Why do CFO’s manipulate accounts - 2

Reasons for manipulation of accounts are more complex than the Harvard research (see last blog) acknowledges.

A dominant CEO was on the telephone to the finance director of a subsidiary company. The business was both manufacturer and retailer of a product so they booked a profit in the accounts whenever they transferred a batch from the factory to a shop and another profit whenever the shop sold an item. The year-end was approaching and the group as a whole was performing poorly so the CEO wanted the subsidiary to consign a large quantity of stock from the factory to a temporary warehouse – because there was not enough storage space in the shops - and take the profit. The finance director was using a speaker phone and the CEO did not realise he was talking to a room full of people – which is how I know the story. This case conforms to the Harvard model – the finance director got to keep his job while any benefit went to the CEO.

More recently I was finance director of a medium sized business and kept the monthly profit forecast conservative despite the optimism of my CEO. I did not want to forecast high and deliver low. However, I was less keen for the cash forecast to illustrate our problems because our chairman had a habit of giving grief rather than support. So, my cash forecast showed how I expected to manage the cash – which gave an accurate figure of the outcome, and showed that it was under control. And I reported separately, in the narrative, that cash was tight.

My accountant chairman was able not to ask the critical questions and I avoided getting a regular earful, which always came without any help to improve the situation. The only way out was to improve trading which we were trying to do – having cut costs as far as possible. I was confident that technically we were solvent.

This second case illustrates two things. Firstly that there is a line between an optimistic presentation and impropriety. I believe I kept the right side and when the situation changed I did not hesitate to act appropriately. Secondly a CFO - or any executive - has motives other than personal financial benefit. Having less hassle is a legitimate motive. You believe (or gamble that) things will get better and not worse, so you won’t be caught out. The test of character comes if things do get worse…what then? If you continue to show an optimistic case then you fail the test. If you cross over into active manipulation to hide the truth then you fail big-time.

CFO’s who cover-up bad news have bought time but they don’t use it to get another job. It seems they are sucked in to the deception and feel bound to use the time to solve the problem – even when that is impossible. Maybe, they suddenly realise it is too late and that the shame of the deception will follow them when it inevitably unwinds. I can understand that. You know that things are going to get very bad - you can’t see a way out - so you enjoy the weeks or months before the pain begins by blocking the situation out of your mind and doing whatever it takes to extend the period of calm before the storm.

The lesson - management is a team game. The whole team needs to enagage with and support everyone else. Don't just blame the CFO - it is a dysfunctional team that causes it and stops it coming to light.

Why do CFO’s manipulate accounts?

A research paper described on the Harvard Law School Forum on Corporate Governance suggests that pressure from their CEO’s is the prime motivation for Chief Financial Officers of listed companies to manipulate their accounts. The pay and rewards of these executives does not seem to be enhanced by the manipulation but that of their CEO’s is enhanced. Also, prior to the manipulation there is an above average turnover of CFO’s in those companies where it has been detected, compared with a control group. The data all comes from the USA, but evidence from major financial scandals in other countries would suggest that the lessons are universal.

Of course we know little of manipulation that has avoided detection and the authors seem not to have tested for other motivations, such as deperate attempts to stave off corporate failure. Nonetheless, this is an important piece of work that reinforces the view that the majority of financial scandals result from over-dominant Chief Executives, without sufficient checks and balances on their behaviour, who treat company assets as their own.

Can good corporate governance coexist with venality in government?

The Institute of Directors in South Africa published its King Code of Governance Principles in 2009, to widespread praise. The code seems to have been heavily influenced by ideas discussed by Tomorrow’s Company and seems to combine common sense, liberalism and social responsibility. However, I was struck by the contrast with an article in the Sunday Times, which reported (28 Nov 2010) a study of South Africa’s 535 MP’s that showed; 7 have been arrested for fraud and 3 served jail sentences, 19 have been accused of bouncing cheques, 71 can’t obtain a credit card, and 117 have been directly or indirectly involved in at least two businesses that have gone bankrupt.

