Disclosures in Financial Statements for better Governance

When there is a contentious issue that requires disclosure, most people throw out the excuse that shareholders rarely read this information or they won’t understand the issue and therefore should not confuse them! In practice this may be true, for small investors. However, companies are obliged to make disclosures to provide information that would not otherwise be obtainable and on which informed decisions can be made. When management understands that they will have to publish something which was not appropriate they would be very careful. Thus disclosure requirements will guide the decisions of management if they know in advance that they will have to reveal the information later.

The need for better disclosures is important to deter management and directors unilaterally misusing or mismanaging companies. Disclosures other than in financial statements like for SEC or regulatory purposes also are very important.

For example, to prevent excessive remuneration being drawn by directors and executives, Switzerland opted for public disclosure of compensation. In addition to disclosure, Switzerland also mandated shareholder vote. Its the so-called “say on pay” mechanism of the ordinance in 2014. The logic is that companies will adjust their behavior to ensure the proposals are not rejected by the shareholders. Mostly, this has resulted in better governance of public companies.

Another way of deterring inappropriate conduct is when company insiders know in advance that a decision will be subject to shareholder approval, this changes the nature and content of the decision itself. For example, entry to a new market or entering into a major transaction, etc. Due to disclosure requirements, management would be forced to justify and evaluate pros and cons, under a conflict of interest situation.

Disclosures on related party transactions would highlight if some shareholders are taking more than their share as directors’ remuneration without declaring adequate dividends, as the basis of distributing profits.

Another area that highlights proper governance mechanism is the communication of judgments and estimates made in preparing the financial statements. The 2008 financial crisis brought to light the inadequate nature of disclosure of risks associated with the business and also the inadequacy of minimum disclosure regime encouraged by accountants and auditors. Needless to say, it’s not easy to provide investors with a complete understanding of the underlying economic effects of transactions and account balances through disclosures in financial statements. The Investor relations unit should handle information needs of institutional investors, in addition to the required disclosures.

Lack of transparency in financial reporting, affects investor trust, especially when it occurs in financial institutions. When this happens the overall stock market will decline and underperform . Consequences of inadequate disclosure therefore can affect the broader economy as investors will stay away from the capital market.

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Increased Tax collection for better Governance.

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The only practical means of raising revenue to finance government spending is taxation. If people continue to require the government to provide goods and services then the government requires money to fund these needs. Tax collection in Sri Lanka has steadily declined over the years. Tax as a percentage of GDP has halved over 25 years. Whereas, tax level in major industrialized countries has reached more than 3 times the level in Sri Lanka.

The Ministry of Finance has recently commenced a publicity campaign to encourage people to pay taxes for a better future.

The ideal tax system should raise essential revenue without excessive government borrowing, and should do so without discouraging economic activity. Therefore, the policymakers in Sri Lanka will have to get their policy priorities right and have the political will to implement the necessary reforms. Tax administration must be strengthened to accompany the much needed policy changes.

How does the government achieve this fine balance of raising revenue for its activities and encourage economic activity without creating dissent among the populace?

  1. Establish a rational, modern, and efficient automated tax systems to increase tax collection and reduce malpractices.
  2. Prevent profit transfer by foreign investors with tight transfer pricing rules with better administration & monitoring.
  3. Strengthen legal provisions to deter tax abuse and provide adequate technical training to build a good team of tax auditors. In addition to preventing evasion by auditing it will signal a more robust enforcement to the would be evaders.
  4. Simplify tax administration. In the Ease of doing business ranking, the combination of number of tax payments per year (47) and the time spent for tax compliance (167 hours) has kept Sri Lanka’s rank down at 158.
  5. Formalize the informal economic sector also known as shadow economy. This could bring in more people in to the tax net and increase collection. For example a lawyer who is paid in cash, the doctor who does not declare cash receipts from patients and large enterprises in import/export trade that choose to avoid taxes using ‘two’ books. Improving both tax policy and tax administration is important to tackle informality.
  6. Use better computer systems and advanced analytics to identify suspicious behavior of registered and unregistered businesses. Individual tax payer’s behavior or lifestyle spending can also be analyzed automatically by integrating data on spending patterns, import or purchase of assets, etc.
  7. Use experts without conflicting client interests or senior tax commissioners to identify and tighten tax loopholes used by companies on an ongoing basis. This way companies may escape one year of non payment due to a specific loophole in law, as opposed to the tax authority taking legal action over many years, later.
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Make honesty Easy for Truthfulness

