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Corporate culture proves an abstract concept for FDs

“THE governance of individual companies depends crucially on the culture that is in place.” So says Sir Win Bischoff, chairman of the Financial Reporting Council, the watchdog tasked with policing good corporate governance among the UK’s largest listed businesses.

Bischoff makes a good point. From Toshiba to Tesco, via Enron, FIFA, Mid-Staffs, the Co-op Bank and any number of the banking failures that led to the onset of the financial crisis, all these corporate failures have one feature in common – each one can be traced back to a failure of corporate culture.

Justin King, the former boss of Sainsbury’s, says “nothing moves a business in a direction as powerfully as corporate culture”. The challenge of directors and management is to ensure that it moves it in the right direction.

This is easy to say, but what does good governance – and the company culture that underpins and enforces it – actually look like?

“Unlike good art, which is hard to define but easy to recognise, good governance is hard to define and hard to recognise,” says Ken Olisa, a director at the Institute of Directors.

“It is hard to define because governance is all about behaviours, and behaviours – whether individual or collective – are hard to reduce to a coherent framework connecting a small number of factors. It’s hard to recognise – at least for the outside observer – because much of it takes place behind closed doors in the boardrooms and executive suites of companies.”

Here we get to the nub of the problem. Conceptually, it is easy to articulate but when asked to truly define and measure culture, it slips into the ‘too difficult’ box or morphs into values which, far from being differentiating factors for the business, turn into a mushy coalescence of familiar adjectives that could be applied to many businesses: integrity, honesty, respect, collaboration, fairness for all and so on.

As recently as Grant Thornton’s 2013 FTSE 350 Corporate Governance Review, only 5% of chairman were giving culture the attention and emphasis that it requires. However, responses to the firm’s current global governance survey show only 19% of respondents feel that insufficient time is given to culture.

“Being of a sceptical nature and based on our experiences here in the UK, I interpret this as a symptom that realisation has yet to dawn, rather than thinking all is well in the world,” says Simon Lowe, large corporate partner and chairman of the Governance Institute at Grant Thornton UK.

Holy Grail of governance

As the Grant Thornton survey shows, changing practice takes time to embed itself in the permafrost layer of any business. This poses a fundamental problem for finance directors.

So much of the FD role – even though it is now more strategic and all-encompassing – relies on mechanical measures and forms of analysis. Data and analytics are used to understand the financial health of the business, analyse market dynamics and ultimately form strategy.

The question – when setting and assessing whether the governance frameworks mandated at board level is the correct one, and ensuring the culture of the organisation is such that these high ideals are being effectively enforced – is: how do you measure something which is inherently unmeasurable?

At a recent roundtable where Lowe spoke on this subject, there was strong recognition of the importance of culture, but also considerable scepticism about boards’ and particularly the chairman’s commitment to turning it from the soft to the hard by way of measurement. Yet there are possibilities, such as developing dashboards to capture a number of factors, including customer complaints numbers, whistleblower statistics, health & safety failings, customer satisfaction results, employee surveys, diversity statistics, community engagement, attitudes to risk, environmental impact, training take-up and performance review completions.

“This was all very encouraging, but if you are going to measure something, you first need to know what you are measuring it against. And here it was, like Groundhog Day – when asked to articulate what their company culture was, back again we came to values,” says Lowe.

“It’s down to the boards of companies to turn the nebulous into hard fact. They might start by first addressing the challenge of articulating what their particular culture isn’t and then determining what factors might contribute to its measurement. The fewer the indications of what it isn’t that occur, the closer you will be to where you want to be.”

The IoD and Cass Business School are doing work in this area, and Olisa is heading a project that aims to understand what good governance is and how it can be measured. The initiative involves a predictive model which combines objective factors and survey data on governance perceptions and produces a score for companies.

This would, in theory, lead to the creation of a reliable corporate governance index.
The corporate governance index, something of a Holy Grail of governance research, would look at everything from board diversity and experience, audit fees and credit scores, senior salaries and investor analysis, to build a picture of the most at-risk companies.

“Historically, we have monitored structural aspects of board. This doesn’t give the whole picture – it’s a very mechanistic way to measure governance,” suggests Roger Barker, director of corporate governance and professional standards at the IoD. “There are measures – credit downgrades, a significant number of profit warnings, a significant shareholder vote against the board – which taken together indicate a high risk.”

Instrumental factors to assessing good/bad governance
• Independent chairman • Is chairman on nomination committee?
• Percentage of directors on board more than nine years
• Percentage of board meetings attended per director
• Years with current audit company
• Ratio of fees for non-audit/audit work • Number of profit warnings in past 12 months
• Director remuneration
• Ration between CEO remuneration and share price
• Type of largest shareholder
• Percentage of shares held by single largest shareholder
• Market value over balance sheet ratio
Source: IoD

Call in the experts

As Barker posits, there are mechanical indicators of where culture isn’t very good.
But can anyone measure culture? “It is not easy to do because you can’t do a scorecard like a credit rating and a lot of questions of culture are quite subjective,” says Peter Montagnon, associate director at the Institute of Business Ethics.

