This comes from the heart, as I am an employer myself...
You should definitely try to put in an Internet Usage Policy as soon as possible. I highly recommend disallowing your employees to browse sites that fit a certain criteria- this criteria may include, Adult, Hate, Violent, Discriminatory, etc...
Not having this in place allows your employees to determine their own policies. Better for the boss to do that.
In addition, an employee's behavior significantly affects other employees' behavior (Read "
Fish"), whether that be positive or negative. The question is, would you really want that type of risk of negativity in your workplace? Negativity directly affects the bottom line, filtering down to salaries and the success of the company. Even big companies have been minimized as a result of negative attitudes!
I would approach the boss with these points, showing that the problem can run much deeper than simple internet browsing- it could ruin his/her company. I'm sure they don't want that. If you can't get anywhere with that, it depends on the direct circumstances, but I wager that sexual harrassment might apply as well.
"Computer illiterate is a dirty word."