As parents most people endeavor to teach kids to take responsibility. Whilst encouraging kids to be honest we also need to create an environment of learning from mistakes rather than leading to an “It wasn’t me attitude.” Kids are made to understand that every action has a consequence. However, as adults in organizations, the cause and effect situation has been forgotten by most people. Realization of ‘we get back what we give’ is restricted to a religious discussion and not observed in the commercial context.

Let’s see if you get the moral of the following story….

There was a farmer who used to sell butter to the baker regularly. One day the baker decided to weigh the butter to see if he was getting a pound and he found that he was not. This angered him and he took the farmer to court. The judge asked the farmer if he was using any measure. The farmer replied to the judge, “I am primitive, your honor, I don’t have a proper measure, but I do have a scale.” The judge asked, “Then how do you weigh the butter?” The farmer replied “Your Honor, long before the baker started buying butter from me, I have been buying a pound of bread from him. Every day when the baker brings the bread, I put it on the scale and give him the same weight in butter. If anyone is to be blamed, it is the baker.”

The baker was getting back based on what he was delivering!

I believe, honesty and dishonesty become a habit. Some people practice dishonesty and can lie with a straight face. Others lie so much that they don’t even know what the truth is anymore. Rarely do they realize that they are deceiving themselves. If kids are not made to understand cause and effect by enforcing punishment, they learn very fast, and won’t take rules seriously because they can convince you to go easy. Similarly, in the corporate world if there are no consequences for dishonesty, people cannot be held accountable.

Surprising to note that childish behaviors of crying for promotions, or blaming everything else for your suboptimal performance without understanding the rules of engagement is a common occurrence in the corporate world, thanks to leaders who like what is called ‘suck ups’ in slang.

Every person needs to learn to accept the consequences of his words, actions, and decisions, and the only way to do this is to create an environment of learning, consistency with rules and discipline.

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History is NOT a great teacher of Governance?

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These issues are copied from an analysis of the Satyam debacle in India to remind directors and CEOs the possible lessons that can be learnt, in the hope history will not repeat itself.

A few notable issues which lie beneath Satyam’s debacle were:

The Board of Directors were clearly lagging in their financial expertise. Form 20-F filed by the firm in 2008 highlights the issue of lack of ‘Audit Committee Financial Expert’, which was an important requirement from the Securities and Exchange Commission.

The choice of directors serving on Satyam’s board was not remarkable. Four of the six members on the board were purely academicians and had a lack of industrial experience and practical knowledge required for proper stewardship. Two of the directors were over-occupied being serving on eight other company boards.

Sarbanes Oxley Act (SOX) and corporate governance principles prohibits directors of having any direct involvement in firms operations. However, in Satyam’s case many of the directors were participating in the operations of the company as well.
Satyam’s Form 20-F filed in August 2008 states “We do not have a Nominating/Corporate Governance Committee.” This, too, is a glaring departure from “best practices” in global Corporate Governance.
The role of auditors who authenticated Satyam’s accounts is surely questionable. Having auditing services from top ranked auditors/auditing companies do not guarantee avoidance of breach of contract.
The absolute power of majority shareholders would overshadow the concerns and voices of minority shareholders and thus prevent their active participation/vigilance in the firm’s affairs.
The Board members had significant relationships with Satyam Corporation and its Management, which may have contributed to their failure to be more proactive in their oversight.
In Satyam’s case the Board was unduly reliant on auditors. Excess of this reliance and trust on the auditors prevented Board to be proactive and staying vigilant. Within reasonable and appropriate limits reliance on auditors and management is desirable. Beyond reasonable limits this reliance can pose serious issues.
Source: Universal Journal of Industrial and Business Management 3(2): 58-65, 2015

Many of these issues are common to many companies in Sri Lanka even today and some of them can be noted in leading companies. Rules are not working in uplifting the moral and ethical values of businesses in general. Greed and growth are considered more important for businesses. Continuous awareness and education of directors about their fiduciary responsibility may have to be mandated by the SEC to reduce or eliminate any debacles in Sri Lanka.

