adviser could have a conflict of interest.’

Contact: [email protected]

RISK MANAGEMENT

Good decision making at risk?

US

Review of ‘excessive’ termination payments

this summary represents the collective results of our study on the basis that companies should be rated satisfactory in all the areas to know what might stop them achieving their strategic objectives.

How have you defined your risk strategy including risk appetite/tolerance? People struggle with risk appetite and confuse process with strategy.

How important is risk management to the Board?Risk is important to the Board, but they lack confidence that key risks are being managed

How have you defined and rolled out a ‘risk culture’ across the business?Aware, but generally informal/not measured.

Do you undertake a structured risk assessment as part of your business or strategic planning process?Majority of companies do; the challenge is in the implementation.

Do your risk management activities focus on the areas that most impact on your strategic objectives?Companies have started to look beyond financial risks; however the focus is still not as much on strategic risks as it should be.

Is management of the risks identified at a strategic level integrated into the operations of your business?Our sense is not.

DON’TKNOW

How comfortable are you with the accuracy, thoroughness and timeliness of your risk reporting?Risk reporting is increasing, but quality remains in question.

How do you identify key emerging risks? What are they? How often do you update this analysis?Most companies rely on a planning process, though there are examples of collaboration within industries. Some companies rely on crisis management.

Key: Satisfactory Requires attention Suggest immediate investigation

Source: PricewaterhouseCoopers ‘In Control’ study 2007


TRANSPARENCy

Investors get demandingon alternative assets

EU

Shareholders rightsAs Charlie McCreevy is nearing the end of his term as internal markets commissioner, the European Commission is looking to finalise certain areas of work. One such area is the recommendation to further improve shareholders’ rights and reinforce the Shareholders’ Rights Directive, which was approved last year to enable shareholders to receive better information, and have their say.

A few months ago Mr McCreevy changed his stance on the EC taking further action on governance and on one-share-one-vote for shareholders. He said that he continued to believe that one-share-one-vote is in the best interest of companies and their investors, but that EU action would not be useful or fruitful. He reached this conclusion on the basis of an external study that said there is no clear economic evidence that control-enhancing mechanisms have a negative effect on companies’ performance or their governance.

In the Commissioner’s opinion, an appropriate level of transparency is the most important issue. This should be guaranteed by a number of existing EU measures such as the Directive on Takeover Bids (which provides a list of relevant control-enhancing mechanisms that have to be disclosed to the market by listed companies annually), the Transparency Directive, and the modifications of the accounting directives in 2006 (which establish new rules on related-party transactions). Also, the recent directive on shareholders’ rights will facilitate the exercise of shareholders’ voting rights, including those of minorities, and will help investors to push for transparency.

The EC is also having a close look at the proper application of the ‘acting in concert’ rules in the Takeover Directive, as there is concern that some member states are giving far too wide a reading to this concept, thereby preventing legitimate collaboration between shareholders.

The EC will also be evaluating member states’ application of the 2005 Commission Recommendations on independent directors and directors’ remuneration.

There are growing calls for alternative investment providers to step up their levels of transparency, disclosure and risk management. This comes at a time when institutional investors are making private equity, hedge funds and real estate a more mainstream part of their asset mix. It is clear that while the industry itself has seen rapid growth, the development of the infrastructure that supports it has not always kept pace.

Insights into the views of institutional investors and alternative investment providers on the regulatory, risk management and reporting environment for these alternative investments are outlined in a PwC report, written in cooperation with the Economist Intelligence Unit – Transparency versus returns: the institutional investor view of alternative assets.

The survey of 220 executives from the Americas, Asia and Europe found that between 30% and 40% of investors expect a greater exposure to real estate, private equity, commodities and hedge funds, but they are frequently dissatisfied with performance. Less than half of respondents are currently happy with the performance of their hedge fund investments, while private equity and real estate fare somewhat better, with 67% and 57% reporting satisfaction.