The report refers to “political feelings of entitlement” and a “culture of impunity”. The paper gives an example of one MP who served only five months of a four year sentence for fraud in 2003 and has been found to hold six directorships despite being banned from being a company director. He is quoted as saying “What has the High Court got to do with my life?...I don’t have to ask permission from them”

We have here an impressive voluntary code of governance in a society whose leaders present an appalling example of venality. There is a similar disparity in Kenya too, where impressive governance ideas coexist with the country’s MP’s being accused of ‘plundering state coffers’ as a result of paying themselves 50% more than MP’s in (much richer) western Europe and on top of generous expenses.

Now I am not picking on African countries. Transparency International’s ‘Corruption Perception Index’ shows South Africa at a significantly better level than the likes of Russia which, in turn, is at a similar level to Kenya. So Kenya and South Africa are also very different. But what is interesting is that in these African countries such venality in some of their institutions seems to coexist with the highest principles in others. I have no idea whether that can and does work or whether the contagion will inevitably seep into the realm of major corporations too. Comments and ideas would be welcome.

FSA forces rise in probes by experts

The Financial Times reports that the FSA is forcing a record number of financial services companies to hire outside experts to investigate their inner workings, prompting complaints over the rising costs of regulation.

Since April it has ordered 90 reports (compared with 88 for the whole of 2009-10) under S166 of the Financial Services and Markets Act for “skilled persons reports” into areas such as capital adequacy, governance and complaint handling. The average cost of a report is now £128,000, while the most expensive was £4.4m.

“The most common issues are systems and controls, but governance-related reports are increasing rapidly” the FT reports. They quote Jon Pain, FSA managing director of supervision, “It is a direct reflection of our desire to be more intrusive. I don’t want to tie up huge swaths of supervisors doing detailed work on one firm….It’s effective because the firm pays for it rather than the costs being spread across all firms.”

Some experts point out that the Bank of England used to ask routinely for reports before the FSA’s creation, but bankers but others argue that it amounts to an abdication of responsibilities in favour of the “Big Four” accountants and the costs can be prohibitive for smaller firms. A ‘senior executive at a global bank’ is quoted as saying the intrusiveness was making London less attractive.

On the one hand, they would say that, on the other hand there is a delicate balance between ‘prudence’ and ‘over-regulation’ shifting banking business abroad. There certainly does seem to be an awful lot of bank bashing going on, not just in the UK but throughout the EU. See my post on CEBS, and Lord Turner's recent musings for example.

Grant Thornton FTSE 350 Corporate Governance Review

Grant Thornton has published its FTSE 350 Corporate Governance Review for 2010, entitled “Evolving with the Code”. It provides research data for the corporate governance record of the FTSE 350 companies, giving comparisons going back 5 years. There are a number of interesting points that emerge;

