Companies since the South Sea Bubble have
used accounting methods not to state earnings but to inflate
them and hide losses. Even General Electric, world’s most
admired company has long been suspected of mastering the art
of financial engineering rather than real business performance.
As Warren Buffet reminds us, while Enron has become a symbol
of the shareholders abuse, there is n o shortage of egregious
conduct elsewhere in corporate America or shall we say rest
of the world. We know the classic story of the accountant
who was asked by his potential employer, how much does 2 +
2 add up to? He replied, depends on what you have in mind,
sir.
It is curious that each time we are confronted
with market collapse our immediate response is to seek new
rules and revise old codes. Little do we realise that corporate
discipline is not something that can be achieved simply by
revising codes or adding new ones. Human greed is so insatiable
and human ingenuity so profound that we will find a way to
beat any system. The very people who today are crying for
company law reform and severe penalties were part of the procession
of cheerleaders of Keneth Lay of Enron and Bernie Ebbers of
Worldcom. They are the ones who stoked the fires of impossible
expectations from their new found heroes and lured them to
make commitments they knew could not be sustained. The culprits
include the investors who were so inebriated with irrational
exuberance of 1990s that they almost willed the companies
to tell lies.
The public outcry following the accounting
frauds in US has led to the passing of the Sarbanes-Oxley
Act which creates accounting oversight board, strengthens
auditor independence, requires CEOs to certify accounts, enlarges
rules governing conflicts of interest and increases criminal
penalties. President Bush signed the Act into law on 30 July
2002 and called the legislation the most far reaching reforms
of American business practices since the time of Franklin
Delano Roosevelt. In the UK, the Department of Trade and Industry
has appointed Derek Higgs, Chairman Partnerships UK Plc, to
review the issues of conflict of interest. He has already
been criticised as he is also the non executive director of
Allied Irish Bank which was in the news recently for detection
of a massive fraud. The key issues on which Derek Higgs is
inviting views are:
· What role should non-executive directors perform
and how does this compare to the present position?
· What knowledge, skills and attributes are needed
and what can be done to attract, recruit and appoint the best
people to non-executive roles?
· Do existing structures and procedures facilitate
effective performance by non-executive directors?
· Do existing relationships with shareholders or others
need to be strengthened?
· How can non-executive directors best be supported
to perform their role?
India too has appointed a Committee under
Naresh Chandra, its former Cabinet Secretary and an illustrious
Indian Ambassador to US to examine the entire gamut of issues
pertaining to the Auditor- Company relationship, professional
regulatory bodies and role of independent directors.
As Enron debacle indicates, good corporate
governance code is no guarantee of good corporate governance.
There needs to be stricter monitoring and enforcement of laws
on punishment for corporate scams to ensure that those violate
the public trust do not go scot-free. Along with a requirement
of disclosures and accountability, laws should be amended
to mete out swift and deterrent punishment to the offenders.
The cornerstone of an effective board is
the institution of independent directors. Our first question
should be to find out why it is not working. Indeed why a
person like Lord Young, the then President of UK’s Institute
of Directors called for its abolition? The key to all this
is the manner of their selection. In a survey conducted in
the UK it was found that as much as 75% of non-executive directors
are recruited as a result of an informal networking by an
existing director. A classic example is of a system called
Golden Triangle whereby a director of company A sits on the
board of company B while the director of company B seats on
the Board of company C and the director of company C seats
on the board of company A. The triangle is called Golden because
non-executive director appointed by this arrangement invariably
end up on remuneration committee as well. It is no wonder,
therefore, that Lord Young has lambasted the institution of
independent directors. He argued that relying on part time
outsiders who barely spend 15 hours a year to police boardrooms
was naïve and dangerous nonsense. Non-executive directors
appointed this way become a greater liability and more harmful
than executive directors who at least know the business.