There is a growing focus on governance. Investors have tolerated weak governance and risk management in the past few years as returns have been

good and the sector has been evolving. Now that returns are moderating and the sector has matured somewhat, the survey reveals that investors are going to be more exacting – their criteria for deselecting a provider is not primarily performance (as it is when they are making a selection), but transparency and the quality of risk management.

The findings indicate that the quality and scope of information provided to investors by alternative asset providers remains somewhat patchy. While most will report on performance and investment strategy, only a small minority volunteer information on a number of key operational metrics, such as back-office operations, risk and controls and valuation techniques.

‘The quality and scope of reporting needs attention, particularly around valuations, given the appetite among investors for investments where valuations are not straightforward,’ said Jeremy Scott, PwC global financial services leader. ‘But investors must also learn to ask the right questions to get the information they need. I expect that developments in global accounting standards will compel both providers and investors to raise their game.’

There is dissatisfaction among investors with some aspects of the current regulatory regime, the survey showed. Just over one-quarter of institutional investors said they were happy with the regulatory regime for hedge funds, and less than one-half for private equity. A high proportion of investors report difficulties with comparing and benchmarking performance, would like to see more standardised valuations, and would welcome more regulation. Alternative investment providers are less enthusiastic proponents of change, with much higher proportions satisfied with the status quo – this is a debate that will continue to attract opposing views.

Copies of the report are available from www.pwc.com/financialservices

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OPINION

Good corporate governance pays offCompanies with good governance structures and active shareholders will ultimately perform better than those without, argue engagement experts Colin Melvin and Hans-Christoph Hirt

The pressure for better governance and greater transparency has not let up – following corporate disasters, regulators and investors around the world demand better standards and practices. Governance codes that provide a framework for the dialogue between investors and companies are increasingly part of the corporate culture. However, many companies still perceive these as something imposed on them, and have concerns that they do not add any value or indeed might restrict their profitable operations. They clearly do not consider what good governance can do for their long-term success and as such for shareholder returns.

Many would agree that good governance can help prevent major corporate disasters, and thus the destruction of value. However, the proposition that governance can actually create better performance and thus create additional value for investors is more controversial. We strongly believe that good governance and active ownership pays off – it is good for business and investors. In other words, there is a link between good governance and performance – as outlined in our report, Corporate governance and performance – the missing links.

Hermes Equity Ownership Services (HEOS) carries out corporate governance and engagement activities for large, international pension funds. Such funds are the classic long-term investors who will be shareholders for decades in a great number of companies across the world. They have a strong interest in the sustainable, wealth-creating capacity of the companies in which they invest.

In our experience, companies with governance structures that allow shareholders to hold their management to account, and those that have active, interested and involved shareholders will ultimately perform better than

and be worth more than those where either of these factors is missing. For this reason, HEOS engages with companies on a wide range of issues that may affect the long-term performance and value creation of companies in the portfolio of pension fund clients. We believe that this engagement, or active ownership, is the missing link we refer to in our report. In our view, it requires active owners with a long-term interest to determine what corporate governance issues really matter to a particular company at a certain time and to encourage positive change.

Hermes recognises that the most appropriate and effective corporate governance structure for a company is contingent on a number of factors that differ between markets and sectors, may change over the life cycle of a company and are generally highly company-specific.

A detailed, company-specific corporate governance analysis to identify changes that could unlock value is an important part of an effective corporate governance-based investment strategy. However, in terms of creating or at least preserving value, the most important part of the investors’ role seems to be to engage in a constructive dialogue with companies and encourage governance changes where necessary or, at the very least, to take an active interest in overseeing the running of investee companies.

In our view, it is not simply the quality of the governance arrangements that is important in terms of performance but, to a significant extent, the appropriate engagement of investors with companies on a wide range of issues as part of an ‘active ownership’ approach that should involve continuous oversight of the management.

Colin Melvin is the chief executive at Hermes Equity Ownership Services and Hans-Christoph Hirt is a director there. For copies of the report, Corporate governance and performance – the missing links, visit: www.hermes.co.uk.

Deutsche Bank was able to demonstrate a positive relationship between the historic governance assessment of the companies it researched and their profitability. During the four and a half year period investigated, the top 20% of the companies in terms of governance structure and behaviour, outperformed those in the bottom 20% by 32%.

