Ethics and financial reporting: is there a connection?

Corporate financial reporting is far from straightforward. There are many questions to consider and decisions to make when preparing financial reports.

Ethics plays a vital role in shaping the professional judgement required to determine the answers.

Dr Peter Do, a senior lecturer in accounting at the University of Queensland Business School, led a 2022 ethics study.

Do’s findings have confirmed a strong link between the culture of ethics, as rated by company staff, and the quality of a company’s public financial reporting.

“Ethics is a very pervasive subject,” says Do. “It affects how people work in a company, the way they think and the way they react to incentives. My impression is that, if they work in a very good culture, people are happier.”

“They are more relaxed about how they work, they will be more productive, and there should be higher work quality.

“Because of all that, I expect that companies with a better corporate culture and a better ethics culture should have better financial reporting quality. That was the premise for my research,” Do explains.

"True and fair" financial reporting

The quality of financial reports is a focus of corporate watchdogs such as the Australian Securities and Investments Commission (ASIC). ASIC conducts risk-based reviews of the financial reports of Australian entities as part of its surveillance program.

Ram Subramanian CPA, senior manager – reporting policy at CPA Australia, says that ASIC examines the preparation of financials in accordance with the Corporations Act 2001 and with the Australian Accounting Standards. The latter are based on International Financial Reporting Standards (IFRS).

The financial reporting requirements in the Act state that the final reports must be true and fair, he says.

“Preparing true and fair financial statements is a well-established concept.

It requires the preparer to ensure that the financial statements are a true and fair reflection of the financial performance and position of the organisation,” Subramanian explains.

Accounting standards that follow the IFRS framework are principles-based.

This means accountants must apply their own professional judgement and expertise when preparing financial reports.

“There is a degree of estimation and assessment, in terms of how certain numbers are measured and presented in the financials.

“The fundamentals of financial reporting, as set out in the conceptual framework for accounting standards, include qualitative characteristics that you expect from financial statements.

"These include attributes such as faithful representation, reliability, relevance and neutrality. These are the fundamental qualitative characteristics that financials should have,” Subramanian says.

Knowing versus doing

An abundance of regulations, guidelines and frameworks govern ethical business practices, but improper behaviour can still slip through the cracks.

The 2019 final report of the Hayne Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry was widely seen as an indictment of unethical behaviours across the sector.

“There are some deeply unethical practices that emerged from the Hayne Royal Commission,” says Wayne Stokes FCPA, a member of CPA Australia’s Ethics and Professional Standards Centre of Excellence.

“Things like selling insurance policies to people who have died – I mean, how much worse can it get?

“As a former CFO, I have had some very robust discussions with my executive peers on what I was and was not willing to put in the financial statements,” adds Stokes.

“Yes, we have IFRS and other accounting standards, but there is still a ‘grey area’ that requires some level of objectivity and common sense.”

Pressures like the drive for shareholder returns are not uncommon.

 

"I think we clearly understand the negative ramifications of not getting ethics right. What I find interesting is there is not enough done in promoting how good ethics can improve the bottom line."

 

“Places like Australia are very compliance‑heavy, for all the right reasons, but I think that introduces an extra layer of stress that can result in the opposite of what it is intended to achieve,” says Stokes.

“Sometimes, personal agendas come into play, because executives may have a personal opinion and they push it, although I think that occurs less these days.”

Clare Payne, EY fellow for trust and ethics and author of A Matter of Trust: The Practice of Ethics in Finance, says organisations must strike the right balance between their social obligations and their drive for profit.

“There is inevitably tension when they have to make decisions,” says Payne, an honorary fellow at The University of Melbourne.

“I think one of the biggest inhibitors of progress towards a more ethical, fairer corporate world is the prioritisation of the short term over the long,” adds Payne. “This is a real dilemma for businesses.

We also see it with governments – how do they invest and make policy decisions over longer than the election cycle?

“There is a tension, and it is something leaders, and particularly boards, have to grapple with. It is why we need brave leaders who will talk about the ethical dimension of their decisions.”

Ethical questions come to the front

Despite this perpetual tension, Payne has observed a move towards more transparency and disclosures that are above legal and regulatory requirements.

She also notes the positive progress that has occurred since the Hayne Royal Commission.

“During the Commission, there was a focus on the question, ‘Even if something is legal, is it right?’,” she says. “It really went to the question of ‘Should we?’, which you could say is the ethical domain.

