The Audit - Three Governance Scenarios

Three different perspectives on the audit function and the governance challenges it presents

Richard Murray

The interaction of audit committees and auditors is an ideal laboratory setting in which to examine the objectives, characteristics and challenges of corporate governance. I will address these issues by asking you to reflect with me through three scenarios in which dialogue takes place between auditors and the non-executive directors of companies.

Scenario 1: The Conformance Approach

The first scenario assumes two things:

1. That we are dealing with the kind of companies that populate the US: Fortune 500, the UK Footsie 100 and similar companies throughout the world. This is the sector of the business community which is dominated by the anonymous shareholder model-institutions and individuals who take long – or short-term stakes in the affairs in the company, but generally speaking have no other relationship with the business or its mission.

2. That these companies view corporate governance as principally a compliance tool. Principles and practices of corporate governance are adopted in order to meet legal and regulatory requirements, and therefore to avoid the pernicious burden of legal liability in the Anglo-American world.

In this scenario the duties of audit committee members are relatively simple and straightforward:

• they must challenge auditors on the effectiveness with which companies' financial statements and related disclosures meet regulatory requirements

• they must also challenge auditors on the depth of their understanding, and degree of their satisfaction with companies' systems of internal control, and

• they must determine if there have been any unreported disagreements between the auditors and management during the course of the fiscal year.

• The auditors' dutes are also easily described:

• they must deal substantively and respectively with the committee's questions, and

• they must determine whether the members of the audit committee know of anything that conflicts with the financial statements or the related disclosure of the company.

Not surprisingly, these meetings tend to be short, polite, unexciting, and of marginal value to anyone, except in those unusual circumstances where there are open conflicts between non-executive directors and the management of the company.

Scenario 2: The Performance Approach

The second scenario continues the first assumption on the nature of the companies, but changes the second. In this scenario we are dealing with companies which view corporate governance as an essential component of corporate performance, and as a strategic competitive tool.

These are the companies which would be viewed as more enlightened by the perceptive study issued recently by the Australian Institute of Directors and the Sydney Institute, which drew the sharp distinction between companies which view corporate governance as a «conformance» obligation, and those which recognise its «performance» potential. A survey that Deloitte recently completed with the World Economic Forum, (a survey of over 6.000 companies worldwide) makes it clear that more than 75 per cent of companies focus on conformance and ignore or underestimate the performance potential.

In this scenario, the meetings between auditors and audit committees get quite interesting. The auditor's duties include:

• An assessment of quality of the company«s disclosures and financial statements. Are they conservative, or is the company pushing the margins of tolerability? Is this, in fact, the auditor»s opportunity to present a report card on the behaviour of management?

• The auditor should express a view of the company«s prospects, addressing more appropriate issues such as any visible flaws in the company»s strategic direction, the financial strength available to pursue that strategic direction in the long term, and the company's competitive prospects. This is far more meaningful than the simple compliance with financial statement reporting requirements of giving reasonable assurance that the company will be able to remain in business for another 12 months.

• The auditor should assess the company«s non-financial assets, including intellectual property, human resource competencies and competitive positioning. This is the opportunity to open a dialogue on the real drivers of the company»s future performance potential.

• The auditor should also address non-financial statement liabilities, such as the risk of product obsolescence and merging competitive threats (and today) the implications of emerging electronic commerce dynamics.

• The auditor should offer observations about management«s attitude and behaviour. Does it make unreasonable demands on the auditor? Does it attempt to intimidate staff into compliance with executive will? Is management willing to listen to external advice? What are the strengths and weaknesses of the company»s financial management competencies? Are there lifestyle aberrations among management personnel that warrant attention?

The audit committee members' responsibilities are also diverse and challenging:

• They should disclose to the auditor any insecurities they recognise in the companies' financial resource plan, such as any distresses in the banking/creditor relationships.

• The issue of management integrity should also be examined from the perspective of non-executive directors.

• Committee members should disclose any business relationships not fully presented by management to the auditors.

• The audit committee should disclose the board«s assessment of the company»s strategic business risks, which can be a useful platform in assisting the auditor to evaluate the effect of the risks on the company's position on such central financial statement issues as the recovery of receivables and the realisation of assets.

• The audit committee should identify factors threatening to the company's future which lie outside its control. These could include the availability and pricing of resources and energy supplies, global trading conditions and currency fluctuations.

You will have recognised by now that in this scenario, the interaction between auditor and audit committee is unlikely to be a once a year, or quarterly event. Effective pursuit of these issues requires a healthy continuing interaction between the two, emphasising and enhancing the board's shared responsibility for company performance and the audit as a tool of strategic value.

Scenario 3: The Diversity of Corporate Ownership

The third scenario requires a change in the first assumption. Rather than mainstream Anglo-American public companies, we assume that we are dealing with large public companies in Europe and Asia, as well as private companies in the US and the UK. Here we have moved away from legally mandated governance responsibilities to the real issue: to whom, and for what, are companies accountable?

At an early meeting of the Advisory Council on the World Economic Forum's Corporate Performance Project, there was a fascinating exchange of multicultural views when this fundamental issue was first posed. A leader of the US Shareholder Democracy Movement confidently declared that companies are responsible to their shareholders and for the generation of profit. In his view, board responsibilities are defined by law, and the period of measurement is in quarterly results.

The CEO of a major European-based multinational challenged this, declaring that companies are accountable to stakeholders and other employees as well as to shareholders. In that view, the responsibilities are defined by a combination of law and the conscience of the board, with the period of measurement, scaled in years rather than quarters.

