Reviewing the FRC

The invitation to contribute to the Kingman review of the FRC published today mentions in passing that the FRC was established after Ron Dearing’s 1988 report “The Making of Accounting Standards”. I can’t find my copy but I remember the cover – glossy red with an overall design based on the word “red” in fancy lettering. I was told by an ICAEW employee at the time that this design was requested by Dearing as it was not only the colour of the cover but also his initials. 

Not long after, ICAEW published a further report with a red cover. This was written by Professor David Solomons. I still have my copy. It is a much more sober publication printed in a very small font and it contains a detailed and scholarly analysis of the conceptual and theoretical aspects of accounting standards.

The Dearing report addressed the structure of accounting standard setting: Solomons addressed the content of the standards themselves. Both are fundamental to the issue of trust in corporate reporting and I think they need to be addressed at the same time. How can we judge whether the FRC is fit for purpose in its role as guardian of  corporate reporting and corporate governance, without considering whether both corporate reporting and corporate governance are fit for purpose?

Is there a better way to fail?

In some instances of corporate scandal or failure, it seems clear who is to blame. Greed and incompetence are simple to attribute and, when punishment does not follow, outrage does. The outrage is usually addressed by promises of systemic change.

The pendulum signifying deficient behaviour swings between three poles. If the board of directors is at fault, we are told that we need improved corporate governance - more independent and diverse boards. If the auditors are at fault, we are told that we need to break up the big 4 to make the audit market more competitive. If the shareholders are at fault, it seems that we need to make them take more active interest in their investee companies and behave as owners rather than traders.

None of this makes a great deal of difference. Part of the problem is due to the process of corporate accountability. The reporting framework was devised in the nineteenth century and has not adapted sufficiently to changes in business activity, business structure, information requirements and communication channels.

There is also a problem of expectation. The literature on audit long ago identified the expectation gap between what people think auditors should do and what they are actually required to do. (I remember being taught that the auditor is "a watchdog, not a bloodhound" which may seem like a useful metaphor.. but don't they both bark?)

But there is also a very wide expectation gap between what the general public believe that companies should do and what they actually do. No corporate accountability system can work without some clear idea of what companies are for and what can be expected of them. This discussion is happening in various places:  for example, The Future of the Corporation, The Purpose of the Corporation, Tomorrow's Company Whether the insights from these different groups can be brought together and synthesised in any useful way remains to be seen but such thinking is needed to underpin policy and regulatory decisions which, at present, work on an ad hoc basis, selecting what appear to be the most pressing issues and tinkering with the system to try to address them.

Companies fail for all sorts of reasons. Risk is inherent in business and can't be managed out of existence. Honest and competent boards and management may make bad business decisions. Covering up may lead to incompetent and dishonest behaviour but no system can prevent that. The new focus on corporate culture assumes that a "good" culture will inhibit such behaviour but evidence of this seems very sparse.

We need to accept that companies will fail, even those that tick all the boxes. More boxes to tick won't change this. As well as identifying causes, perhaps we should be looking more closely at how the failure process is managed and how those caught in the fallout can be better protected.

Transparency?

This recent publication by Larcker and Tayan caught my eye: "Netflix Approach to Governance: Genuine Transparency with the Board".  It's a short descriptive account of the "highly unique practices" (can "unique be qualified?) of the Netflix board. 

I'm a fan of Netflix (love "The Crown") but I'm not convinced that what is described represents "genuine transparency", whatever that means.  We are told:

"The Netflix approach incorporates two highly unique practices: (1) board members periodically attend (in an observing capacity only) monthly and quarterly senior management meetings, and (2) board communications are structured as approximately 30-page online memos in narrative form that not only include links to supporting analysis but also allow open access to all data and information on the company’s internal shared systems, including the ability to ask clarifying questions of the subject authors. This quarterly memo is written by and shared with the top 90 executives as well as the board."

I do think that distance from management is a problem for boards, now that executive directors and NEDs don't sit around the boardroom table together. But attending management meetings? Reed Hastings, the CEO, says:

 “I don’t want the management meeting to be any different because they’re there.” 

Really? Has he heard of the Hawthorn effect? I can't believe that management won't behave differently if observed by the board. I also find it difficult to believe that board members could keep their mouths shut if they think that mistakes are being made. Transparency? The cynic in me whispers that meetings can be stage managed to avoid difficult issues and important discussions can take place outside management meetings. Just like board meetings, in fact...

