Search the Internet          Tips  Sites: Finance, Investment

How to prevent conflicts in businesses

R Ravimohan

The failure of Enron and its subsequent impact on Arthur Andersen have led to much debate on how to prevent conflicts of interest between businesses.

The failure of the auditors to detect fraud has been attributed, among other factors, to the possible softness in conducting audits as some audit clients were also large consulting clients for the same firms. The following paragraphs explore the validity of this hypothesis.

In the case of Enron, Arthur Andersen billed audit and consulting fees roughly of $25 million each in 2000. Would the absence of $25 million earned from consulting have induced disproportionate rigour, that the first $25 million earned from audit failed to do?

Assuming money is the root of all evil, what level of residual greed will be left with the auditing firm as it pursues only its auditing business? Would the investing and the creditor communities be happy with that residual perversion?

Solutions to improve auditing rigour need to be instituted in its own confines. Looking for easy answers such as hiving off the consulting business into a separate subsidiary, and other structural solutions, will not address the fundamental malaise.

It may sound a bit facetious, but there are many situations that seem to have the same potential conflict between inducement and improper behaviour. Key employees are one such source of perversion.

Indeed the same episodes as above threw up many villains. Can the same penalty of shutting out the services of the key personnel to 'root' out the source of improper behaviour be conceived? Procurements and contracting are again areas of concentrated corruption. Would the template solution of curtailing the source, work?

Some systemic solutions have also been proposed, which suggest incorporating checks, declarations and perhaps compliance to some proposed boundaries.

These too may prove cosmetic and inadequate and subject to misuse by those who intend to subvert the system. Indeed the additional danger such measures introduce into the system is that they make it easy for potential offenders to 'tick-mark' compliance with such mechanical requirements.

Neither structural nor systemic steps may be fully able to stop the malaise. Some measures that do plug the obvious holes will certainly have to be procedural and structural.

Such measures can be used to make it difficult, and to leave audit trails for post-facto investigations. However, the keys to addressing these concerns have to be intrinsic values and strong deterrence.

Effective enforcement and swift punishment strong enough to deter potential offenders are needed. Undoubtedly prevention is better than cure. The reality, however, is that neither has a fail-safe prevention system yet been discovered, nor have systems not been misused by offenders bent upon misdemeanour.

In the ultimate analysis, it boils down to the values that organisations working in such areas uphold. Being in a position of public trust calls for an organisation to have the highest values and ethical behaviour.

Its credibility is key to its survival. The mere thought that these 'conscience keepers' need to be told to be conscientious and taught the virtues of values is perverted.

The organisation and its people at all levels including the top management have to live and breathe the values of selflessness, fairness, independence and integrity. These organisations must have strong systems to cross-check and validate the integrity of their opinions.

Many auditing firms rely on the integrity of their partners to ensure rigour. Perhaps some level of cross checking mechanism may improve the effectiveness of the process.

The organisation must believe in being as transparent as possible, by setting its own criteria and benchmarks in such a way that its behaviour can be checked by neutral observers. These, and other such measures must be voluntarily initiated by these organisations to generate and sustain confidence of the markets in their actions.

Action over a period of time must establish to the market the validation of integrity and independence, apart from competence. No amount of certification, structuring, auditing or indeed regulating will ever be able to inspire that trust that the organisations own 'just' action could.

For instance, there are a few cases where CRISIL has been engaged by clients on both its ratings and advisory sides.

All of CRISIL's ratings, including those where CRISIL was also engaged on the advisory side, have been objective and independent of business considerations.

There are many instances where CRISIL has been invited after repeated downward revisions of ratings, by the same client to engage in advisory work because the client values CRISIL's objectivity and capability.

Its rating process is independent and is carried out without any fear of loss of business, either in ratings itself or in other businesses.

Indeed, from 1997 through 2000, CRISIL lost its market share in the ratings business from its dominant position of 65 per cent to 35 per cent, in reaction to its proactive downgrades.

A consistent display of the highest standards of objectivity over a decade has earned CRISIL its reputation of impartiality and integrity. To further the scrutiny of its action, CRISIL disseminates its criteria for ratings openly and in detail.

The trouble with subjective terms like values, integrity and ethics is that they cannot be measured. They do not give something for the regulators to get their arms around. Regulation, for instance, is a hard, digital and unambiguous necessity.

When it comes to firms that deal with public trust, there is very little by way of tangible facts that regulators can flag off proactively, to ensure that the offence does not take place.

The regulators' hard, structured way of handling this difficult issue in fact sometimes tends to reduce the subjective elements to what appear to be tangible definitive elements, like the ratings symbol.

Many regulations prescribe rating levels in investment guidelines. Ratings symbols are arrived at after taking into account a number of factors including subjective elements. The possible outcome of such usage may indicate to the market that ratings are hard facts, which they actually are not.

Similarly, prescriptions of accounting guidelines also allow many interpretations to arrive at the accounted numbers, which again contributes to the possible gap between the tangible and the nebulous representations.

The other intervention that could be positive is for the regulators to prescribe norms that promote transparency in a firm's policy and criteria, post critiquing and dissertations aimed at bringing the right interpretations of the firm's action.

For instance, auditing firms could have a criteria publication which lists out their stand on Off-Balance-Sheet transactions, ESOPs, et cetera to promote the right interpretation of the accounted numbers.

CRISIL, for example, publishes the criteria which it uses to rate companies in a manner that will allow the market to be able to validate the ratings it has accorded any instrument. Thus, if there were any perversions in any specific transaction, the market is alerted.

The last, but perhaps the most effective, way is for the regulators to develop a system to catch the offender swiftly and impose punishments which have a good deterrent value.

The system should be transparent, and clear rules and procedures should be contained upfront in the regulations so that players understand their responsibility and fashion their behaviour.

Since these regulations concern issues that are subjective, they should focus on process integrity and not only on the actual outcome. Periodic reviews between the regulator and the firms would also serve well to ensure that firms stay the course of objectivity and rigour.

Powered by

ALSO READ:
More Specials
More Money Headlines