Discussion has focused on corporate governance mechanisms to address the issues of financial reporting quality following scandals in the USA and Europe.
As a post-Enron development, audit committees, for the UK at least, represent a governance innovation that might promote financial reporting quality.
Effective corporate governance in turn means a series of mechanisms which ensure effective resource use, financial performance and social accountability and responsibility.
These emphases are suggestive of a relationship between corporate governance and social and environmental disclosures as manifestations of financial reporting quality, and that an effective audit committee will promote that relationship.
Using environmental reporting as a specific case of social disclosures, we examined the relationship between audit committee effectiveness and the quality and extent of narrative disclosures, specifically those relating to environmental matters in a paper recently published in the Journal of Applied Accounting Research (JAAR): “Audit committees and financial reporting quality: Evidence from UK environmental accounting disclosures”, which I co-authored with Aly Salama and Steven Toms.
The paper uses data that includes all firms continuously listed in the UK’s FTSE 350 in the period 2007–2011, thereby providing a window to test the Smith Report’s recommendations for audit committees following the issue of the UK Code.
We find firms with higher quality audit committees tend to increase quality but not volume of environmental accounting disclosures. The Smith Report provisions, therefore, improve environmental disclosure quality. Where firms go beyond Smith, there are further improvements in quality, and these benefits are greater for smaller firms.
Audit committees and financial reporting quality
UK regulation, based on the Smith (2003) report, and now assimilated into the UK Corporate Governance Code (Financial Reporting Council Guidance on Audit Committees) specified desirable audit committee features, whilst allowing some discretion as to their adoption.
It recommended that there should be at least three independent non-executive directors, with at least one member having significant, recent and relevant financial experience and that there should be no fewer than three meetings during the year. According to the code, firms are required to comply or explain non-compliance, and firms may go beyond minimum requirements.
Rules concerning audit committee scrutinisation of disclosures and related information, including risk-management processes, are set out in only general terms of clarity and completeness. Social, environmental and reputational risks should be viewed as potentially important elements of risk assessment in a company (KPMG, 2010).
Survey and anecdotal evidence suggests good reasons to link audit committees with the quality of environmental disclosures.
KPMG conducts an international survey of corporate responsibility reporting every three years. There has been an important shift with corporate social responsibility (CSR) reporting becoming a standard practice instead of an exception, where more companies disclose information relating to specific CSR objectives and strategies.
Recent surveys (KPMG, 2013, 2014) show that audit committees’ scrutiny is widespread. For example, 47% of audit committee members, representing the highest percentage of respondents in 2014 (49% in the 2013 survey) believe that economic, political and social risks are among the most important (aside from financial reporting risk), which justified agenda time to discuss these challenges.
The above surveys indicate that audit committees should be involved with CSR initiatives and their impacts on society and community. However, because the degree of involvement varies, research that examines the effects of these variations on the quality of environmental disclosures across a large sample of firms should be able to quantify the differential effects of audit committee quality.
The utility of such an examination is compounded by recent suggestions that the audit function requires extending to include social and environmental issues, strengthened through changes to corporate governance and company legislation.
Our focus on the quality and extent of voluntary narrative disclosures on environmental matters is useful because environmental disclosures are associated with relatively high managerial discretion, providing the opportunity to assess the incremental contribution of audit committees where their role is not substantially proscribed by regulation.
Consideration of environmental disclosures also helps regulators appreciate the effects of current provisions on environmental responsibility, either because it obviates the necessity for further specific regulation, or if such regulation is needed, assists in determining its character.
Implications of the study
Environmental disclosures are mostly voluntary and market-driven, and our study provides insight into the determinants of such disclosures and the effect of audit committees on disclosure behaviour.
Where there has been regulation (for example, the codification of the Smith Report in UK corporate governance practices) the impact on disclosure quality has been positive.
The potential effect of audit committees in this respect suggests that regulation aimed at improving corporate governance processes is also likely to increase the quality of disclosure and improve wider accountability of firms for the environmental consequences of their actions. Also, there is less pressure to specify mandatory environmental disclosure requirements.
As environmental issues become more commercially and politically significant, there will be a corresponding increase in the scope and value of audit committees.
Habiba Al-Shaer is a lecturer in accounting and finance at the Newcastle University Business School.