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Thursday, 4 September 2014 00:00 - - {{hitsCtrl.values.hits}}
Perhaps nothing captured the zeitgeist of these reversals as poignantly as the titles of the bestselling books of Jim Collins, the eminent management guru – ‘Good to great’ in 2001 had turned into ‘How the mighty fail’ in 2013.
Amidst the rancor, the insecurity and the inevitable schadenfreude surrounding the upheaval, it was worth taking a step back to reflect upon the salient contributory patterns that had led to the spiral. While it is true, to paraphrase Tolstoy, that each unhappy story was unhappy in its own way, five afflictions frequently emerge from the postmortems: weak leadership, negligent internal control practices, poor accounting and audit functions, failure to adapt to market trends and poor ethical standards and or poor regard for social responsibility.
Weak leadership
It is a truism in management that you can’t manage what you don’t measure. However in the higher echelons of power in many of the failed corporates, this fundamental standard had mutated into ‘You can’t manage what you don’t like’. The need to feel right and the consequent denial of reality turned smart people into zombies, data analysis into self-serving myopia andreportee objectives into sycophantism, all while the manager became the hero who slayed the underlings that questioned his superpowers and the enterprise turned into an out-of-print Dilbert strip.
Paul Sullivan, in his book ‘Clutch’, describes the approach of two corporate leaders as a contrast in leadership styles. On the one hand, he profiles Jamie Dimon of J.P. Morgan & Chase leading a successful takeover of Bear Stearns and Washington Mutual, while on the other hand he demonstrates how Ken Lewis of the Bank of America botched his takeover of Merrill Lynch. Sullivan’s argument is that both corporate leaders faced the same situations and pressures but that Dimon took the time to study the details of the deal and turn it favourable towards his shareholders while Lewis focused his energies on popping the champagne and framing the press releases. As narrated by Sullivan, Lewis did not take the time to identify the risks of the acquisition and frequently called for the process to be expedited, which may have resulted in short sifting of due diligence.
Based on this case, and others, Sullivan goes on to identify three traits observable in what he terms weak leadership, which he terms ‘choke’ – overconfidence, over-analysis and the failure to take accountability. Overconfidence is the delusional self-fawning that fails to take into account inconveniences and practicalities. Over-analysis is the extreme opposite – a severely cautious approach that turns challenges into bugaboos and prudence into stagnation. The condition is best captured by the popular term ‘analysis paralysis’.
For a leader amidst competition, time is more valuable than money and someone who palpitates at the slightest awkwardness would fail to realise his business’ potential. Finally, a lack of accountability is the shirking off of responsibility when strife hits the business. It is hard for a leader who does not value his responsibility, to deliver, or to expect others to deliver.
Lax internal controls
Internal controls are the risk management systems of an organisation that ensure its compliance with regulation and providing a basis for effective operations. The profile of internal control has ascended in recent times and some governments even require that directors of public listed companies explicitly declare their accountability to uphold internal controls of their corporation.
According to the Committee of Sponsoring Organisations of the Treadway Commission (COSO), internal controls encompass the control environment, risk assessment, control activities, information and communication, monitoring and should be defined into the roles and responsibilities of the board of directors and senior management.
The Barings Bank was Britain’s oldest investment bank, which counted reigning monarchs amongst its clientele. Due to the failure of its internal control system, rogue employees of the corporation – notably Nick Leeson, its star trader – managed to manipulate its operations to such a malicious degree that in 1995 when it collapsed, it was liquidated for the price of one British Pound.
One of the most glaring shortcomings of the bank was to allow Leeson oversight into both the front and back offices of its Singapore unit. This allowed him to engage in risky trades heedless of his company’s ability to back these positions and create error accounts that covered up the losses generated by his follies until it was too late.
Not only had the banks internal controls failed by not being proactive enough to prevent such a conflict of interest, it was also too unwieldy in taking remedial actions and prevent Leeson from magnifying the losses even when internal audit detected and raised their suspicions. Finally, the control systems were inadequate to account for the liquidity crunch that came when they were forced to repay the ill-gotten investments.
In order to be effective internal controls must first and foremost be embraced by the leadership. The top management should engage with internal controls as part of the business’ DNA, deploy effective information management systems to monitor and report on the systems and be on the alert for vulnerabilities and loopholes. The corporation should also facilitate the reporting of violations of internal controls through anonymous whistleblowing and non-retaliation policies. The risk assessments undertaken towards developing internal controls should be robust and take account for the complete business cycle. Most importantly, through proper corporate governance, the company should be able to respond to highlighted threats and weaknesses.
Poor accounting and audit function
Autopsies on failed companies often unearth creative accounting practices and outright fraud. All accounting standards advocate the fair representation of an organisation’s performance and current status. No regulatory framework can provide for every eventuality and pontification is a poor foil for self-interest and greed. Generally Accepted Accounting Principles (G.A.A.P.) require that financial reporting should represent the underlying economics of the business and be persistent and predictable over time, i.e. they should be relevant and reliable.
Accordingly accrual, asset identification and debt management should accurately reflect cash flow amounts, timing and certainty involved in the cash flows. Management incentives should be aligned towards such truthful presentation; very often they aren’t, with bonuses and stock options providing incentive for managers to prematurely recognise revenue and obfuscate or underreport losses and expenditure.