This, in turn, was supplemented by the view of a senior officer of a large Japanese multinational. He suggested that in some countries and cultures, boards are accountable primarily to employees, and occasionally to national economic purposes with shareholder interests not necessarily in first place. In that view, conscience should rule in terms of board responsibility, and legal requirements tend to inhibit rather than enhance the exercise of conscience. In that view, also, the appropriate period of measurement is, if not in decades, at least in multiple years.

It is in this scenario that the most fundamental challenges of corporate governance are to be found. They deeply affect the roles of both auditor and non-executive director. But many of these issues have not yet matured into established principles, like those emerging from Anglo-American traditions, and are often not even recognised for the depth and complexity of matters at issue.

For example, beginning with rather simple mechanical challenges. It is often assumed that financial statement presentation should rapidly be harmonised by those companies and their auditors under a globally recognised standard of financial reporting, such as the International Accounting Standards (IAS).

There are some impediments to doing so. There is no country in the world today which has established IAS as its national standards, and the regulators of financial reporting in most countries would impose civil or criminal sanctions on the companies and auditor who attempted to use non-approved standards.

Then there is the challenge of identifying the audit committee, or its equivalent. For example, in many Western private companies (including some of the world«s largest) there are either no non-executive directors, or they are in such minority that establishing a truly »independent" audit committee is not possible. In these circumstances it is difficult for the auditor to have a Stewardship dialogue with anyone other than the management wearing a different hat.

Beyond this lies more substantive issues, having more to do with the business context. In those countries where endemic corruption is tolerated, or conducted, by government, it is hard to pay serious attention to the challenges of corporate governance, when the company's success or even survival depends upon the purchased largesse of officials or third parties.

There are also countries, many of them in Asia where the conflicts between the old and emerging business cultures present challenges that seemingly overpower both audit and corporate governance capabilities. An excellent current example is the struggle to reorganise TPI in Thailand – where the old ways, and the IMF-imposed new ways, of doing business are struggling to coexist.

There are equally difficult challenges elsewhere in dealing with the contrast between ownership and management styles of the PRC's state-owned enterprises, and their intersection via window companies with the global equity and debt markets. Enterprises constructed on the foundation of government promises, rather than business logic, are difficult for auditors and governance alike.

The Ultimate Challenge

It is in this third scenario that we encounter the largest single corporate governance issue of our times: what processes of governance and stewardship are suitable to link domestic businesses with global foreign direct investment?

There is no doubt that the shareholder democracy principles espoused, by capital providers of foreign investment, principally increasingly organised communities of institutional shareholders in the US and UK, have produced great value. They have been the fuel for growth, and they have been a boon to replacing entrenched management incompetence with more efficient dynamic leadership – most impressively thus far within the Anglo-American communities.

However the role of foreign direct investment, and in particular that of organised institutional shareholders is powerful and has potentially adverse influences as well. Consider, for a moment, the economic power held by these institutions. A recent study by the Conference Board illustrates the point. The study notes (among other things) that the assets of one institutional investor, TIAA-CREF alone are five times as large as the total market capitalisation at year-end 1998 of the Indonesian and New Zealand Stock Exchanges, and greater than the exchanges in Thailand, Singapore, Malaysia and Korea.

The potency of this economic influence can be dangerous. The massive flight of such capital out of Asia in 1997 and 1998 contributed mightily to the resulting Asian financial crisis and threat to global economic instability.

Managers of that capital, who are themselves compensated for their competitive quarterly performance, are hard pressed to behave as a sort of «patient capital» needed for long-term sustainable development. Other speakers here have noted the investment opportunities to lie found in «under-performing stocks» in developing economies. Many of those situations may be the result of badly managed companies whose performance can be enhanced.

That many more might be companies performing exactly as their stewards wish – investing heavily in their potential for stable growth and. profitability over the long term rather than optimising quarterly profits. Investor power seizing these «under-performing» opportunities, and actively exercising their powerful shareholding influence, are quite capable of inhibiting the very fibre of corporate purpose and long-term objectives which management, other shareholders and stakeholders desire.

Beyond the behaviour of foreign direct investment, one must also consider the life-span of such investments. Another study by the Conference Board has noted the dramatic decline in average holding periods for all shareholders in a variety of public companies. The study noted that the average holding period in major traditional companies is declining sharply – for AT&T for example, from an average holding period of 3.2 years in 1995 to a holding period of 1.1 years at the end of 1998. At that same date the major, and then apparently very successful big Internet enterprises (IE Price Line. Amazon and Yahoo) had average shareholder holding periods of less than 10 days each.

In these circumstances, one must have concern for the potential of foreign direct divestment to have the consequence, perhaps unintended, of threatening the self-determining missions of many companies, particularly in developing and transitional economies.

This leads to my final observation. The subject of corporate governance is very closely tied to the increasingly dramatic confrontations in today's society over the globalisation debate. It is often difficult to understand exactly what that debate is about, though trade policy is often a central issue. But trade policy can be credibly described as a win-win situation where the global lowering of barriers provides economic value for developed and developing economies alike, without damaging the strength of developing economies.

By contrast, an unintended consequence of corporate governance rules facilitate shareholder democracy and therefore the active intervention of powerful Anglo-American investment communities. This can at least theoretically threaten to create a win-lose situation, in which the economic vitality and often the precious resources of developing economies have their value consumed by ownership and economic power from the most developed economies.

I do not suggest that this is some massive plot to suck the resources from the Southern Hemisphere into the hands of those in the developed Northern Hemisphere, but it is certainly understandable how the issue could be seen from the viewpoint of developing economies, and equally possible to see how the result would be achieved even without internationality.

Corporate governance is not only a vital issue affecting corporate performance, it is a vital issue affecting the most significant socio-economic and political movements of our age.

Source: The Hong Kong Accountant, February 2001.

Richard Murray is the Director, Legal & Regulatory Affairs Deloitte Touche Tohmatsu. US.