The board memo could be a good idea. Maybe this is transparency. The ability to drill down and ask direct questions could be very valuable. But how much time would this take out of a director's day? Would they bother?  We are not told how long the Netflix board has been operating in this way, although it implies that the practices were in place at the time of the Qwikster debacle which was in 2011. So the directors interviewed could have been asked about the actual use they make of this facility and how much of their time they devote to it.

"Hastings cautions that directors granted this level of access to management discussion and documentation need to exercise self restraint about influencing decisions outside the boardroom." You bet!

At a broader level, these practices raise an issue about the boundaries of corporate governance. The challenge is to provide board members with information that enables them to fulfil their oversight duties but not so much that they are tempted to become de facto management.  Or at least that is the received wisdom: the discussions I have had with NHS NEDs suggest that the boundary could be permeable under some circumstances.

We need to know much more about information flows around the board. It's quite possible that other companies use similar - or even more innovative - methods. Some rigorous research into this would be very valuable.

It's conference time again...

Back from two interesting days at the annual conference of the British Accounting and Finance Association. This year those of us who had received awards from BAFA in past years were invited back specifically to provide feedback to early career researchers. One of the privileges of an academic career is the opportunity to help those who are just starting out so I was delighted to be asked although my heart did sink slightly when I read the papers in the session which I had been assigned to chair with Mike Page. They were all about audit but all quantitative and only one author had any practical experience of auditing and that wasn't really apparent in his work.

The presentations were excellent - all kept to time and were very accomplished, especially when considering that English was not the first language of those presenting. Mike was able to give them some feedback on their stats and we both agreed that they needed to tell more of a story to give their work greater context.  If you've spent several years immersed in the fine detail of doctoral work it's quite a shift to step back and look at the big picture. But I did think that some of the research questions addressed, particularly those considering relationships between people, were not best tackled by the use of archival data.

In a very lively and thought provoking plenary address, last year's Distinguished Academic, Professor Jeffrey Unerman discussed the implications of the Brexit and Trump campaigns for accounting and finance academics. In the course of his presentation, he urged the audience to consider carefully the choice of research tools to investigate their research questions. I was certainly struck by the dominance of quantitative approaches in the papers at the conference but it is not difficult to see why this is happening as the opportunities for getting qualitative studies published in top ranking journals is limited and it is much easier and less time-consuming to find archival data to crunch than to gain access to appropriate interviewees or documentary sources.

At the other extreme, a paper, which attempted to stretch the understanding of what accounting is, considered war cemeteries as a means of accounting for the cost of war. Bizarrely, I found myself among a group of non-British academics who, while explaining how moving they found these places, also seemed to be developing a critique of the British government's management of the aftermath of World War 1. As a Brit whose great-uncle's wartime death is commemorated on the Chatby memorial I felt that I should have some comment to make but couldn't quite frame it appropriately.

Many of the papers scattered throughout the conference programme included corporate governance in their titles. This led me to joke that such attention probably signifies that corporate governance is dead. It appears that I am not the only one thinking this: Bob Garratt has written an interesting piece with this title for the RSA website. I agree with Bob that the focus of accountability should spread beyond boards but I don't think his remedy goes far enough to address the mismatch between the legal and regulatory structure which frames corporate reporting and the wider demands for accountability now being placed on business. When integrated reporting was first mooted, I thought this might be a big step towards solving this problem but it has been slow to make an impact. But several people attending the conference told me that they were looking at IR in their work so maybe academics can progress this in some way.

A paper by Niamh Brennan and Phil Shrives developed their continuing study of compliance with the UK Corporate Governance Code, looking at serious serial non-compliers. I think this is a very useful documentation of the impact of the Code but it is again important to step back and look at the big picture, in this case the way that approaches to the Code have evolved from its inception. But I would say that, wouldn't I? And I did suggest that they should read my book...

The paper that worried me most attempted to link the presence of female executive directors on boards with levels of executive remuneration in the UK. I found the fundamental assumption, that female directors could influence the level of accounting conservatism and thus the earnings on which executive compensation is based, quite unconvincing. Having focused only on female executives. they seemed to have ignored two important facts: a) the increased number of female directors since the Davies report are predominantly non-executives and b) it's NEDs who form remcos and make decisions about executive remuneration. But the really worrying aspect lay in their list of future research possibilities where they suggested exploring the impact on executive pay of other aspects of board diversity such as ethnicity, disability and sexual orientation. In one of those daft after-dinner conversations one has at conferences I had suggested that every company board should include a dog: this paper seemed to be moving perilously close to that idea...