Source: Deutsche Bank, Global Corporate Governance Research, Beyond the numbers (2006, 2005, 2004, 2003)

McKinsey surveyed more than 200 institutional investors back in 2002 and found that 80% of the respondents would pay a premium for well-governed companies. The size of the premium varied by market, from 11% for Canadian companies to around 40% for companies operating in countries where the regulatory backdrop was less certain, such as Egypt, Morocco, and Russia.

Source: Coombes and Watson (McKinsey) (2000, 2002), Global Investor Opinion Survey

Research shows link between governance and performance

News & Opinion

The European Commission (EC) has proposed transitional arrangements for auditors from a number of overseas countries. The EC’s approach of awarding transitional arrangements for certain overseas countries is widely supported, as it avoids blanket implementation of an unwieldy system and reduces cost for business.

This should assist companies incorporated outside the EU that are listed on a member state’s regulated market. Articles 45 and 46 of the statutory audit directive (8th Company Law directive) state that a third country auditor of a company listed in the EU has to satisfy certain education criteria and register with the relevant member state oversight body. They would then be subject to quality assurance checks by that body. Failure to register renders the audit opinion (and by implication the annual accounts) void, which would result in the company being removed from the regulated market unless it obtained a further audit of its accounts that complied with the directive’s requirements within the permitted time.

To respond to concerns about the potential costs of these requirements for companies and regulators, the directive does allow for member states to rely on the supervision and regulation of third country auditors by

their home country, but only if the EC has determined that the home country system is ‘equivalent’ with that in the EU.

The transitional arrangements proposed by the EC are a step forward in the process, and recognise that regulatory systems in a number of countries are still developing.

Peter Wyman, PwC regulatory partner, told World Watch: ‘We have requested that each member state clearly sets out the registration requirements for those overseas auditors who will not be captured by the transitional arrangements. This will hopefully give overseas companies confidence in the appointment of their auditors for the forthcoming financial year.’

A number of other amendments to the 8th Company Law Directive on Statutory Audit will also come into force at the end of June following a two-year implementation.

EURoPEAN UNioN

New requirements for overseas auditors

Assurance

Statutory audit packageUpcoming changes to the statutory audit package, announced by Commissioner McCreevy:

A recommendation limiting •auditor liability to be brought forward in 2008 (see page 38)

A consultation on ownership •restrictions in audit firms (Q3 2008)

A recommendation setting •standards on audit quality and inspections (Q2 2008)

A scoreboard to monitor •the implementation of the Statutory Audit Directive by member states

A decision by the EC is due •before the end of 2009 on whether to adopt International Standards on Auditing (ISAs)


INTERNATIONAL AUDITING AND ACCOUNTING STANDARDS BOARD

ISA 550

New ISA on related parties

Further progress on ClarityMomentum is growing towards achieving the International Auditing and Assurance Standards Board (IAASB) goal of completing the Clarity project by the end of this year with the approval of an additional four clarified ISAs at the IAASB’s March meeting:

ISA 550, • Related Parties (revision)

ISA 250, • Consideration of Laws and

Regulations in an Audit of Financial

Statements (redraft)

ISA 510, • Initial Audit Engagements –

Opening Balances (redraft)

ISA 570, • Going Concern (redraft)

Their release as final pronouncements

is pending confirmation by the Public

Interest Oversight Board (PIOB) that due

process was followed in their development.

The effective date for these and for all of the clarified International Standards on Auditing (ISAs) (see table), is for the audits of financial statements of periods beginning on or after 15 December 2009.

As all of the clarified ISAs have now been released as exposure drafts, the IAASB’s 2008 agenda is focused on analysing responses that they have received and finalising the ISAs. The table below summarises the current status of the Clarity revision project.