• There does seem to be something of a ‘boilerplate’ approach to narrative reporting, with the average length of the annual reports reaching 128 pages – the biggest was apparently 500 pages. The review suggests that companies set themselves a target of cutting back 10%. One of the wisest points made in the field! Cut the ‘boilerplate’ and the ‘box ticking’ and engage with the values.
•  Boards are not very diverse. 46% of companies have exclusively male boards and only 9% of directors are female. I would guess the ethnic diversity is even worse. As I have written elsewhere, companies need to be more receptive to flexible career paths before they will become diverse in any meaningful way. As long as they stick to the old ways and very traditional thinking, failure will follow.
• Although nearly half the FTSE 350 (153 companies) claims full compliance with the UK Corporate Governance Code, only 48 provide detail to verify this (schedule c of the code)
• The 2010 Code brought in annual elections for directors. I am not alone in thinking this a daft idea but so do the FTSE 350: only 17 companies have annual elections of directors and only 50 have triennial effectiveness reviews, of which only 5% provided more than the bare minimum of detail. Actually I think the idea of facilitated board effectiveness reviews is quite a good idea as long as the board engages with the process and tries to gain something.Both these points emphasise, for me, that it is not just a matter of imposing rules but of winning the argument.
• Compliance with the Corporate Governance Code has improved steadily over five years as has the number who explain non-compliance. In 2005 7% did neither but this dismal record had virtually disappeared by 2010
• The estimated cost per meeting for a non-executive director is £2,800 for the mid 250 companies. Of course this is not the whole time they give to their companies, since reading and informal meetings are likely to double the average of 17 per annum. Nonetheless, it illustrates the level cost that smaller companies might struggle to find.
•  Only 41% of mid-250 companies gave detail of how their board operates
• There is something of a trend amongst larger companies to outsource internal audit: in 2010 there were 64 companies out of the 350 who did this.
• Turnover amongst external auditors was very low. If this continued their average tenure would be 31 years
• Companies have proven reluctant to disclose their strategy and direction in their annual reports: fewer than 50% comply with this requirement. Grant Thornton feel this odd because many companies do disclose such information on websites and in presentations, so it is scarcely secret. 
• There is little evidence of companies providing verification of performance against non-financial Key Performance Indicators (KPI’s)

Lord Davies considers forcing FTSE firms to appoint more female directors

The Sunday Times reported 0n 12 December 2010 that Lord Davies, who is preparing a report for the UK government on how to remove obstacles to women making it to the board, is considering recommending the imposition of a gender quota for listed companies. This follows the annual report and index in the FTSE Female Board Report from the International Centre for Women Leaders at Cranfield Business School. They claim their data shows a plateauing of a previous gradual improvement in female representation on big company boards. Actually, looking at their data, it seems to be continuing very slow improvement but very slow and at a very low level. Worse, if anything, most of the female FTSE 100 directors are non-executive – a mere handful are executive directors. They recommend a quota to redress the balance.

The UK Corporate Governance Code recommends diversity in the boardroom.

But all this misses the point. Until companies feel able to accept flexible career paths very few female directors will be appointed to boards on merit. The women that do make it will generally be those who have chosen, or been forced by the constraints of their career, not to have children. Companies expect their senior executives to be there the whole time – it is a rite of passage – they can’t cope with career breaks nor with flexible hours. In this way they waste the talent of half of the population. Redressing this narrow mindedness is the way forward, not imposing quotas.

UK Serious Fraud Office to fight bribery by foreign companies

riberyIn recent years the USA has started extraditing individuals from around the world to face courts in America for alleged crimes committed elsewhere. This report appeared in The Times last week

“Jeffrey Tesler, 62, a dual British-Israeli national, is accused by US authorities of conspiring to funnel more than $130 million (£85 million) in corrupt payments to Nigerian officials to secure engineering contracts.

It is one of several cases in recent years in which British nationals have fought to avoid being sent for trial on American soil.

In 2006 a group of bankers known as the “NatWest Three” were extradited on Enron-related fraud charges. In March Ian Norris, the ailing former chief of the applications engineering company Morgan Crucible, was sent to the US where he was convicted for conspiring to obstruct justice.Gary McKinnon, who is accused of illegally accessing Pentagon computers, continues a lengthy legal fight against extradition.”

Tesler’s lawyer said “In essence this case is concerned with an allegation that a non-US national and non-US resident conspired to bribe officials in a third party state: Nigeria. The conduct and alleged criminality, at its heart, is extraterritorial and does not concern bribery in America, nor in the UK.”