In fact, non-executive director is a misnomer
and an oxymoron. Non executive directors are outside directors
who have no previous connection with the board nor have any
management ties. It is the non-executives and not the CEOs
who are the eyes and ears of the shareholders. Theirs is the
job to bring objectivity and impartiality to the board’s decision
making. They also widen the horizon of the board in formulating
strategy, applying both a wider general experience and any
relevant special skill and knowledge that the board may otherwise
lack. Cronyism in the appointment of non-executives and the
cosiness in the supervision of board room pay can spell disaster
to independence and make a joke of non-executives. Non-executive
directors are crucial to maximising effectiveness of the board
and it is time that the process of recruiting independent
directors is given as much importance as appointment of a
CEO. Ideally, appointment of both auditors and non-executive
directors needs to be made by a group or a vehicle, which
is independent of the board. The process needs to be made
as transparent as possible which is possible only if each
appointment is made through an appointment committee. This
committee should develop criteria for the appointment and
engage an independent search firm for recruitment.
Auditor independence is another area of concern.
Their judgement becomes questionable when auditors perform
a significant consultancy role. It has often been noticed
that the audit contract is a loss leader linked to a lucrative
consultancy contract. As Mike Rake, International Chairman
of KPMG says that auditors accepting consulting services in
the same company simply is unacceptable. Having a $3m audit
fee and $100m non-audit services [fee] just does not meet
the perception test.Forbidding auditors from offering other
services to clients must become an article of faith for ensuring
good corporate governance. Worldcom paid Arthur Andersen $12.4
million last year for such services compared to $4.4 million
for audit fees. Sarbanes-Oxley Act’s requirement of rotation
of auditors to prevent cosy relationships undermining the
integrity of the audit is also worth emulation. Andersen had
been Worldcom’s auditor since 1989. Periodic change of the
auditor might have led to more probing and indepth examination
of accounts.
The most important task before us is to establish
common international accounting standards. For far too long
the accounting standard have been emphasising form over substance.
We need to move away from the prescriptive rule making to
the ground realities of business. This poses one of the biggest
challenges for the International Accounting Standards Board.
We also need to settle once for all the controversy over accounting
for share options which according to John McFall, chairman
of the Treasury select committee, whose report on the financial
regulation of public limited companies, post-Enron, has been
recently published, allows rich executives to retire to a
life time of luxury. It is strange why stock options have
not been treated as an expense so far and why it was left
for Warren Buffet of Coca-Cola to take the lead in this respect.
There is also a need to rein in excessive
executive compensation. Prudential shareholders had set a
good example in scrapping a new pay scheme that could have
netted its Chief Executive Jonathan Bloomer a £4.6 million
bonus on top of his basic salary of £660,000 if certain
targets were met. It has now been generally admitted that
corporate governance principles in US have been used to advance
corporate greed of CEOs. In 1990s while CEO salaries increased
by 30% a year the employee wages remained static. In his recent
address commemorating 9/11, Bill McDonough, President New
York Federal Reserve, denounced the excessive increase awarded
by CEOs to themselves during the past decade. Reminding the
congregation of the commandment to love thy neighbour as thyself,
he said the policy of vastly increasing executive compensation
was .terrible bad social policy and perhaps even bad morals.
He pointed out that studies now indicated the average chief
executive made 400 times more than the average production
worker, compared with the ratio of 42:1 two decades ago. Mr
McDonough urged chief executives and directors to adjust pay
levels to more reasonable and justifiable levels.
In fact, independent auditors, non-executive
directors and audit committee are also not enough. What is
needed is greater overall accountability from everyone in
the company from a clerk to a CEO. They need to be educated
to detect a fraud at an early stage and realise that it is
their job to report any suspicious transactions and activities.
If they do not they could face prison sentences and financial
ruin. What we need is a culture change within companies to
fight the financial fraud, which in the UK alone, according
to City fraud litigation specialist Philippsohn Crawfords
Berwald, has registered an alarming increase of 200% during
the last 6 months. Lot of this fraud is also a byproduct of
new technology. Organisations must use every opportunity for
exposing staff to training in new technologies. Remember,
highly motivated, continuously developed and trained staff
are the best insurance against fraud.