Enron’s collapse in 2001 was not just an organisational collapse but also a systemic failure of accountancy – its auditor, Arthur Anderson, a part of the Top Five, folded soon after due to its commissions and omissions involving the Enron affair. For six consecutive years prior to its fall, Enron was rated as the most innovative US Company by the Forbes magazine. It turned out that Enron had taken innovation into the realm of fantasy. Through mark-to-market accounting, a practice that had originally been devised for securities, Enron managed to conjure phantom revenue and evaporate genuine losses.
WorldCom, an organisation that filed for bankruptcy a year later, managed to report annual profits of over $ 3 billion by filing its expenses as investments. Interestingly enough, their auditors were Arthur Anderson as well.
The tragedy of all this was that it was that fraudulent accounting was a known menace. In 1998, Arthur Levitt, the Chairman of the US Securities Exchange Commission had identified five potentially malicious manipulations of accounts by many organisations – big bath charges, creative acquisition accounting, cookie-jar reserves, materiality, revenue recognition and decried them as ‘accounting hocus-pocus’. Some of the major reforms undertaken in the aftermath of Enron and WorldCom were the need for stronger corporate governance, internal controls and regulatory framework.
But perceptive observers also realised that the root cause of the issue may have been the incentives provided for management to meet investor expectations. Corporates were not expected to make profits, but also the earnings projections that they had made. Any shortfall would result in a dampening of the share price and any way the management found to overshoot the guidance was handsomely rewarded in price appreciation and ensuing bonuses that had been tied into share value.
Several changes have emanated from the increased scrutiny into this area. These include an increased reliance of core earnings and cash flow, the revision of performance incentives to enable more sustainable growth, corporate governance and internal control enhancements and more conservativeness in projecting earnings, or as in the case of some companies such as Coca Cola, a repudiation of the practice all together.
Failure to keep up with consumer preferences
The transience of consumer preference has only been exacerbated by the wider connections that the internet and mobility have delivered. It is just not the taste – the ramifications of a bad service are far more lethal today than it was. But the major threat to business remains what it ever was essentially, the inability to formulate a winning strategy that attracts consumers.
Based on Michael Porter’s analysis, a corporate faces five forces within its microenvironment – the threat of new entrants, threat of substitutes, bargaining power of suppliers, bargaining power of customers and competition amongst existing sellers – and needs to base its strategy based on the SWOT (Strengths, Weaknesses, Opportunities and Threats) analysis emanating from this milieu. A failure to do so would lead to the organisation’s erosion and eventual demise.
One reason for failure is the inability to adapt to changing consumption taste. Henry Ford’s engineering innovations and business acumen helped create the automobile industry. The sales model Ford adopted was to make a low-cost reliable car for the masses, turning the motor car from a luxury to a household appliance. The strategy was backed by innovations in production, most notably the assembly line.
However, when consumers demanded variety and customisation, Ford balked, infamously declaring that the consumers could have any choice of colour for their car, as long as it was black. When his subordinates questioned his approach, Ford had them fired. Soon his competitors managed to swarm into these markets and oust him from the very industry he had pioneered. This case was replicated almost blow-by-blow in the travails of Nokia, when they dismissed the smartphone as a luxury item and failed to change their products fast enough to capture consumer demand.
Poor ethical standards
Corporate Social Responsibility and sustainability are not just good things to have but are increasingly being viewed as essential business practices. The repercussions of irresponsibility are high with increased stakeholder awareness and concern and the upsides are tremendous in increased customer base, premium pricing and operational efficiencies. Repeated studies have demonstrated that sustainable companies outperform their competitors, sometimes by as much as 15%.
Mismanaged sustainability leads to mismanaged businesses. When the Deepwater Horizon oil rig exploded leaking 700 billion litres of oil into the Gulf of Mexico, it unleashed one of the worst environmental disasters at sea. But it also laid bare the poor management of risk and the lack of accountability at BP and they could no longer hide behind glossy marketing. At times it is not just the company but the supplier chain. For years, due to Jeff Balinger’s activism and reporting, Nike earned a poor reputation that its suppliers were sourcing labour in inhuman conditions or sweatshops. According to the Business Insider, by 1998 the demand for Nike had also been adversely impacted by the allegations.
However Nike managed to embrace sustainability and turn around its fall. One of the major decisions it made was increased transparency with independent audits of its supply chain and public disclosure of the labour conditions and wages of all its employees. Increased transparency and disclosure are now almost mandatory to survive in the business world. The next step that companies are increasingly looking to adopt is integrated accounting where costs of environment are explicitly called out. The opportunities of a sustainable business are bountiful. The risks of an unsustainable one are grave.
Conclusion
One of the major pitfalls that companies should avoid is the false sense of security that comes with being profitable. The corporate environment is simply a sped-up ecosphere and the fate of those who fail to adapt are similar in both worlds. It has been said that for every animal remaining on the planet, at least a thousand have died. A business has essentially the same odds. Considering the number of ways that things can go wrong, the prudential entrepreneurs will be heedful of the evitable mistakes, the unforced errors and draw from historical lessons learned from the choking of the imperials in order to ensure that their businesses turn into one of the rare breed of happy survivors.
(The writer was the President of Organisation of Professional Associations in Sri Lanka, Institute of Chartered Accountants of Sri Lanka and the Sri Lanka Branches of CIMA, ACCA. He read a paper on ‘Application of Financial Models and Presentation on Financial Dashboard’ at a seminar on ‘Corporate Collapse’ held recently.)
