An Oligopoly’s self imposed Path to Destruction and Disgrace

FF343BE0-2FD9-4E04-B847-0297BE39B0ED.jpegOligopoly is a market structure with a small number of firms, none of which can keep the others from having significant influence. There is no precise upper limit to the number of firms in an oligopoly, but the number must be low enough that the actions of one firm significantly influence the others. Oligopolies in history include steel manufacturers, oil companies, rail roads, tire manufacturers, grocery store chains, and wireless carriers. The accounting firms like Big 4 or 10 are not considered as they probably don’t meet certain criteria, one being they’re definitely not price setters. 

In the accounting industry due to re-tendering  and rotations the fee is on the decline, the regulatory requirements are on the rise and risk of failure is on the rise due to increased complexity of business. Though risk is increasing – profitability is declining, the need for good talent is increasing but the pay scales can’t keep up due to reducing fees. The regulators in every global market are moving the goal post for quality, requiring more work for which the profession has to invest in better technology and more talent. This scenario is disproving the historical economic sense of high risk will have higher return or more demand will push the price (salaries) up.

The principle problem the way I see is that, each firm has an incentive to cheat to capture market share. If all firms in the oligopoly agree not to undercut and keep quality high with a well paid talent pool, then each firm stands to benefit. But what is practiced is to capture substantial business from the others by undercutting. It is like digging your own grave and then complaining that someone is trying to kill you! Such competition cannot be sustained through prices alone as it will lead to shrinking talent pool and therefore expanding output is also restricted. Many opponents will say ‘that’s why you need to invest in technology’ little realizing that you need money to do such investments!

What is portrayed by the media and regulators are the frauds and errors not detected – on an exception basis. These may cover say 1000 companies. What is not reported are the frauds and errors prevented or detected by good audits in the rest of the million companies in the world. This has led to many regions jumping on the band wagon to regulate the auditors. If they spent some of this time on eliminating poverty, terrorism, religious extremism or even global warming… the world would be such a better place! 

Are we on the road to discarding what is good in search of what is better? Can’t we retain what is good and then do incremental work to go from good to great? 

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Ethics is Not yet at the Heart of Business.

Ethical business conduct and Ethical investments are great concepts in the developed world but the findings about ethical behaviors based on public perception is no different to a developing country. Because ethics programmes will only have an effect on corporate culture if they are allowed to take precedence over profits. Whereas all businesses world over are just focused on profits despite the talk of improving environmental, social and governance aspects. 

The Institute of Business Ethics (IBE) carried out a research with the British public in 2016.  The findings disclosed the perception of the general public saying that British business behaviour is not as ethical as it has been in recent years. For the first time since 2012, those that view British business as behaving ethically fell below 50%.

According to these findings:

✅ Less than half of the British public (48%) believe that British business is behaving ethically.

✅ Corporate tax avoidance remains the number one concern of the British public and has seen the biggest increase in prominence between 2015-2016. 

✅ The top three issues were: corporate tax, executive pay and exploitative labour.

Some of the previous findings are relevant in view of NOCLAR ( non compliance with laws and regulations) rules implemented by IESBA for accountants the world over. The IBE 2015 ‘Ethics at Work’ survey highlighted that whistleblowing and speak-up mechanisms are still not being used by employees, and if they are, they are not considered effective. 

When NOCLAR rule was implemented in many countries there were concerns by employees that they do not think anything will be done by management if they decide to raise an issue. However, the governing bodies of the accounting profession did not pay attention to such an issue. 

In the 2015 report, One in five of all British employees say they are aware of misconduct at their place of work. A growing number (84%), say their organisation provides a confidential means for staff to raise their concerns. Yet only half (55%) chose to raise their concerns, and 61% of those say they were dissatisfied with what happened after they had done so (it was 30% in 2012). This helps to clarify that NOCLAR reporting is not going to have a great impact in curbing bribery & corruption. 

