Ethics, Compliance, and Corporate Value
We have one more point to explore about that new research finding that strong internal whistleblower activity correlates to better business outcomes — namely, why a speakup culture and better business outcomes are moving in step with each other, and why that two-step dance is only going become more crucial to corporate success in the future.
So far, the research published by George Washington University, based on internal reporting data from NAVEX Global, only explains how those two trends correlate. More internal reporting activity tracks with fewer material lawsuits, smaller litigation settlements, higher profitability metrics, fewer external whistleblower reports to government agencies.
Other research has found similar correlations. Ethisphere, for example, has noted for years that businesses on its World’s Most Ethical Companies list outperform the market overall on stock price.
That’s great, but deeper trends are at work here that compliance officers should understand if you want to talk to the CEO and board about investing in all that ethics and compliance entails — which, let’s be honest, is a lot. Senior executives’ natural tendency will be to invest in a compliance function only as much as legally required, or only as much as technology might allow you to “do more with less.”
You can make a different argument, one that positions ethics and compliance in a better light. Boards, after all, are foremost concerned with the organization’s ability to create move value. Sometimes they worry more about how to preserve that value; other times they want to invest in efforts to increase value.
Regardless, value is a number. It exists on the balance sheet. You can calculate it. That’s what boards, CEOs, and CFOs do every day.
If we consider some of the broader forces in business and technology changing where a company’s value comes from, compliance officers can frame ethics and compliance as crucial to a company’s ability to create more value.
So if we consider some of the broader forces in business and technology changing what that number is — changing where a company’s value comes from — then compliance officers can begin to frame ethics and compliance as crucial to a company’s ability to create more value. And you can do it in terms that boards and senior managers understand.
Remember Return on Assets
Start with one notable finding from that GWU research: that companies with stronger internal reporting activity tend to be more profitable, as defined by return on assets.
ROA is calculated by dividing net income into a company’s total assets. It’s expressed as a percentage, and the higher it is, the better. For example, in 2017 the S&P 500 collectively had an ROA of 7.6 percent.
That’s the wonky accounting definition. Conceptually, ROA is a measure of how well a company can put its assets to work to generate profit.
In that context, it’s no surprise that companies with more internal reporting activity also enjoy higher ROA. More internal reporting is really a measure of how much employees (and managers) are willing to talk about problems in the organization. It’s a measure of your speak-up culture — and if a company is generally more willing to talk about misconduct, it’s also more likely to have better communication generally.
So of course that company is probably going to have higher ROA, or as Ethisphere’s research shows, higher share price returns. Companies that communicate well know how to work as a group, and can put those company assets to work more efficiently. They are better at overcoming those silos we always like to talk about.
Here’s the kicker, however: those assets that companies are putting to work — slowly but surely, those assets are also becoming more dependent on strong corporate cultures. The very nature of the assets a company owns, and therefore what determines the company’s value, is changing.
A company’s assets fall into two basic categories: tangible assets that physically exist (factory, inventory, cash), and intangible assets that don’t (intellectual property, trademarks, goodwill).
Well, if you look at the portion of corporate balance sheets attributed to intangible assets — they are, inexorably, rising over time. The tables below show intangible assets and goodwill as a portion of all assets, over the last five years.
Table 1 examines the trend for all U.S. publicly traded companies as a whole.
Table 2 examines the trend for the average S&P 500 company. Same as the first trend.
The trend is clear: we are placing more value on the intangible assets that a company owns. Moreover, the numbers shown above probably underestimate the total value of intangible assets, thanks to a quirk of accounting rules that says you can only report intangible assets you acquire as a line item on the balance sheet; intangible assets a company develops in-house aren’t reported so clearly.
Now start putting all the pieces together.
From Assets to Ethics and Compliance
First, we have rising corporate value attributed to intangible assets such as intellectual property, trademarks, licenses, and “brand value” as capture in goodwill paid for an acquisition.
That’s only going to become more true in the future, thanks to better technology. Companies will derive less value from possessing physical assets such as factories and inventories; and more value from their skill at manipulating goods or providing services.
Companies will also need people to do that — potentially fewer people, but also smarter people who can develop and manage all those intangible assets. That’s why companies like Apple are worth more than Walmart ($915 billion vs. $297 billion), while Apple has far fewer employees (123,000 vs. 2.2 million).
Companies will derive less value from possessing physical assets such as factories and inventories; and more value from their skill at manipulating goods or providing services. They will also need people to do that — potentially fewer people, but also smarter people.
In the macro-economic sense, we might wonder what all this means for gainful employment. Compliance officers, however, don’t work for the macro-economy. You work for specific companies, with specific boards, scrambling to increase enterprise value amid a complex global economy.
Those employees will need to work well together. They will need to navigate highly regulated industries and highly complex organizations — where codes of conduct, regulatory compliance, and proper procedure all matter much more than they did in the past.
They will also tend to be better educated, and therefore more employable. So they will therefore be more likely to have an opinion about the company’s ethics and culture, or to tell the company where it can go if it ignores those issues. So your ethical culture better be a good one.
Ethics and compliance functions help to build the corporate culture that supports all those needs. Does greater internal reporting activity cause the strong culture that companies will need to survive and create value in the future? No. But a culture that supports strong internal reporting is the same one that energizes and mobilizes employees to push the company toward better business performance.
And from here forward, to a greater extent every passing day, that’s how a company is going to generate more value in this hardscrabble world.
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