The IAASB has approved the revision of ISA 550, Related Parties. The new ISA has had a long gestation, including two exposure drafts. ‘The challenge was to find the right balance in defining the auditor’s responsibilities in light of the inherent limitations associated with related-party relationships and transactions,’ explained Diana Hillier, PwC partner responsible for global assurance standards and a member of the IAASB Related Parties Task Force. ‘It was important to set the requirements so that they would embed appropriate scepticism while, at the same time, setting realistic expectations.’

The new ISA overlays a risk-based approach with certain minimum procedures that the auditor must carry out to provide a reasonable basis for identifying and assessing the risks of material misstatement that arise from related parties.

Auditors will be expected to obtain an understanding of the entity’s related-party relationships and transactions through: inquiries of management; understanding the relevant controls established; and inspection of all the relevant records and documents. Particular focus will be placed on

significant transactions outside of the normal course of business and on investigating any previously unidentified and undisclosed related parties or significant related-party transactions that are identified. In addition, auditors will need to obtain sufficient appropriate audit evidence regarding any assertions made in disclosures about transactions being conducted on terms that are equivalent to those prevailing in an arm’s length transaction.

The ISA will be effective from 15 December 2009, pending the PIOB’s final review of it.

Released final Clarity iSAs

Clarity iSAs approved by the iAASB and awaiting PioB confirmation

Exposure drafts of iSAs

ISA 230, Documentation ISA 250, Laws and Regulations ISA 200, Objectives

ISA 260, Communications with Those Charged with Governance

ISA 510, Initial Audit Engagements ISAs 220/ISQC 1, Quality Control (firm and engagement levels)

ISA 240, Fraud ISA 550, Related Parties ISA 265, Control Deficiencies

ISA 300, Planning ISA 570, Going Concern ISAs 320/450, Materiality/Evaluating Misstatements

ISA 315, Risk Assessment ISA 402, Service Organisations

ISA 330, Responding to Risk ISA 500, Audit Evidence

ISA 540, Estimates, including Fair Values

ISA 501, Evidence – Specific Matters

ISA 560, Subsequent Events ISA 550, External Confirmations

ISA 580, Written Representations ISA 520, Analytical Procedures

ISA 600, Group Audits ISA 530, Sampling

ISA 720, Other Information ISA 610, Internal Audit

ISA 620, Experts

ISAs 700/705/706, Auditor’s Report and Modified Reports

ISA 710, Comparative Financial Information

ISAs 800/805, Special Purpose Audit Reports/Summary F/S

ISAE 3402, Assurance on Controls at Service Organisations


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ISA 501

Clarifying ISA 501 – principles vs rules?

IAASB

Building a global SAS 70 model

From the outset, one of the concerns about the IAASB’s Clarity project was that it could result in more rules-orientated auditing standards that drive a ‘tick-box’ mentality rather than sound application of professional judgement. For the most part, however, the revised Clarity ISAs have avoided that trap. Although the redrafting process has undoubtedly resulted in more ‘requirements’, they have remained objective-orientated.

The recent Exposure Draft of ISA 501, Audit Evidence Regarding Specific Financial Statement Account Balances, is, however, an interesting test of the IAASB’s commitment to principles rather than rules.

‘ISA 501 has always been somewhat of an anomaly in the body of ISAs,’ noted

PwC partner Diana Hillier. ‘It was a mix of required procedures related to specific financial statements amounts and disclosures.’ The explanatory guidance in the extant ISA was quite procedural, but the bold lettered requirements remained at a relatively principles-based level. The intent of the extant ISA was to mandate certain procedures, not how to do them.

‘Straight application of the Clarity drafting conventions in this particular case results in elevation of much of the “how to” guidance to requirements,’ Ms Hillier told World Watch. ‘The result is an ISA that is out of character with the other ISAs.’ Indeed, it is difficult to draft the objective of this ISA, as its purpose is to mandate certain procedures but the requirements themselves

contemplate circumstances when the procedures are not required.

There is concern that the IAASB’s decision on this ISA could set a precedent for future ISAs. If ISA 501 remains as detailed as proposed in the draft, it could encourage the introduction of further procedural requirements in other ISAs, or the proliferation of ISAs with individual requirements for specific assertions for various line items in the financial statements. It is hard to reconcile either with a set of principle-based auditing standards.