The Ethics at Work survey may point towards a disconnect between the provision of NOCLAR reporting or whistle blowing, and its effectiveness. Accountants can’t make NOCLAR work in a vacuum. Boards need to address all relevant concerns raised by their employees to encourage whistle blowing to improve ethical business conduct. Though ethical programs increase ethical awareness, as long as profits take precedence over ethics, whistle blowing regulations or enforcing NOCLAR reporting may be pointless. 

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Failure to Demine the Accounting Minefields

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I borrowed the following two paragraphs to point out that the financial reporting world has not become better in two decades, despite many new  accounting standards and rules. The relevant article was titled  “Tread Lightly Through These Accounting Minefields” (H David Sherman and S David Young from the July–Aug 2001 HBR Issue), and I quote;

“The nightmare of risky accounting is on the increase. In the current economic climate, there is tremendous pressure—and personal financial incentive for managers—to report sales growth and meet investors’ revenue expectations. According to the SEC, misleading financial reports, especially involving game playing around earnings, are being issued at an alarming rate. …

To avoid such a calamity, shareholders and their representatives on corporate boards should keep their eyes peeled for common abuses in six areas: revenue measurement and recognition, provisions for uncertain future costs, asset valuation, derivatives, related-party transactions, and information used for benchmarking performance. If disaster strikes, it will most likely occur in one of these accounting minefields.”

The above situation has not changed for the better. The release of more complex accounting standards in the last few years has only aggravated the preparation of misleading financial reports. The latest standard to impact asset valuation is IFRS 9. The hope was that a realistic assessment of financial instruments would reflect a true picture of current economic reality. However, the estimates and judgments involved in the measurement of instruments has injected enormous subjectivity into the financial reporting process creating new avenues to manipulate financial statements and mislead users.  

Consider the accounting treatment of Greek bonds by European banks in 2011, involving government debt in Greece. Write-downs of the bonds varied from 21% to 51% despite all large European financial institutions having access to the same market data. The Royal Bank of Scotland, for instance, recognized a charge to earnings in the second quarter of 2011 of £733 million, after a 51% write-down from the balance sheet value of £1.45 billion for its Greek government bond portfolio. In doing this, RBS followed the IFRS fair value hierarchy, which states that if observable market prices are available, they must be used. On that basis, RBS noted that market prices had dipped by just over half the price paid for those bonds when they were issued. Meanwhile, two French financial institutions, BNP Paribas and CNP Assurances, looked at the very same data and chose to write the bonds down by only 21%. They rejected the market prices on the questionable grounds that the market was too illiquid to provide a “fair” valuation. Instead, they resorted to so-called “level 3” fair value estimates in a process known as mark-to-model (in contrast to the mark-to-market valuations used by RBS). Source: HBR/internet

If such difficulties arise with tradable securities, imagine how difficult it is to apply fair value principles and quantify expected credit losses in a loan portfolio, changing from the incurred loss model used previously. By selecting inappropriate methods banks can inflate the opening balance impact and show increased profits in the current period with inflated earnings per share being used to hype the market price of shares. An opportune time to ‘pump and dump’ bank shares and buy back when the market collapses further? It’s only my theory. You know what they say, “the proof of the pudding is in the eating”. The problem is one has to wait till the disaster occurs to prove the theory!

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Why governance for SMEs?

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When Joe or Alice opened a corner shop in the neighborhood they never thought of governance frameworks and policies. They knew they had to sell stuff at a price exceeding cost and make a living out of what is called profit.  They may have 

not known standard costing or absorption of fixed overheads nor understood variable cost, etc. They could have continued this way without any borrowings from financial institutions and being below the tax bracket. They may not need more employees and didn’t have the need to segregate duties to safeguard assets, etc. 

If Joe wants to scale up and become an SME or become even bigger he has to invest more, expand beyond a one man show and put processes to sustain long term success. Therefore, impact of other stakeholders like financiers, employees, society, government, etc will start to increase. If the corner shop becomes a medium sized company then, external directors and internal control processes and many other structures will be required. Good corporate governance will make it easy to bring in outside expertise, attract funding, and ensure long-term sustainability.  There are many researches and organizations like the OECD and IFC supporting this view. 

