What does the illustration above show? This century-old image tasks the viewer to decide and will elicit an initial binary reaction: it’s either a duck or a rabbit. However, from actively changing your perspective, you learn to see both, and no longer feel it appropriate to conclude one way or the other. Regardless of which opinion you started with, having considered the other perspective, you better understand what you are looking at.
For an investor, speaking to a company will frequently involve interactions with the investor relations department, the CEO, and maybe also the chair of the board. These conversations will invariably give a consistent and deliberate image of a company framed from the perspective of the company’s strengths and opportunities – a rabbit.
Speak to the audit committee and investors stand to gain a different perspective on the company’s position, based on its threats and weaknesses, presented by those responsible for the board’s prudence – a duck.
The need for investors to see both perspectives is accentuated by the deeper integration of ESG considerations to (occasionally fully) inform investment decision making processes. In turn, the broadening requirement for managing risks, including the need for appropriate reporting, raises the pressure on board oversight.
A limited view of risk
There is already significant momentum in the reporting space for consolidating non-financial risks into financials, with the aim of making it clearer for investors to see the impacts on long-term value. However, despite this progress, the degree to which investors explore risk with portfolio companies is still limited in too many cases to “just seeing the rabbit”.
The UK’s Financial Reporting Council (FRC) has recently encouraged investors to address this gap by providing a list of ice-breaker questions for prospective engagements for investors to broach when meeting with an audit committee chair.
The questions look to reaffirm established lines of enquiry regarding significant issues relating to the financial statements, and the committee’s role in oversight of principal risks; however, the FRC encourages investors to stretch their questioning to non-financial risks (such as, climate and cyber, but other material risks as well), and the effectiveness of the external audit, amongst other areas.
Quizzing audit committees on these issues allows an investor to dig deeper into the confidence they have in corporate strategy, the trust they have with the board oversight, and gain a better understanding of the inputs that drive ESG-era investment decision making processes.
Improved understanding, trust, and alignment between investors and corporate boards is a potential outcome, however, the necessity for engaging with companies on this, as with other engagement efforts, is subjective. Those companies with more complex reporting, or complicated value chains, will be higher up on the priority list for this style of engagement, and it is easy to see how (in the case of a bank, for instance) engaging with the audit committee will give a deeper and differentiated view.
An opportunity for the company
Engaging with the audit committee, therefore, presents an opportunity for the company as well. By showing the alternative perspective, companies may be able to better align investors with their view, consolidating the support for their strategy, their management of risk, and the integrity of their reporting.
Regardless of the merits of this access, if we are to encourage this approach, it is incumbent on the board of directors to ensure that the audit committee is effective and representing a strategically important entity. Investors will expect to hear holistic views on the risks impacting the business, in particular the connection between the audit committee’s perception of risks and methodology of internal controls testing and the statutory audit.
Investors will expect to see diverse professional profiles on the audit committee, reflective of the inputs that the committee is having to deal with, not only limited to financial expertise. Further emphasis is placed on this when considering recent controversies relating to the audit industry, which put into focus the heightened need for the audit committee to challenge the robustness of the work of external auditors.
However, as with other aspects of board governance (such as the handling of executive remuneration), with greater transparency comes greater accountability. Closer engagement between investors and the audit committee will require boards to pay closer attention to the effectiveness of the committee to ensure that it is fit for purpose, and strategically additive.
Therefore, while there are benefits for both sides for this style of engagement to take place, it could create a healthy discomfort that encourages higher standards as audit committees become more exposed to investor frustrations.
In summary, investors will benefit from concluding that their portfolio company is both a duck and a rabbit, and it is incumbent on the board to show their investors these perspectives. While this may encourage another front for investor frustrations, it is in the interests of both companies and investors to make sure that audit committees are not, in fact, “just drawing a duck”.
Andrew Brady is a director in the shareholder activism team at advisory firm SquareWell Partners