The comment deadline was at the end of March – the IAASB expects to approve the standard at its September 2008 meeting.

In January, the IAASB released an exposure draft for a new assurance engagement standard on Assurance Reports on Controls at a Third Party Service Organisation. In broad terms, this new standard will become the international equivalent of the US Statement on Auditing Standard (SAS) 70, Service Organisations (AU Section 324).

Some jurisdictions, such as Canada and the UK, have their own standards for engagements to report on service organisation controls. There has not been, however, a recognised ‘international’ standard. As a result, US SAS 70 is currently used not only in the

US, but also internationally. Once released, it is anticipated that the IAASB’s ISAE 3402 will be widely used as the standard for conducting engagements to report on controls in a service organisation.

‘This is a welcomed development,’ said Tony Pedari, PwC partner who chairs PwC’s global ISAE 3402 Advisory Group. ‘The advantages of having a common basis for the conduct of engagements to report on controls are readily apparent and, therefore, it is useful to fill this gap in international standards.’

‘Differences in recognised standards governing such engagements globally would be unfortunate,’ added PwC partner Diana Hillier. Both the US and Canadian standard setters are revising their respective auditing standards concurrently with the IAASB’s project. ‘The liaison among the groups is encouraging and bodes well for convergence of the respective standards.’

One of the significant changes from current practice proposed in the exposure draft is that it is designed as an assertion-based engagement – that is, management

of the service organisation is expected to confirm assertions regarding the description, design and, for Type B reports, the operating effectiveness of the controls. The assertions would be included in a statement made available to intended users that accompanies the description of controls.

Although different from current practice under SAS 70 and other equivalent national standards, this is consistent with financial reporting models.

‘To work well, it will be vital that service organisations’ management understand the assertions they are being asked to make and the criteria on which they are based,’ said Tony Pedari. ‘We are not yet convinced that the proposed ISAE is sufficiently clear in this regard or that it provides sufficient guidance.’

The views of service organisations are important to this discussion. The IAASB allowed an extended consultation period on the exposure draft to enable the Board to reach out and engage fully with them. The IAASB will be deliberating on the comments received from auditors, service organisations and other interested parties in the second half of this year.


IFIAR

Regulators get their heads together

EU REFORM

EC to take action on auditor liability

Independent audit regulators from 22 countries participated in the third meeting of the International Forum of Independent Audit Regulators (IFIAR). The Commission de Surveillance du Secteur Financier (CSSF) of Luxembourg and the Financial Reporting Council (FRC) of Mauritius were admitted as members, bringing the membership up to 24 jurisdictions.

A number of issues were discussed at the meeting, including reviewing the role of audit regulators in the current market turbulence, and it was agreed to discuss members’ experiences at the next meeting. Members also received updates on the steps taken in some jurisdictions to examine the issues of concentration and choice in the audit market.

A core area of focus for IFIAR is audit inspections, and following a successful second audit workshop in January 2008, a further workshop will be held early in 2009. This workshop will provide an opportunity for the continuing exchange of inspection techniques and experiences.

Members also agreed to keep the impediments to information exchange between national regulators under review, particularly to assess the implications of upcoming changes in legal requirements in a number of jurisdictions. They are keen to be able to share information to support their supervision, investigation and enforcement activities for cross-border group audits as well as international audit networks.

Other key issues discussed at the meeting included:

Audit quality•

Foreign auditor registration•

Issues relating to International •Auditing Standards

Dialogue with other international •organisations

The IFIAR representatives present agreed on the text of a charter for IFIAR that members expect to adopt at the next meeting, scheduled for September this year in Cape Town, South Africa.

The European Commission is expected to issue a recommendation imminently that calls on member states to allow auditors to limit their liability. Currently, the limiting of auditors liability varies from country to country – Germany allows for financial caps, the UK allows for proportionality agreements, while France does not allow for any liability limitation.