Joe’s corner shop nor any other business does not exist in a static state. All businesses are constantly evolving due to volatility and uncertainty in the business world. This requires the role of the owner or the board also to evolve over time. As the corner shop evolves into a SME and matures, there will be a greater need to bring in outside directors. Those external board members may initially be most valued for their complementary skills. Such external director’s role will be useful to improve governance practices and to manage future related party transactions and potential conflicts of interests. 

However there are many obstacles to implementing good governance measures in SMEs. These may include:

  • a lack of understanding of board room dynamics and roles
  • a lack of understanding of how independent non executive directors (NEDs) are supposed to work
  • difficulty in finding high-quality NEDs who are independent.
  • a distrust about the positive results of raising corporate governance standards in the business
  • failure to see the urgency of improving governance when compared with other pressing business issues, such as managing cash flow
  • a concern about the additional costs.

There are many challenges to understanding the role that corporate governance can play in helping SMEs to  grow. The biggest challenge is to make the owners of SMEs to take the time to understand what corporate governance means and how improving it could benefit the business. Another challenge is the belief that, in an economy characterised by widespread corruption or weak enforcement of laws and regulations, implementing corporate governance standards will lead to frustration and have limited impact.

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Governance & Journalism in good Ole Lanka!

 

In contrast to Donald Trump’s war cry about “fake news”, a humble Barack Obama emphasized in one of his speeches to the African leaders that “good governance means everybody has a voice, that government is transparent and, thereby, accountable. And even though leaders don’t always like it, the media plays a crucial role in assuring people that they have the proper information to evaluate the policies that their leaders are pursuing.”

Unfortunately for us in Sri Lanka we’ve got camps of journalists, many of them not being a critical art of civil society respecting the right of the people to receive unbiased news. They’re in the business of cashing in sensational news. While Governments have respect the right of journalists to practice their trade as a critical part of civil society and a critical part of any democratic norm, journalists and news corporates need to reciprocate. 

Obama draws a connection between good governance and economic development. He said that “More and more countries are recognizing that in the absence of good governance, in the absence of accountability and transparency, that’s not only going to have an effect domestically on the legitimacy of a government, it’s going to have an effect on economic development and growth.” Unfortunate again for us in Sri Lanka only a minority of local leaders realize this aspect. Fraudsters think we don’t need ethical funding from IMF or any multilateral agency but can continue to borrow from China and enjoy life infinitely! The opponents of good governance know that economic independence of people will reduce the power and dependence on politicians, who act like demigods.

The US approach under Obama was stated as follows to the African leaders and it applied to our progress in the last few years. He said  “We will work with countries even though they’re not perfect on every issue. And we find that in some cases engaging a country that generally is a good partner but is not performing optimally when it comes to all of the various categories of human rights, that we can be effective by working with them on certain areas, and criticizing them and trying to elicit improvements in other areas.” Unfortunate for us again, our politicians want to put to test this statement and they may not face a challenge as the president of the US today is Trump. 

How does a third world country get out of this trap of geo politics, bad governance, selfish politicians & journalism and an ineffective civil society? Revolutions, terrorism and other unrest is not the answer. In developed countries politicians are treated as normal beings and held accountable. In undeveloped or developing countries politicians have created an aura of godlike image. What we need to do is;

Stop funding corrupt politicians, 

Stop asking for illegal/unethical favors from politicians, 

Sensible & fearless journalism

Corporates learn to compete on a level playing field

Stop worshipping politicians, 

Treat politicos like normal people who are elected to serve us and not like gods, to save us from this Unfortunate situation.

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Audit Committee role in IT Governance

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With increased automation of operations in companies, internet connectivity and reliance on IT the associated risks have also increased many folds. Questions have been raised regarding the role of the audit committee in monitoring increased IT risks. The audit committee seems to be in the best position to have oversight responsibility to monitor IT risks.  In many governance structures the board of directors is responsible for the strategic direction and decisions regarding IT. However, in the absence of a specific risk management or a similar committee, the audit committee should be responsible for the oversight of IT operations and risks. 