For me, the most stimulating paper of the conference was presented by Lisa Jack who, working with Julia Mundy, is looking at the relationship between investment analysts and companies from a perspective of fairness and relational justice, using the theories of John Rawls. Unpicking such relationships is no easy task, with all the challenges of access to those involved, but this seems to me a very important attempt to throw light on the opaque workings of the investment intermediary chain. I shall watch the unfolding of this work with considerable interest.

Theatre, art and corporate reporting

This week I went to the cinema to see the Royal Shakespeare Company's production of Twelfth Night streamed live. It was an excellent production, set in the Victorian era with fine sets and brilliant music. Adrian Edmondson's Malvolio was very good (although he did seem to be channelling the late Leonard Rossiter at one point). But although the camera work allowed many very effective close-ups of the actors' faces, and of the costume and set details, which the audience in the theatre wouldn't always see, I would have much preferred to see the play in the theatre. I was very conscious that I was being forced to see the action through the eyes of the director and the camera operator. I wanted to see the entire stage so that I could decide where to focus my attention at any point.

What has this got to do with corporate reporting?

Every number in a financial report is the result of processes of measurement, estimation, valuation - judgements and decisions made at various levels within the organisation. The auditor's report similarly rests upon a range of judgements about the integrity of those processes. The contents of the report have been through many eyes before publication. While this is addressed to shareholders, many of them rely not on the report itself but on the further interpretation by analysts and the news media.

We are unable to view the fundamental activities which underpin a company's business model and we know little of how those activities are measured and how they come together to form a revenue-generating process. Our view of the outcomes is mediated through many decisions made by people we know almost nothing about. As outsiders, we rely on intermediaries to assess the credibility of people and processes. Boards are similarly distanced from the fundamental activities that make up companies and they too rely on intermediaries.

I don't think that these intermediate processes and their potential effects are sufficiently considered. Numbers in particular look very definitive: we forget all the judgements that lie behind them. The standardisation of the reporting of those numbers hides further judgements and decisions. Corporate reports are layered outcomes, built on many hidden assumptions. We can't see through them: their presentation focuses our attention on specific areas, often chosen by regulators. The increase in narrative reporting may allow us to see more of the action, unimpeded by the complexity of numbers. But we are still not seeing the entire stage through our own eyes.

This is noticeable when companies collapse. Although the crisis may be a surprise, after the event it often appears that the information was there in the financial reports all along. It may have been overlooked or interpreted incorrectly. We look for where things went wrong, the bad decisions. But perhaps we should be paying more attention to when things go right, to where the decisions about the numbers proved to be accurate, and studying the processes of judgement that made that happen.

This week I was also privileged to attend a preview of the new BBC series "Civilisations" which was followed by a panel discussion with the three eminent historians who present the series. It provided  a fascinating insight into the intellectual judgements underpinning the creation of the series - decisions about what to include, what to leave out, how to present the works themselves and the explanation of them. Knowing this will provide me with a deeper appreciation when I watch the series. [1]

I was very struck by Mary Beard's provocative observation that we look at classical statues - and other art works - with a kind of awe that impedes discussion of their merits and prevents us from being honest about whether we actually like them or not. It seems to me that we treat the numbers in corporate reports in a similar way.

Perhaps we should recognise more explicitly that even directors and auditors are viewing the information that they report and attest through other peoples' eyes and that each number hides multi-layered decisions and judgements. We might then arrive at a more useful view of the strengths and limitations of corporate reporting and how it might be changed for the better. We may not be able to see the whole stage but we could make our own critical judgements about the choices made by others about where our attention should be focused.

[1] At academic conferences I have for many years been frustrated by researchers' presentation of their findings. I want to know more about how the study was undertaken - what prompted the research question, how choices were made about research methods - and I think that then provides a better contextual understanding of the findings. I want to see the whole stage. (Books about how research is done - rather than how it should be done - are few and far between but Frost and Stablein's "Doing Exemplary Research" is worth reading.)

Carillion redux

I watched with interest the BEIS committee grilling of Carillion directors.

The directors tried to paint a picture of a perfect storm of high debt inherited from acquisitive predecessors, combined with unforeseen problems in major projects, slow paying clients and an uncertain economic environment; of an embattled group trying to manage all these factors beyond their control, who, if given time and support to manage the cash flow problem could have sorted it all out; and who had fully deserved their high pay.

Whoever prepared them for their appearance before the BEIS committee had done a poor job.  The apologies were rehearsed (some repeating almost identical words) but were shown to be sham in the blistering final five minutes faced with Rachel Reeves’ barely contained fury at their unwillingness to put their money where their mouths were.