The unattractive word for this is extraterritoriality – though, just to confuse things, as well as countries reaching beyond their borders to impose their laws it also refers to the opposite: individuals (such as diplomats) being exempt from the laws in their host country. And it is a side effect of globalisation. If a country outlaws a practice, such as bribery, then it cannot permit people (or companies) to evade the law by using intermediaries hiding overseas. The UK has also gone down this road; recently the Times reported…

“the former chief executive of PWS, a London based insurance broker….was prosecuted by the fraud office after the case was referred by the Foreign and Commonwealth Office in October 2005. He was accused of presiding over a network of corrupt payments during his time as head of the company’s American division before he became chief executive.” He “oversaw 41 illicit payments to senior officials at Instituto Nacional de Seguros (INS), the Cost Rican state insurance company…”  He was imprisoned for 21 months

But this is not just about principle…it is about commerce. The Times (6 December 2010) quoted Richard Alderman, director of the Serious Fraud Office (SFO)

“I’m determined that British companies that pursue good corporate governance and ethical business practice shouldn’t be placed at a competitive disadvantage by foreign companies, wherever they are based, using bribery and corruption to win contracts.”

In a global market, if you take a principled stance then you have to try to stop your competitors from taking advantage. I don’t disagree with the approach, but it raises difficult issues. Since the SFO could prosecute companies with any presence in the UK, will it drive business from the UK? Will the UK start prosecuting corrupt politicians from other countries who accept bribes?

Interesting times.

Punishments for failed bank bosses

Robert Peston writes in his BBC blog after a conversation with Lord Turner, chairman of the FSA.

“Directors of banks responsible for catastrophically bad decisions, which put their respective banks in jeopardy, could face a new punishment of having two years' pay clawed back from them.

[Turner] was attracted to imposing such a sanction - which is part of the so-called Dodd-Frank financial reforms in the US - as a way of discouraging banks from taking excessive risks. The clawback of bank bosses' pay would be punishment for misguided or stupid behaviour, rather than for illegal behaviour.”

 Wow! Lots of issues here. First of all Robert, the Dodd-Frank Act that was passed into law this summer does not do that, you should have checked. It provides for a clawback following a restatement of published accounts and applies only to ‘incentive pay’ that would not have been awarded under the restated numbers.

There are also lots of potential problems with this legislation that may become clearer when cases reach the courts. It refers, for example, to clawback if companies are ‘required’ to restate their accounts. Well who certifies that it was unavoidable? Suppose new management takes over and decides to restate the accounting numbers, perhaps to make life easier for the new regime, is that required or optional? See Lane & Worcester for more.

Now Turner is not completely barking, he does explain in an article in the FT that banks are different…

“But banking is not like other sectors. The fact that many banks made decisions in the same way as other companies was itself a key driver of the crisis, a big problem, but not one that regulators had adequately identified. In some other sectors we want bold risk-taking, which might sometimes result in failure, shareholder loss or even the danger of bankruptcy. But banking is different.”

I accept that, but they are also businesses and businesses take risks, that is what they do. If you stop them taking risks then they will decline. It is more to the point to try to understand why checks and balances in the boardroom did not constrain the rush at RBS to acquire ABN Amro. What went on there, if it was so obviously a big risk (as Turner claims with hindsight). Also…Turner admits to errors in FSA supervision being part of the picture for RBS and Northern Rock et al. So will the bosses of the FSA also face collective punishment for failures…perhaps a future case like Equitable Life, say….I just wondered….

The Institute of Directors new Governance Guidance

The IOD published its Corporate Governance Guidance and Principles for Unlisted Companies in late November, skilfully adapted by Roger Barker (IOD Head of Corporate Governance) from a pan-European edition published by ecoDa earlier in the year. It deserves publicity. Although it does not seek to break new ground and can read, at times, as if trying to cajole some grumpy company founder into wiser ways, it is pretty good on the whole – addresses the issues that need to be addressed and any company director would benefit from reading it.

But its most important attribute of all is that it takes governance to the unlisted company. For too long the governance industry has directed attention to the listed sector because there is a sense that their shareholders need protection. By addressing the unlisted sector the message inevitably becomes nuanced to become ‘this is the best way to run a business’. That is a message that can be directed to all businesses, listed or unlisted.