Sarbanes-Oxley Act has done a commendable
job in introducing an Oversight Board which will have five
members appointed by SEC to oversee accounting firms that
conduct audit of public companies. This board will set standards
to uphold the integrity of public audit and will have the
authority to investigate abuse and discipline offenders. There
are in the UK 23 regulatory bodies which make the task of
supervision of auditing standards extremely difficult. There
is an urgent need for a single independent body to oversee
all accounting aspects on the lines of US’s Oversight Board.
The requirement of personal certification
of accounts by CEOs with deterrent penalties for wrong doers
is another step in the right direction. It is necessary for
each CEO to get their financial directors to check whether
the financial reports give you and your shareholders a truthful
account of the state of the company or uses accounting discipline
to hide behind the figures. Remember the phrase profit is
an opinion whereas cash is a fact. CEOs must ask themselves
do the financial reports reveal the information you would
need if you were an outside investor? Are your reports comprehensible
to a lay man? Annual report should contain a section written
by the audit committee summing up issues and explaining them
in simple language keeping special regard to any items of
creative accounting such as accelerated revenue recognition
of balance sheet vehicles and other complex transactions to
hide company losses.
IT can have an important role in improving
the effectiveness of the board. Businesses are becoming increasingly
complex and problems such as Enron are natural to occur when
business has become global. Failures of Enron in fact are
not of accounting but management. Accounting was used to hide
those management failures. Important thing, therefore, is
to prevent such management failures through better governance
structures and creating real time systems like digital dash-boards
that help you access constantly fresh data about different
streams of operation to keep things under control.
Legislators can wave their magic wands and
pass any number of rules. These will be of no avail until
we realise that the market realities themselves have changed
vastly during the last few years. According to Elliot and
Schroth the forces driving the slide include:
§ Complexity. In business, particularly
in global business, complexity becoming deeper and wider and
is providing the hiding places for new forms of business deception.
§ Technology. Advancements are proving speed for business
maneuvers, both the good and the legal and the bad and illegal.
§ Inability to Grasp Reality. Corporations are losing
touch with the performance reality states of their business
operations, finance and accounting, deal making consequences,
and the value of their intellectual capital.
§ The Need for Precision. Managerial task require more
rigor, more precision, and complete accountability in the
boardroom and from the leadership teams.
Unless corporations understand the new requirements
for business performance and the importance of innovation,
budgetary controls and closer monitoring, legislations will
be like firing grenades to stop a tornado. Corporate directors
need to be more radical and revolutionaries constantly spurring
their companies towards creating new competitive spaces through
a spiral staircase of innovation.
The corner stone of the absolute minimum
standards for the constantly gyrating new economy for corporate
managers will be a new form of scientific management based
on performance reality and accuracy in reporting on corporate
capabilities. There needs to be a National Quality Programme
for accuracy in corporate information and all forms of company
disclosures. We should make quality assurance as part of the
corporate reform movement. This will be the foundation for
real performance quality programme based on precision of information
and reporting of corporate data. Quality Awards need to be
restructured and applied to corporate information problems.
Currently Six Sigma is applied for developing and delivering
near perfect product and services. This can be used to improve
the management capability for advancing the best companies
and checking the fraudulent.
Good corporate governance is required not
only to prevent frauds but to maximise value for all stakeholders.
The role of non-executives in the Boards is not only of watch
dog but also, and more so, of creating wealth. Shareholders
are at far greater risk from a mismanaged and under performing
business than an errant individual. Companies have to bear
in mind the potential trade-off between polishing corporate
reputation and delivering growth, says a survey report by
the Economist Intelligence Unit. Tight governance can protect
firms and investors from fraud, error and undue risk, but
it can also threaten agility and innovation.
