Internal control: the human factor needs encouragement
April, 07th 2008
Some of my professional friends took exception to my saying, in one of my earlier columns on internal control, that all individuals are inherently greedy. They felt that I was using the example of a few black sheep to denigrate the entire professional community. Indeed, if we take greed to mean the desire to enrich oneself without any regard for law or morality, then my friends are right: only a few people are greedy in this sense.
But in another sense all of us are greedy: we all come to our organisations already imbued with a culture, with life goals, with ambitions, with a vision of right and wrong. The far-sighted organisation must seek to shape itself in a manner that cleverly channels individuals' aspirations and ambitions into directions that promote the collective goal. And nowhere is this more important than in the internal control function, which forms the bedrock of a corporations reliability. To the age-old question of Who shall guard the guardians? our answer should be They themselves, given the right incentives and environment.
The human factor enters at the very outset, in the design of the internal control system itself. If the managementwhether promoters or professional do not have any regard for the interest of investors, the internal control system too would not be designed in a way that protects investors.
For example, if a business group believes that tunnelling of resources from a group company to another group company is an acceptable business practice, then the internal controls designed and installed in the company will not protect interest of dispersed investors from expropriation of resources by promoters. Perhaps the audit committee should check such tunnelling of resources. However, in practice, it depends on the effectiveness of the audit committee, which in turn depends on how independent the audit committee members are from the management. If the audit committee may turn out to be ineffective because its members may be greedy: if not for material benefits then for the comfort that comes from not rocking the boat.
For the last few days the media has been abuzz about the potential loss that a large number of companies have incurred on foreign exchange derivative contracts. It appears from media reports that many of those companies did not understand the economic implications of those contracts and had no risk management system in place. Moreover, many of those companies had no intention to disclose the (possibly notional) losses arising from the marktomarket measurement of open contracts. The Institute of Chartered Accountants of India (ICAI) has now directed the companies to recognise losses on open contracts and to disclose particulars of those contracts.
Does this episode reflect a failure of internal controls? The answer is yes. Managers of those companies exposed the investors wealth to undue risks because companies entered into contracts without appropriate risk management system and without understanding the economic implications of those contracts. They aggravated the risk to investors by deciding not to recognise losses arising from such contracts and not to disclose the particulars of such contracts. The temptation of managers to speculate with investors money is yet another form of greed that renders internal controls ineffective.
The law does not protect investors from incorrect business decisions. It is interesting to note that the theory of honest services has been put forward by the attorney of former Enron Corp. CEO Jeffrey Skilling in the appeal against his conviction. The theory says that employees of a company are bound to serve honestly and should not put their interest ahead of companys interest. The flip side is that if the employee did what the company wanted them to do and did not profited herself from those actions, it can be claimed that she did not deprive the company of her honest services and that therefore she should not be convicted for her actions, even though they might have caused loss to investors. An employee deprives the company of her honest service' only if she is involved in fraud or embezzlement and her actions are not aligned with the corporate goal. In case of Enron, the appellate authority (the 5th Circuit) has already overturned several Enron-related convictions based on the honest services theory.
The effectiveness of internal controls also depends on the culture the top management sets for the company.
For example, if a company does not have a well-laid out promotion policy and incentive scheme and only those employees are rewarded who never question the superiors instructions even if those are not aligned to company objectives, it is more likely that internal controls will be breached. This is exactly what happened in WorldCom. Similarly, whistle blowing systems, which are part of internal controls, will not work if the top management fails to provide protection to whistle blowers.
Who shall guard the guardians? is an age-old question. Studies of organisations and human behaviour teach us: They themselves, but only if given the right incentives.