The Hindu Business Line : Good system = good governance?

WHILE all the discussions about improving corporate governance are welcome if another Enron situation is to be avoided, there is another key issue in this debate: Can companies' internal systems help to keep things on the straight and narrow?

How much protection can investors hope to gain from improvements in corporate governance? The best the `corporate governance approach' can hope to achieve is that the guardians appointed by shareholders have the correct motivation and access to information. Auditors rely on data given to them by executive directors and so are looking at only a small sample of the records. And non-execs, like auditors, normally work with only limited information in their role as providers of `moral' guidance. But auditors and non-execs are now being asked to act like police: detecting or (preferably) deterring deception. It is debatable how successful this approach can be: improvements in governance need to be matched by improvements in the security and transparency of the systems that produce financial statements.

How can good systems help? If a company's key financial reporting systems are `secure', the audit task becomes easier. The type of systems that are relevant here operate with business rules that automate most processing, but they have a facility for `Journaling' when there is a need to make non-standard changes in the accounts.

Auditors will usually go through the journal records with an enthusiasm that the rest of us reserve for films or food. They may also take a keen interest in the business rules used to automate the standard processing. But this may be in vain, because most current systems allow other ways to make non-standard changes — experienced users can simply alter the numbers. If they do this without creating records, the accounts become impossible to audit. Modern systems can prevent this or allow it only with a journal-like audit trail, so that each change to a number is recorded along with the reason for, and the source of, that change.

This is where non-execs come in, because they should insist that their company has a modern, secure system. They should also call for an external systems audit to ensure that it is set up correctly. This system should be able to ensure that no change to the business rules or data is possible without creating a trail that an auditor can follow.

How can we ensure that the numbers loaded into the reporting system in the first place are reliable? As far as the financial reporting system is concerned, the numbers that are entered will be half-yearly or annual or quarterly reporting data, representing the balance-sheet and profit and loss account of a subsidiary business. This subsidiary will be audited, so it needs systems with similar levels of integrity.

Auditors of simple subsidiaries have a much easier job than that of the head-office auditor — they check the bank accounts, contracts, fixed assets, and so on, in the way they always have done. In large subsidiaries, the business will often be run using an enterprise resource planning system. In order to preserve integrity and transparency, this will need the same degree of audit control as the head-office system. The tools that are used to transfer information from one system to another need to be similarly secure.

In the future, if good systems are implemented, can we hope to say good riddance to corporate scandals? Good systems only help the auditor. If the auditor is aiding and abetting the management, then no system will help. The big problem at Enron was that debts were being hidden in a subsidiary that was not included in its consolidated accounts. This was done in a way that was not unlawful and, apparently, had the auditor's approval. We can hope that this would have been impossible in the UK, because auditors here must certify that the accounts give a true picture of a company. But recent revelations about Pilkington where a creative treatment of preference shares counted them as shares, not debt, have shown that black holes can exist in British firms too.

Shareholder disappointment comes more often from inflated expectations than from any wrongdoing — there is no system that can prevent a sales director from making an unrealistic forecast. But modern systems can make it easier for observers to detect excessive predictions. Using graphical business intelligence tools to calculate and present key ratios, both non-execs and external analysts can now determine whether they are being told unreasonably good news.

(Edited extracts from Financial Management, a journal of CIMA, London. www.cimaglobal.com.)

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