“I have heard this question asked when discussing business within the finance sector and across other sectors,” adds Payne.

“This demonstrates an acknowledgement that meeting the legal minimum might not be enough. I think this has become more commonplace since the Hayne Royal Commission, because that was the standard that organisations were held to.”

Payne has also noticed a greater accessibility to leaders of organisations in recent times.

“During the Hayne Royal Commission, we saw CEOs fronting up to answer questions, and I do think that leaders are now a bit more visible and more accessible, and therefore more accountable,” she says.

“Historically, leaders have been able to hide behind corporate communications or just deliver a ‘No comment’. There’s a different relationship with the community now, and I think this was either already happening or has accelerated after the Hayne Royal Commission,” she explains.

A lot of the change is driven by growing stakeholder expectations of ethical behaviour and strong environmental, social and governance (ESG) commitments.

“The level of sophistication, in terms of how people make purchasing decisions, is increasing,” says Patrick Viljoen CPA, senior manager – ESG at CPA Australia.

“When you bring it down to basic economics, if your customers are demanding a particular service or product with ethical expectations and you fail to deliver on that, they will vote with their feet. There is an economic imperative here.”

Stokes adds that ethical practices lead to greater consistency for shareholders and financial analysts.

“You will also have better credibility and a happier organisation,” Stokes says. “People will be remunerated appropriately.

You will have a P&L [profit and loss statement] that is substantiated. It will not then be subjected to misstatements or pressures that ultimately come out a few years down the path, when some of the individuals have long gone.

“I think we clearly understand the negative ramifications of not getting ethics right.

“What I find interesting is there is not enough done in promoting how good ethics can improve the bottom line,” says Stokes.

Fostering ethical environments

Financial reporting is a window into ethical conduct. Stokes believes organisations need to create an environment that encourages individuals to do the right thing.

“In a boardroom setting, there is often a hesitation to dissent if five of the seven people are in agreement,” Stokes says.

“There is a natural, inbuilt mechanism to protect yourself and to not be the odd one out, and therefore you may not want to voice your opinion.

“The boardroom has to create a safe culture of willingly speaking out and not being dismissed. I think that comes back to the chair’s role of creating that safe space.

“We talk about it among the executive ranks – creating that safe space for feedback.”

 

"Preparing true and fair financial statements is a well-established concept. It requires the preparer to ensure that the financial statements are a true and fair reflection of the financial performance and position of the organisation."

 

Increased transparency should not be seen as a proxy for ethics or trust, Payne adds.

“Companies can be transparent and have numbers that are not particularly good, or they can ‘cherrypick’ numbers, so that people do not really understand what is going on,” she says.

“There are other factors that matter in addition to having more transparency. For example, when companies have an AGM [annual general meeting], how do they respond to questions?

"How do they speak to their financial reports? Are they honest?”

For Stokes, ethics comes down to doing the right thing at both an organisational and an individual level.

“You are always going to get the ‘rogues’ and the ‘heroes’ at either end of the spectrum,” he says. “We really need to focus on the 95 per cent in the middle, where there is a ‘grey area’ for people who are either misaligned or pressured into doing the wrong thing.

“I think that when your team sees you take the highroad and a more conservative approach – rather than being a ‘cowboy’ when it comes to the finances – they take comfort in that,” adds Stokes. “You have to sit back and simply ask yourself – is this right or wrong? We all know the answer.”

Ethical conduct and financial reporting quality

Findings of a research project led by the University of Queensland’s Dr Peter Do show that firms with better ethics scores produce higher quality financial reports.

The research, supported by CPA Australia through its Global Research Perspectives Program, draws on ethical culture reviews for ASX-100 companies published on the employer review site Glassdoor between 2008 and 2022.

Using an artificial intelligence tool, researchers have analysed the natural language in the reviews, have interpreted what it conveyed about the ethics of an organisation and have assigned each review an ethics score.

The research has found that, for every one‑point increase in a company’s ethics score, the likelihood of their financial statements being restated reduced by 36 per cent.

The research also examines the relationship between the level of ethics at the organisation’s corporate reporting functions and the investors’ reaction to the financial information released.

The findings also indicate that, for every onepoint increase in a company’s ethics score, the stock returns on the day of financial statement release are 0.2 per cent higher.

The researchers now plan to expand the sample size to the ASX 300 to increase the range of different conditions that affect corporate financial reporting quality and investors’ reactions to it.