Nevertheless, it is increasingly expected that even an organisation’s supply chain should operate under the same values, ethics and codes of conduct, even if the various players are separated by thousands of miles. Boards have to both understand and shape what drives behaviour at all levels in the business, and also to assure themselves that the culture they think they have is the one they actually have and that it is consistently embedded throughout their organisation.

This, according to Montagnon, is where internal audit comes in. Acting as the eyes and ears of the board but independent of management, internal audit is in a unique position to judge and advise on whether the tone from the top is being adhered to across an organisation. Through internal audit, a board can satisfy itself not only that the tone at the top represents the right values and ethics but, more importantly, that this is being reflected in actions and decisions throughout the organisation.

“The internal audit teams know what goes on inside a business. They are closer to the coalface compared to the board, audit committee and senior management,” Montagnon says, but adds that it is “wrong to assume you can tell internal audit to walk in there and come out with scorecard”.

However, he maintains that internal audit is well placed to spot the place in which a future crisis may lie if it is “given the right mandate to join up the dots”.

Can external auditors provide assurance above and beyond that of internal audit? According to Stephen Griggs, managing partner for audit at Deloitte, no one firm has figured out the best way to provide assurance over an ‘intangible’ such as culture.

“It may be that key questions around culture have to be answered in the auditor’s report. For example, has management addressed poor staff engagement scores? Have they made positive progress to turn around unsatisfactory customer engagement scores? While a difficult challenge, getting it right could shine an important light on new company information for investors and that can only be a good thing for the capital markets.”

Company culture graph

Change is afoot

Research undertaken by Montagnon at the IBE finds that internal audit’s ‘cultural’ role is gaining tractions with Britain’s biggest companies. For instance, Barclays, which avoided the need for a government bailout during the financial crisis but subsequently underwent a change of top management, now attaches considerable importance to cultural values.

In the IBE report, Barclays audit committee chairman Mike Ashley explains that he is looking for the comfort that the bank is breeding a culture where people are less likely to do things in the wrong way and, when they do, they are dealt with appropriately.

“Appropriately does not necessarily mean that you go out and hang everybody the first time they fail to make the grade as regards culture. It is part of the balance, but an essential part. Where appropriate, however, you educate them on how to behave in the future,” he says.

However, he is not convinced that culture is something you can audit separately. “It is more that, when you’re carrying out an audit, you get to understand the culture of what it is you’re auditing,” he explains.

“I encourage our internal auditors to look at what objectives have been set for the head of each business unit being audited, to talk to the people who sit above that unit, to understand what they’re driving the unit to do, and the mechanisms they have to understand – and how that’s being interpreted on the ground. It’s also not sufficient to not breach the cultural values. You have to positively reinforce them all the time.”

Other FTSE businesses are already pioneering change in this area. In 2012/13, Aberdeen Asset Management undertook an audit of culture in recognition that culture was fast becoming a key regulatory and business focus.

“Some people talk about risk culture, but, fundamentally, what I was trying to demonstrate was indicators of behaviour that concerned me and concerned my board,” says Scott Strachan, global head of internal audit at Aberdeen.

Project ownership was one such area. “We are involved in the project methodology at Aberdeen. We get invited along to the change process, and it became quite clear to us in some of the post-implementation reviews that there was sometimes a mismatch between what was delivered and what was expected,” explains Strachan.

“Somewhere along the line, something had broken down. Our analysis was telling us that maintaining business engagement throughout the project timeline in line with operational delivery was a challenge. This sometimes resulted in significant post-project development and change. After testing, the behaviour that we found to be wrong was the business not staying engaged.”

So has Aberdeen cracked it? Not quite. More work needs to be done by finance directors, internal audit and boards generally to make sure the correct indicators are being used.

“That’s where we have to learn, and there might be different issues for different organisations. For every business, there is a suite of management information that needs to be consolidated and challenged to ensure we are using it to not just run a business but also to ensure our people are running it with the behaviour and values we expect. The difficulty is balancing this with gut feel – that’s very subjective and a matter of experience and relationships. The latter is hard to define but no less important,” concludes Strachan.

Au contraire: The role of the Devil’s Advocate director
Companies should appoint a “contrarian director” who systematically challenges management recommendations to the board and suggests a range of alternative outcomes, says the winning paper in the 2015 Cambridge-McKinsey Risk Prize.

The paper, authored by Cambridge Judge Business School MBA student Siobhan Sweeney, argues that a contrarian director would help prevent rubber-stamping of management decisions by too-collegial boards whose supposedly “independent” directors are anything but.

This contrarian director concept was inspired by the Catholic Church’s “Devil’s Advocate”, a position introduced in 1587 to argue against a candidate’s canonisation in order to uncover any character flaws. But in the case of boards, it could be used to challenge cultural failings that are set, administered and assessed by company directors.

“The introduction of the CD institutionalises the ability to stand outside the tide of Groupthink and effectively warn and caution the board,” says Sweeney. However, always being the naysayer on a board could be career limiting, suggests Tanya Barman, head of ethics, professional standards and conduct at CIMA.

“It is more powerful to have voice of challenge that is not always from same person,” she explains. “A really good chair has got to orchestrate debate so it is challenging.”

 

 

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