There are other important issues too but for those you will have to wait to read my book, due out in May or June 2011.

Government interference in bankers bonuses

I may be a bit early on this item, since the Committee of European Bank Supervisors (CEBS) is not due to publish its rules on bonuses until Friday 10 December. But the Times reports that they are due to set a 20% cash limit on bonuses, 20% in shares that cannot be sold for some time and 60% deferred for several years.

Now, I understand that governments and regulators are eager to discourage bank staff from taking huge risks in order to achieve huge bonuses. But…put aside the anecdotes and the outrage against people earning lots of money…does the evidence show that large short-term bonuses were a causal factor in the banking crisis? And are these proposed rules limited to those who could possibly take actions that cause economic harm in pursuit of bonuses?

Don’t misunderstand me, I am as outraged as the next man at people earning vast sums that seem unrelated to their contribution to society. But if the motivation is jealousy then what about footballers and lawyers and film stars and lottery winners? And is it the job of government to interfere in freely negotiated wages? I am worried that governments that should lead are reacting to the news agenda and not taking rational decisions. The economic stupidity of raising UK marginal tax rates to 50% still irritates me. And will the regulations work anyway or will ways be found around them or, worse, will these banking activities migrate overseas? Banks have been slanting remuneration more towards basic salary and less towards bonuses for two years now anyway. Beware populist measures that have unintended consequences.

Film: The American

I saw Kat Muir’s review of this film in The Times on Saturday. It is an odd review. She makes a mistake in placing the action in Tuscany, which seems slight enough, except that it is set in the Abruzzo region of Italy (south and east of Tuscany) for the very specific reason that it is more mountainous, more isolated and less developed than Tuscany. It sets a scene where the visiting American protagonist, and the other foreigners who pop up in the story, stand out. But the second surprise is that she gives it four out of a possible five stars – pretty good then? Well, the scenery is pretty and it is a compelling watch. But a failing for a thriller is that the story really doesn’t hang together. At a key point, for example, when it is clear that he has been betrayed, George Clooney, the anti-hero does…nothing. Curious police inactivity in the face of a double murder in a very small town is also pretty hard to believe. But Clooney is not bad in it…not great but not bad. A little wooden. He gives little indication of what volcanic emotions are bubbling inside to make him behave as he does – you just have to accept it. Oh, and you have guessed how it will all end some way out, which is not so good in a thriller.

Government interfering with governance over Goodwin?

I was disturbed by the FSA investigation into the collapse of the Royal Bank of Scotland because it seemed to owe more to government feeling a need to respond to public hysteria than to any sensible reason.  

The Financial Services Authority asked a narrow question: were fraud, dishonesty or failure of governance processes responsible for the bank over-extending itself so badly before the financial crisis that it cost taxpayers £45bn to keep it from collapsing?

Did anyone sensible ever harbour suspicions of fraud etc? Dominic O'Connell in the Sunday Times on 5 December neatly summarised the answer.

"If you aim high, you won’t shoot yourself in the foot. That’s true, unless you are the Financial Services Authority, where a foot-maiming moment is always just round the corner.

Officials at the FSA aimed high when deciding to investigate whether Sir Fred “the shred” Goodwin had done anything wrong in taking Royal Bank of Scotland down a ruinous road of over-expansion. Anyone who had followed RBS could have told you the answer immediately. Fred was guilty of an autocratic management style, was carried away by the idea of ever-expanding credit markets, and made a serious error with a top-of-the market purchase of ABN Amro. His failings had serious repercussions for the country, but not even his harshest critics seriously thought he had done anything criminal or fraudulent. He made bad decisions, but he made them in good faith.

Little surprise then that the FSA’s investigation, which has dragged on for more than a year, finally concluded last week that Goodwin had no case to answer.…Goodwin …probably suspects — as do most in the City — that the investigators took a long time to come to a conclusion that could have been arrived at after 45 minutes"

 But the FT, in its report, included a quotation that summarised the hysterical demand for a head to be cut off 'pour encourager les autres'.