Oversight means to oversee someone or an activity. Oversee means for somebody/something to watch somebody/something and make sure that a job or an activity is done correctly.  Such definitions are sometimes confusing in the context of holding an audit committee responsible to oversee IT Governance. An audit committee has to achieve this purpose while performing an non executive function.

Simply put, the Audit Committee should ensure that Management is performing ongoing assessments of all IT risks and be satisfied that these risks are adequately addressed. The CFO and CIO along with the Internal Auditor should be held responsible to provide assurance regarding design & implementation of controls to mitigate all IT risks. 

How can the Audit Committee perform an ‘oversight’ role? 

  1. Define its scope within the Audit Committee charter
  2. Set in place a corporate culture that’s followed by IT staff who are trained to acknowledge what could go wrong, able to recruit control conscious people and encourage sharing as well as open and honest communication. 
  3. Ensure a proper framework like COBIT is used by the CIO and receive a comprehensive plan from the CIO comprising an assessment of the IT function, potential risks and  IT controls in place. ( COBIT -Control Objectives for Information and Related Technologies is a good-practice framework created by international professional association ISACA for information technology management and IT governance. )
  4. Use internal audit to support oversight. Internal audit should be equipped with IT knowledge and that should be used to assess effectiveness of IT controls and how they mitigate all key risks. 
  5. The Audit Committee may obtain an understanding of the extent of the IT-related testing and evaluation performed by external audit to get comfort on the IT risks affecting the financial reporting process.
  6. The audit committee may also use an independent external expert to critically review the IT risk assessment and the designated controls to ensure they’re sufficiently comprehensive and appropriate to provide the necessary assurance, based on good industry standards.

The audit committee should use all three i.e, the CIO, Internal Audit and External Audit to obtain assurance that IT is being managed and that IT risks are being mitigated properly. 

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Govern Artificial Intelligence or face Destruction

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After reading the title, many well read corporate leaders and IT pundits must be wondering what’s wrong with me or thinking if I also need AI, which may have been useful considering the state of our political situation! Considering our local politicians’ ability to be happy and have eternal power without Any Intelligence (also “AI”) and without ethical values makes the book Homo Deus look like something of the past and not the future.  

In the book: “Homo Deus: A Brief History of Tomorrow” written by Israeli author Yuval Noah Harari, professor at the Hebrew University in Jerusalem, he speculates about the human ambition for happiness and power based on evidence from the past and present. Harari believes that humanism may push humans to search for immortality, happiness, and power and the inheritors of the present human race will be godlike.

My counter argument is if humans want to continue to be the dominant being, why would they invest so much in creating robots or super humans with AI who can potentially destroy their creators. Yeah, sounds like the story line in Terminator, Transformers, iRobot, the Avengers Age of Ultron or even the Matrix. Why not put that investment in cancer research, HIV control, improve life expectancy or even into ensuring food security of the human race? 

Technological developments have threatened the continued ability of humans to give meaning to their lives. Harari suggests the possilibity of the replacement of humankind with a Superman  or “homo deus” (human god) endowed with abilities such as eternal life. Therefore, if big data, algorithms and robotic processes are to dominate the human race in the future, whats the point in living. May sound like slavery in the past centuries. 

Considering the seriousness of the analysis in the book, Harari‘s himself closes with the following question addressed to the reader:”What will happen to society, politics and daily life when non-conscious but highly intelligent algorithms know us better than we know ourselves?”

Needless for me to present the enormous benefits of AI as we hear them on a daily basis. But we should remember the words of Max Tegmark, President of the Future of Life Institute; “Everything we love about civilization is a product of intelligence, so amplifying our human intelligence with artificial intelligence has the potential of helping civilization flourish like never before – as long as we manage to keep the technology beneficial.“

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