Here was a company which on the surface complied with corporate governance best practice but with a board apparently not up to the job of grasping the risks inherent in the company’s complexity.  (Watching three successive CFOs expressing surprise at what the numbers under their control revealed was quite bizarre.) Sound corporate governance cannot prevent poor business decisions but code compliance seems to carry an implicit assumption that it can mitigate the negative outcomes of poor business decisions. Is this expectation justified?

To what extent can NEDs be expected to sort out the consequences of poor business decisions compounded by Ponzi-like attempts to plug gaps in the hope of rescue or turn around? Even if NEDs know what is happening – and this board insisted that they were provided with full information, that they challenged management and yet they were all surprised at what happened – at what point should they take action? And what action should they take? This board did sack the CEO and the CFO, actions that the committee did not appear to probe in detail: examining  the background to those decisions might have been revealing.  A NED rolled up his sleeves and took on the CEO role: it would be interesting to know how board dynamics changed at that point.

I have watched many of these hearings. On this occasion committee members, especially the female ones, seemed better prepared and asked more probing follow up questions. The female members of the Carillion board were less impressive (someone should have coached them so that they didn’t start every answer with “So…”).  There was no evidence in this example that the presence of women on the board had had a positive effect.

I think the unravelling of this particular corporate collapse is going to provide clear evidence of the impossibility of our current regulatory system to meet  the expectations placed upon it. Tinkering with the corporate governance code will not help. We need a radical rethink of our assumptions about corporate accountability and the tools needed to achieve it.

Carillion and NEDs

 As the aftermath of Carillion begins to unwind, it is inevitable that concerns will be raised about the company’s corporate governance.  Among news reports on Monday, I heard the BBC’s attempt to talk to Baroness Sally Morgan: she said that as she had only been on the board since last July she wasn’t the person to talk to.

Now, I wouldn’t want to be put on the spot by a reporter in those circumstances but she is the senior independent director, a significant role. And she’s had six months to get used to it. Six very turbulent months, if reports are to be believed. I’m a little surprised that she hadn’t got her ducks in a row for the possibility of this outcome for the company.

The other female NED is Alison Horner who is also head of HR at Tesco. I’d have thought that job would be quite enough for anyone without the added workload of a NED post on a huge complex company in a completely different sector.

I think this raises an important question which, as far as I know, has never been researched: why do people seek NED appointments? The expectations placed on NEDs in the UK corporate governance regime are very high and, I have always thought, impossible to achieve.

When I interviewed audit committee chairs in FTSE 100 companies for my PhD research back in the 1990s, two of my interviewees were also FTSE 100 finance directors (when  did we start calling them Chief Finance Officers? And why?).

One explained that the chairman of his company had encouraged him to seek a NED appointment: he found it quite challenging in terms of time but saw a major advantage for his company in the information he was able to gather about how other companies grappled with similar problems to those he faced in his FD role.

The other FD held several NED appointments: he told me that he did this for intellectual stimulation and so that other companies could benefit from his extensive experience and it wasn’t that much of a challenge as he had his FD role running very smoothly and well under control (as it happens, that company disappeared not long after I talked to him…).

I once asked Adrian Cadbury why his committee set such store by NEDs, when there was already evidence from the US that they had difficulty in performing the oversight role assigned to them. With a twinkle in his eye, he first told me that that was the one thing that the committee could agree on … but then he explained his firm conviction, based on his own experience, that boosting the NED role would improve corporate governance.

That may well have been the case in the business environment of the late 1990s when boards included more executive directors than now and when there was a good supply of potential NEDs like Adrian: of sharp intellect, with many years of experience on boards and a strong belief in the public interest role of the public company. That generation is no longer with us: such men are few and far between these days.

Yes, they were men. It would be even more interesting to know why women accept NED appointments. Today they are greatly sought after, since appointing female NEDs is a quick way to satisfy demands for board gender diversity. But we’re told that the pool of available candidates is still small because the pipeline through to senior executive appointments is still slow, so I wonder about the pressure this then places on the women in that pool. And are they the first choice of headhunters? An inability to recruit NEDs would be a powerful signal of corporate problems…

A better way to increase board gender diversity could be to enlarge boards and to bring back the members of the executive group to main board membership. This would also ensure that NEDs sit around the same table as senior executives. At the moment, it is unclear how such interaction takes place. If contact between the board and the executive group is mediated through the CEO, this surely undermines an important purpose of UK corporate governance arrangements. which were originally intended to boost the oversight function of NEDs and curb management power.