A Thought Leadership issue

Much has already been written about the causes of the economic crisis the world finds itself in at present. While the root causes have been extensively reviewed, there is a need for companies to start analysing what went wrong and how the lessons learned during this crisis should be used so as to avoid such a crisis in future.

This is, however, much more difficult than it seems, as an understanding of how the crisis could have been avoided is still something of a debatable issue. Much of the effort around tracking down the causes is focused on attributing blame, rather than the more constructive effort of learning from the mistakes of the past. The drive to find people to blame seems to be a construction of the global media, and does little either to resolve the current crisis or to help plot a way forward for companies currently suffering.

Strategic planning
The simple truth that we, as members of the global business community, need to face up to is that few if any organisations were prepared for the severity of the crisis. This indicates that most of the strategic planning initiatives that were instituted over the past few years could not have served their purpose. This is most likely a result of organisations underestimating the potential scale of the difficulties they were likely to face. It is this failure to plan for a worst case scenario that has amplified the scale of the crisis, and directly resulted in the economic situation in which we find ourselves today.

In reality, what happened is that much of the strategic planning that has gone on inside organisations has been focused on the idea of taking advantage of a market that is perpetually growing, with little thought going into planning for a market in retreat. Suddenly, from companies using their planning resources to look for new market opportunities, they are now having to refocus on a more risk-based analysis, including an in-depth evaluation of the risks that are facing companies from both inside and outside.

On a practical level, we need to take a long hard look at the planning systems that we have implemented. It is vital that, if these are focused on identifying growth opportunities at the expense of creating contingency plans for surviving downturns, they must be urgently realigned to ensure that plans are focused on a number of possible outcomes, not simply the one that will provide the greatest profit for the company in the short term.

Risk management
The financial crisis as we see it today is not so much a crisis of greed or the collapse of the US housing market or of the failure of accounting standards to allocate value properly to the assets being bought and sold. It is rather a failure of risk management systems in companies and public entities that didn’t identify the dangers posed to the global economic system, and thus also to every enterprise.

The reason that risk management systems fail is because they have been created to ensure compliance with the ever increasing burden of corporate governance. This has created an environment where the focus of risk management has been to ensure that all the relevant boxes are ticked so as to avoid getting into trouble.

This is, in fact, the antithesis of risk management. Risk management should, in fact, be examining the broadest spectrum of risks to which an organisation is exposed, and providing intelligence to management, allowing it to assess these risks and establish whether the potential harm to the business is outweighed by the cost of planning to survive it.

What we have learned from the collapse of many such companies is that simple business ethics were all too often abandoned in the rush to make as much money as possible as quickly as possible. Prioritising short-term profits over sustainability is one of the key reasons that the world’s economy finds itself in the state that now exists.

On a practical level, companies need to create risk management systems that closely monitor the complex web of interactions that is part of business today. This includes monitoring all parts of the value chain, which pose the greatest risk to both suppliers and customers, as well as which parts of the company itself pose a threat. If risk management systems are not examining the controls that are in place to prevent individuals from committing fraud, then they have already failed. It is time for every company to audit its risk management systems and ensure that the check–box reliance on these systems is not, in fact, putting the company at greater risk.

At a time when the market needs to be prioritising business ethics, the potential for fraud is higher than ever. Executives at some companies that, in the past, had held themselves to the highest ethical standards, may now be looking to use every trick in the book to ensure their company’s survival. What is now the case is that companies are much more likely to put the survival of the company above ethical behaviour and sometimes even above the law.

Fraud is something that is typically driven by three factors, colloquially known as the fraud triangle. The three points of the triangle are: incentive, opportunity and rationalisation. In a market where many companies are under pressure, the incentive to commit fraud is much higher. As the pressure to meet profits continues, the opportunity is likely to increase, as those with the responsibility for awarding tenders or signing purchase orders are also under financial pressure, together with the rationalisation that by committing fraud they are saving the company or preserving jobs. Any incidents of illegal activity are likely to create conflict between auditors and their clients. This is very different from the focus the profession has had to have in recent times.

In a growth market, auditors had to watch for companies looking to inflate growth figures through dubious accounting methods, driven by the need to keep shareholders satisfied and meet targets. In the downturn, management is driven by much more of a survival instinct, especially if the company is in financial difficulty.

While it is possible to mask poor governance in good times behind strong cash flow and robust growth, when times are harder these poor governance practices will be brought to light, and this is likely to cause conflict between the company and its auditors.

Another risk that companies face is the spectre of shareholder discontent. Because some companies have managed to hide their inefficiencies behind a strong market for the past few years, many shareholders are ill-informed on the risks facing the company.
Lessons learnt
If we learn one lesson from this crisis, it should be that transparent communication with all stakeholders is something that cannot be neglected. Hiding potential problems from stakeholders will only result later on in anger.

When times are bad, we cannot hide this from those that are invested in our organisations, be they part of the supply chain or those that have invested in our enterprise. While it may not be necessary to share every detail with the public at large, providing insight into identified risks and the plans in place to mitigate them will significantly reduce the pressure on management to live up to unrealistic expectations.

For those looking for real-world lessons from the global economic crisis, disappointment may be on the horizon. The lessons that they are going to learn are more focused around the strengthening of ethical business practices and rebuilding risk management systems that have failed badly to prepare the business world for the current environment.

These lessons are not something that need to be learned only by companies, rather solving the problems needs to be a collaborative effort between the private and the public sectors. This effort should be focused on ensuring that corporate governance and risk management systems aim to create businesses that deliver long-term value and not short-term profit.

Ajen Sita CA(SA), BCom, BAcc, is Head of Assurance for Africa Sub-Area at Ernst & Young.