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The need to have a Financial Expert in the Audit Committee

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A realistic question that comes to mind is, “Do audit committees have at least one financial expert?” An expert should be somebody who is capable of getting results that are superior to those obtained by the majority of the population. Therefore, such a person must be recognized for his or her extensive knowledge, skill and experience in finance to qualify to be the financial expert in the audit committee.

If we understand what the audit committee has to achieve by its oversight then it would be easy to understand why a financial expert is required. The audit committee has to understand many aspects listed below and will need a financial expert to provide a good insight of these matters.
1. The quality of the balance sheet based on the aggressive nature of accounting estimates & judgements used by management. For example; provisions for potential losses or impairment of assets may be too low, Revenue recognition may be too aggressive and early, Loans & advances in a bank or claims in an insurance company may not be based on reasonable historic assumptions or realistic discounting techniques.
2. The quality of earnings and impact of adjustments that distort the performance for the year. For example; profits can be created by adjusting estimates for depreciation, reversal of provisions, adjustment of deferred items, etc, which may not be clear for a non financial expert. Without a proper analysis, how would the audit committee be satisfied with the reliability of monthly or quarterly results?
3. The nature, extent and scope of external audit and some of the diplomatic explanations provided by external auditors, to make sense of the underlying issues in the company. Even provision for contingencies or impact of a disputed tax adjustment or under provision for idle/ obsolete assets can be manipulated by management and auditors can be convinced through documentation that it is approved by the board. Audit committee members should be able to challenge these because of their expertise and also having insight of board’s intentions.
4. A financial expert will understand the whole system of internal controls and be able to direct the internal auditors to supplement external audit findings. A person with appropriate expertise can understand the nuances of control weaknesses and visualize what could go wrong due to such weaknesses.
5. Enterprise governance or enterprise risk management systems require oversight by experts to the extent they impact financial reporting. If the people who are implementing are the experts and the committee that should provide oversight does not understand the process, they can be easily misdirected. These are the circumstances that caused the down fall of Barings Bank, Societe Genarale, the Swiss bank UBS, Lehmans, etc.

Therefore, it’s time regulators had a more stringent test for the qualifying criteria regarding a financial expert on the Audit committees. Nomination committees also should take this aspect a little more seriously prior to recommending friends of friends to audit committees or taking the easy way out of finding a retired accountant to be the financial expert!

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New Paradigm for Corporate Governance

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Walmart is buying clean energy, PepsiCo is promoting healthier snacks, P&G is committed to improving environmental sustainability of its products and Apple is into recycling. Unilever’s sustainable living plan pledges to cut the company’s environmental impact in half by 2020, it also vows to improve the health of one billion people and enhance livelihoods for millions.

Many such global corporates are racing to make the business case for Long-Term Investments, Reinvesting in the Sustainable Business for Growth and Pursuing R&D and Innovation. These corporates are striving for minimal negative impact on the global or local environment, community or economy.

In this new paradigm for governance each company should articulate how such investments are reviewed and demonstrate why and how they matter to long-term growth and value creation. Stakeholders need to understand that such sustainable business investments will take time to bear fruit and the value creation in terms of the planet and people will be equally important as profits and dividends. Sharing sustainability information and corporate responsibility initiatives publicly and bringing them to investors’ attention are significant actions in the new paradigm.

Designing sustainable products and services
In 2015, Procter & Gamble partnered with Constellation, a subsidiary of Exelon, for the development of an up to 50-megawatt biomass plant that will help run one of P&G’s largest U.S. facilities. The plant will significantly increase P&G’s use of renewable energy, helping move the company closer to its 2020 goal of obtaining 30% of its total energy from renewable sources.