Rob MacGregor, Unite’s national officer, said: “The report’s conclusions are an outrage. It is unacceptable to suggest that the behaviour of the management in this iconic UK bank did not ‘lack integrity’ when they brought RBS to its knees.”

 Well, sorry mate, but businesses (even big businesses - even well run businesses) make mistakes - it happens - get over it. But governments and their agencies should not join the hysteria. They are meant to lead and to show calm judgement. Even announcing an FSA investigation to buy time while things cool down, sends the wrong messages to those who pursue their own agendas by shouting loudly and wildly.

Executive Remuneration

November boasted two articles related to executive remuneration that showed immense insight. Firstly, Chris Bones, stepping down as head of Henley Business School, delivered a speech in which he skewered the ‘Cult of the Leader’. He discussed the reward disparity of the leader

"There is a plethora of statistics to show the unequal rate of growth of CEO and leadership rewards versus that of the average wage-earner.

In 2006 the chief executives of America's 500 biggest companies got a collective 38% pay raise to $7.5 billion. That was an average $15.2 million apiece.

In the UK in 2007 chief executives earned on average 98 times more than the average for all UK full-time workers.  Ten years ago the pay differential was 39 times that of the average worker."

Then he addressed the weakness of the justification

"And, with some notable exceptions … performance doesn’t seem to come into it.  Sixty companies at the bottom of the Russell 3000 Index in the US lost $769bn in market value in the five years ending 2004 while their boards paid their top five executives at each firm more than $12bn.

Many of today’s leaders of enterprise are rewarded far more like the entrepreneurs than corporate stewards.The point of being an entrepreneur is that you are prepared to risk your own capital and if you fail there is no one to give you a handsome severance payment and a pension pot worth millions of pounds when they fail."

And then he homed in on the problem

"When you get this reinforcement of personal worth within a corporation displaying all the signs of being narcissistic you have the ingredients for a tragedy."

The problem we face is self-reinforcing. Because heroic leaders are the fount of all success they must be paid massive rewards, which they must justify by adopting high risk/high return short-term strategies. If these work, their market value boosted, they will tend to move on to another role. If they don’t work, they will move on, cushioned by a large severance payment. And, of course, they must be heroic…look how much they are paid!

Then Sir Paul Judge, an immensely successful business leader as well as a philanthropist, wrote an article in the Times, with the authority of first hand experience, that explained at least part of the origin of the problem. He lays a large part of the blame at the door of the Greenbury report into directors’ pay in 2003.

"...remuneration practice since has been fatally undermined by the innocent paragraph 4.16: “The (remuneration) committee should have access to reliable, up-to-date information about remuneration in other companies and should judge the implications carefully.” This was coupled with paragraph 5.2: “We attach the highest importance to full disclosure of directors’ remuneration as a means of ensuring accountability to shareholders and reassuring the public.

The law of unintended consequences often bites hardest those who believe most in their good intentions. Those two paragraphs were an invitation to consultants … to provide boards with reams of comparative information. The consultants then scour the annual reports and provide an analysis of pay practices for salary, bonus and long-term incentives. These typically show a spread of about plus or minus 30% around the average figure.

The remuneration committee then decides where its executive should fit. I have never known of a remuneration committee prepared to declare that its chief executive is below average (they would presumably then have to sack the person). Typically, a committee will pitch the salary at around the upper quartile of the comparator companies.

However, when the pay consultants go through the exercise the following year — using the latest information incorporating increases resulting from companies having placed their executives at the upper quartile — pure arithmetic means the average must have increased. Detailed maths shows that if there is a plus or minus 30% spread and all committees separately agree the upper quartile for their executives then the average will rise by about 15% — exactly what it has done since Greenbury was implemented."

Judge believes in restoring the link between top pay and bottom pay through an approach that uses multiples rather than comparability with other overpaid executives.