As we identified in the last edition, the European Commission carried out an independent research project into auditor liability reform in 2006. Internal markets commissioner Charlie McCreevy announced in December that the commission recognises the

evidence in favour of limiting liability and will recommend that member states bring forward domestic legislation that allows auditors to limit their liability. The two areas that are thought to have received particular focus by the commission in reaching its decision are: the risk of cataclysmic liability claims against audit firms; and the attractiveness of the audit profession to new entrants.

A number of European countries, which do not currently limit liability, are thought to have already started considering how to allow for limited liability within their legislation.

POB

Transparent reporting

ISA 540

Auditing fair values

The Professional Oversight Board (POB), one of the seven operating bodies of the UK Financial Reporting Council (FRC), has recently published statutory regulations that require auditors of public interest entities to disclose annual transparency reports and set minimum criteria for those reports. The changes became effective for financial years starting on or after the 6 April 2008.

This move implements article 40 of the European 8th Company Law Directive on statutory audit in 2006, which states that public-interest entities should ‘publish transparency reports within three months of the end of each financial year’. Many other EU member states have also started to implement the requirements.

Paul George, director of the POB, noted that, in addition to improved monitoring of the individual public entities, the new legislation now in the Companies Act would also give those public entities ‘the opportunity to differentiate themselves, for example by setting out the ways in which they achieve high-quality audits’.

Similar to other standards setters and regulators, the IAASB has been contemplating whether additional standards or guidance for auditors might be needed in light of the credit crisis. A video conference with stakeholders was held in February this year.

The release of the new ISA 540, Auditing Accounting Estimates, including Fair Value Accounting Estimates, and Related Disclosures, is particularly timely – although the new standard will not become effective immediately. Some believe that there may be specific topics relating to audit evidence where further guidance is desirable – for example, whether broker quotes provide sufficient evidence when there are no other observable inputs to support a valuation.

A working party is being formed to investigate the need for, and nature of, further guidance. As a first step, a series of consultations took place in April to learn from audit firms’ experiences during the current audit cycle.


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OPINION

Big GAAS, little GAASWe don’t need a separate, simplified set of principles-based auditing standards for smaller entities, argues Jim Lee, because a single set that is scalable will work for all; but certain variations might make sense

in light of the discussion about simplified accounting standards for small and medium-sized companies, it is the right time to consider whether there should be a simplified, self-contained set of auditing standards for smaller entities too.

Generally Accepted Auditing Standards (GAAS) used in the audit of companies – from the largest listed to the smallest, non-listed entities – have traditionally been the same for companies within the same jurisdiction. In part, this is because audits, no matter what size an entity is, are designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement.

One set of auditing standards for allMy firm, therefore, supports a single set of principles-based auditing standards that can be scaled to suit all entities – rather than separate sets. Principles-based standards allow audit processes to be scaled appropriately for both small and large entities through the exercise of well-reasoned, professional judgement by the auditor. This is also consistent with the concept that audits are intended to provide a similar level of assurance to users of the audited financial statements, no matter what size the entity is.

These users, whether they are reviewing financial statements of a large listed entity or those of a small, non-listed entity, have the same expectation as to the level of assurance that the audit provides. A separate set of simplified auditing standards for smaller entities would only contribute to the gap that exists today between the expectations of users of audited financial statements about the level of assurance provided by an audit, and the level of assurance actually provided under current auditing standards.

Some differences might workThe unique characteristics of small and medium-sized entities should be fully considered in setting auditing standards in the first place. In appropriate circumstances, however, PricewaterhouseCoopers would support differences in audit requirements that do not have an adverse effect on the level of assurance provided by the audit.

For example, it may be appropriate for auditing standards to require different forms of communications for auditors to engage those charged with governance – one set for smaller entities and different requirements for those going to larger or listed entities. This is because those charged with governance in smaller entities often have an active role in day-to-day operations of the business as well.

Another example might be to have different audit documentation requirements for audits of smaller, non-listed entities. This would recognise that audit documentation requirements for larger, listed entities might also be used by regulators to facilitate their inspection processes. Such differences, if properly designed and implemented, might reduce the costs of audits for smaller entities without sacrificing audit quality.