P&G is working to eliminate deforestation in its palm oil supply chain. Separating sustainable sources from non-sustainable sources in the production of palm oil and palm kernel oil is highly complicated, but Procter & Gamble is stepping up to address the problem. The Company is conducting an in-field study to understand the practices of small farmers – and how those practices can be improved to protect local forests.

P&G also found U.S. households spend 3% of their annual electricity budgets to heat water for washing clothes and if they switched to cold-water washing, P&G reckoned, they would consume 80 billion fewer kilowatt-hours of electricity and emit 34 million fewer tons of carbon dioxide. That’s why the company made the development of cold-water detergents a priority. Tide Coldwater laundry detergent was launched in 2005 by P&G as a way to for consumers to switch to cold water washes to help save energy, reduce their carbon footprint and cut down on household utility costs. Heating water for laundry loads accounts for up to 80 percent of the energy used per wash load in the U.S.

Unilever’s Brands that suit the Environment
As chief executive of Unilever, Mr. Polman has made sustainable production — of Hellmann’s, Lipton tea, Dove soap, Axe body spray and all the other products Unilever makes — the company’s top priority. Detergents are being reformulated to use less water. Packaging is becoming more efficient. Unilever’s sustainable living plan promises to cut the company’s environmental impact, improve health and enhance livelihoods. Some examples of Unilever’s brands are:
Hellmann’s
Mayonnaise trying to use oil made from sustainable soybeans; introduced a more ecologically designed plastic bottle.

Maille
Mustard line encouraging consumers to refill ceramic containers rather than buy new glass jars.

Lipton
Tea bags now filled with leaves certified as sustainable by the Rainforest Alliance.

Magnum
Ice cream using vanilla and chocolate certified as sustainable by the Rainforest Alliance.

Comfort
Fabric softener designed to use less water than rival brands.

Omo
Laundry detergent from Brazil marketed as more efficient than the competition.

Conclusion
“Climate change is destroying our path to sustainability. Ours is a world of looming challenges and increasingly limited resources. Sustainable development offers the best chance to adjust our course.”
– Ban Ki-moon

Leading a sustainable business that operates in an environmentally responsible way protects the planet and also contributes to the bottom line. If not for a business case the global corporates are unlikely to run charitable businesses. Therefore, it is possible for any company to design Its products and business processes in such a manner that no negative environmental impact is felt as a result of their existence. This is the challenge and the new paradigm for corporate governance.

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How Cyber risks affect the financial statement Audit

imageA financial statement audit focuses on providing an opinion on the fair presentation of the financial statements. The auditor should be aware of the risk of cyber incidents specifically in the financial reporting process, that may affect the numbers in the financial statements.

Typically an IT system would encompass the perimeter network, internal network like LAN or WAN, operating system, database and an application like SAP or Oracle. A financial statement audit does not focus on all data and systems of a company and therefore an auditor will not evaluate the entire IT platform and do penetration tests, etc to mitigate cyber risks. The responsibility for mitigating risks including Cyber, is of the management and the buck stops at the board of directors door.

However, the auditor will focus on data and systems that are relevant to preparing financial statements. Therefore, understanding data and systems relevant to financial reporting and addressing the IT risks affecting the said process is key to a good audit. The auditor should use people knowledgeable in IT to test access controls relevant to financial reporting and reduce the risk of significant impact to the financial statement from cyber incidents. In a financial statement audit, access controls relating to applications, databases and operating systems would be relevant. Controls at the internal and perimeter network layers are unlikely to be the focus of the auditor, but may need to understand if the management has adequately mitigated risks at this level.

If a cyber incident comes to the attention of the auditor, he has the responsibility to:
* Understand the incident
* Evaluate its impact on the audit approach
* Evaluate management’s assessment of the impact on the financial statements
* Communicate findings to management and audit committee
* Assess impact on audit report or disclosures.

It is important to understand that an auditor does not provide assurance on the adequacy of controls to address cyber risks or the company’s ability to withstand a cyber incident. The audit committee should know to obtain assurance on cyber security under a separate engagement.

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