Executives at the top ten firms by market
capitalisation in the US, the UK, France, Japan and Germany
have expressed concern that tougher corporate governance rules
would negatively affect merger and acquisition deals because
of lengthening due diligence procedures. A majority of company
bosses also believe that the ability of their firm to make
effective decisions would be compromised by closer scrutiny
and tighter legislation. And while corporate governance is
seen as a leading issue by the vast majority of those polled
in this survey, it ranked relatively low on the list of dangers,
executives saw threatening their firms’ share price. Adverse
markets, a shortage of top quality management, reputational
risk and a lack of innovation all beat out concerns over poor
financial reporting and lack of transparency. The report also
calls into question the ability of the regulators to set more
than a broad framework for good corporate governance. Ultimately
rules are no substitute for ethics or how trust operates in
business, says the report’s author, Victor Smart. There is
no one set of regulations which is going to stop Enron.
It should be remembered that, while laws
and their enforcement are necessary to drill good governance
practices, they will never be enough to eliminate them. Human
ingenuity is so phenomenal that people find ways to overcome
these. There is a strong need for voluntary action. This comes
from personal commitment to ethics, social values, equity,
fairness, transparency, rule of law, legitimacy, respect for
individual and recognition of diversity and gender balance
as value enhancer. What we need is an inner value system,
garnished by a strong belief that translucence and deceit
will not pay. We must know that knowledge economy has changed
the world. Earlier companies made money by not informing people.
Today you make money by informing people. The problem comes
of informing people when you have failed. In an innovative
economy of today when you have to constantly design new models
you cannot have a winner all the time. When you are hitting
at a constantly moving target you are bound to miss some shots.
The answer is to have courage to own your failures and share
them with shareholders. Courage is the obverse of transparency.
Transparency cannot be achieved without courage.
Corporate scandals and the consequent collapses
have a lethal effect on the poor and the old. Not only these
destroy their life saving and reduces them to penury and desperation
they take away their confidence in the markets self. They
have no hope to make good their loss. It is a great national
loss. We have to something, therefore, to prevent them happening
again. But revising codes of corporate governance is certainly
not the answer. We have a great capacity to beat the codes.
Andersen have asserted all along that whatever they did at
ENRON or WORLDCOM was within the law and thousands of firms
do the same. Again nothing that President Bush has said in
the aftermath of so many accounting scandals is new. Plastering
over the capitalism’s cracks simply won’t work. It needs a
systemic change which will come only by looking inside and
not from outside. It is we who have to change our paradigm
from individualism to integration, from tangibles to intangibles,
from capital to knowledge, from objects to relationship, from
parts to the whole, from domination to partnership, from structures
to process, from short termism to long termism, from growth
to sustainability, from confrontation to collaboration and
from covering up failures to owning them up.
It is unfortunate that our economic structures
are built on an inaccurate view of the human psyche. Scientists
have recently discovered that the small, brave act of cooperating
with one another, of choosing trust over cynicism, generosity
over meanness, altruism over selfishness makes the brain light
up with quite joy. Experiments conducted on young women engaged
in cooperative effort showed the longer they engaged in cooperative
strategies, stronger were the blood flows to the pathways
of pleasure. Obviously our effort should be to increase opportunities
of cooperation and down play unbridled competition.
As we move into 21st century there is a growing
recognition that the ultimate goal of economic effort ought
to be to improve the quality of life. Money is not a measure
of all things that make us happy and markets are not the best
mechanism to enhance human happiness. Indeed, if completely
unfettered, they can do the opposite by encouraging selfish
behaviour. Our focus should not be only on financial capital
but also the human capital, intellectual capital and environmental
capital. Good Corporate Governance must aim on maximising
the value of all capital.
We need to think of business designs that
go beyond the externalities of quarterly profits and provide
intrinsic sustainable value to all shareholders. With its
belief in equity, fairness, transparency, legitimacy, integrity
and responsibility corporate governance is the best vehicle
to improve quality of life for all and enhance the value of
financial, human, social and environmental capital of this
planet. Alas, it may take many more scandals to move to such
a radical solution but since the alternative is so grave it
might be worthwhile to steer the debate in this direction.