Watch the expectation gapIn conclusion, it must make sense to support differences in auditing standards for smaller entities provided they do not conflict with the principles of a single-set of auditing standards. Such differences must not exacerbate the expectations gap about the level of assurance provided by the audit, or incur unnecessary costs.

Jim Lee is the global chief auditor at PricewaterhouseCoopers.

Date Key upcoming events location / Contact Sponsors / organisers

04 – 06 June 2008

Carbon Finance North America 2008

New York, US +44 20 7251 9151 www.environmental-finance.com

SCC Americas, Orbeo, Lovells, Merrill Lynch, CCX, ICAP, TFS Energy & First Climate

05 June 2008

The World’s Moving to IFRS New York, US www.financialexecutives.org

Financial Executives International

09 – 10 June 2008

The Forbes CEO Europe Forum

Cannes, France www.forbesconferences.com

Forbes

11 – 12 June 2008

FAIRE 2008 – the Annual Forum for European Responsible Investment (6th edition)

Paris, France +33 952 164 065 www.frenchsif.org

Eurosif

18 – 20 June 2008

13th Annual International Corporate Governance Network Conference

Seoul, South Korea +44 20 7612 7098 www.icgn.org/conferences/index.php

International Corporate Governance Network

23 – 24 June 2008

The Sustainable Finance Summit 2008

Brussels, Belgium +44 20 7375 7170 www.ethicalcorp.com/finance

Ethical Corporation Conferences

24 – 25 June 2008

The Green Supply Chain Summit 2008

london, UK +44 20 7375 7573 www.ethicalcorp.com/greensupplychain


26 – 27 June 2008

CSR Partnerships Summit Amsterdam, the Netherlands +44 20 7375 7165 www.ethicalcorp.com/partnerships


30 June 2008

International Conference on Corporate Governance

Birmingham Business School, UK +44 121 414 6530 www.business.bham.ac.uk/events

Birmingham Business School

06 – 11 July 2008

17th IFAC World Congress Seoul, South Korea www.ifac2008.org

IFAC

03 – 05 September 2008

4th SME/SMP Congress Copenhagen, Denmark +32 285 40 83 www.fee.be/events

SME/SMP


8th Forbes Global CEO Conference

Sentosa, Singapore www.forbesconferences.com

Forbes


RIAA International Responsible Investment Conference 2008

Melbourne, Australia www.responsibleinvestment.org

Responsible Investment Association Australasia

06 – 07 October 2008

11th Annual EMAN Conference Budapest, Hungary http://eman2008.uni-corvinus.hu/

Sustainability and Corporate Responsibility Accounting

06 – 07 October 2008

9th Annual Meet the Experts Conference

london, UK +44 20 7017 7484 www.meet-the-experts.org

In association with International Accounting Standards Committee Foundation

15 – 16 October 2008

Business and Sustainable Environment (BASE)

ExCel, london, UK +44 20 3170 6040 www.businessandasustainableenvironment.com

BASE Communications Ltd

17 – 18 November 2008

Current Financial Reporting Issues Conference 08

New York, US www.financialexecutives.org

Financial Executives International

Autumn 2008 One Planet Leaders Buckinghamshire, UK +44 1444 811 273 www.panda.org

World Wildlife Fund

Diary Dates

pwc.com

Corporate reporting hot topics and the emerging issues that companies need to think about are discussed in the PricewaterhouseCoopers blog. It was set up in recognition of the growing importance and rapid changes in this area.

Written by David Phillips, PwC senior corporate reporting partner, the blog is

updated twice a month and aimed at CEOs, CFOs, financial controllers and others with responsibility for preparing corporate information.

Thousands of people have visited the blog since it started in February last year. Recent topics have included: simple actions to make corporate reporting more effective; a tale of two

reports on transparency; and a sense of urgency on recasting the reporting model.

‘Take a look and submit your comments’ said David Phillips. ‘A blog works best when it is interactive.’

Corporate reporting blog – www.pwc.blogs.com/corporatereporting

governance and corporate reporting world watch* · 29 transatlantic corporate governance cox calls...

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