REBUILDING CONFIDENCE

By Rob Brouwer

 

 

 
 


We are facing a crisis of confidence in our capital markets. It's come about, in part, as a result of some spectacular breaches of trust by a number of business leaders. As a result we are now looking at a new era. Regulators, the professions and business organizations are responding in an effort to make changes that will re-establish a climate of openness and confidence.

You are business students. Most of you will likely be involved in capital markets or financial management. You may choose to become accountants or auditors, investment dealers, financial executives or managers in the private or public sectors. But in each and all of those capacities, you are going to have an impact – you are each going to make a difference.

What you bring to your careers and how you do it, in terms of both expertise and integrity, will shape our future. At this point, let me acknowledge that what I'm going to be talking about is Rebuilding Confidence not Building it. Because in the context of our capital markets today, it is rebuilding confidence that’s required.

Over the past few years, our confidence in capital markets and other institutions has been severely shaken. Every day, we see and read news about people who have broken trust with those who should have been able to rely on them.

In discussions about the current crisis in business ethics, the question is frequently asked “Have public expectations risen? Or have our standards – standards of behaviour -- fallen?”

In my view, there has been a serious slippage in standards, an erosion of business and personal conduct.

To be sure some corporate failures have been driven, in part, by good old-fashioned economic cycles. But there is also irrefutable evidence of systemic weakness, of poor corporate governance, of ethical failure, and of a cavalier attitude to other people's money.

Particularly since the collapse of Enron in December 2001, in North America attention has been riveted on corporate wrongdoing. WorldCom. Adelphia. Tyco. Even poor Martha Stewart. They represent failures - and in some cases downright fraud - of management, directors, external auditors or regulators. And of course, don’t think it’s just a US wave. We have seen failures around the world. The collapse of Parmalat is the single biggest financial failure in Italian history. There have likewise been spectacular banking and insurance failures in a number of countries.

Here in Canada, we can’t consider ourselves exempt either – after all, we are the home of Bre-X, Cinar, Livent and YBM.

It's not just public companies. Here in Canada, the federal government's spending of millions of dollars in sponsorship money, highlighted by Auditor-General Sheila Fraser, has undermined our trust also in the handling of the public's tax money.

And, I don't know about you, but I wonder every time some level of government reports that it has a net deficit or surplus on its books -- how real or valid is that number? It seems that each and every time a new government looks at the same books – they give us a different answer.

To try to assess the impact of this erosion of public confidence on Canada's business climate, my firm, KPMG, conducted a survey of the directors of the 75 largest corporations in Canada. We asked questions directed to their perceptions of the risk of manipulation of a company's financial statements. Now, let’s recognize that the manipulation of corporate financial statements is generally carried out as a conspiracy – there is typically collusion. In every recent example there was a group of senior people who acted together to deceive directors, auditors, shareholders and others. Generally it's done for financial gain. Sometimes, just to make the perpetrators and the company look better and more successful than it is. I can tell you that directors take the risk of financial statement manipulation very seriously. In fact, they ranked it as the greatest reputational risk a public company can face. So we asked the directors to rate the possibility of financial statement manipulation.

The directors were asked how confident they were that the companies whose boards they were on would not encounter manipulation of their financial statements. On the positive side, a majority were confident it wouldn't happen – but only 54%. What is more telling, is that the other 46% weren't sure, or believed it could happen.

Let’s be clear. None of us expect that there is, or will be manipulation of financial statements at anything like half of our public companies. No. What this is telling us is this – the people who have lost confidence in Financial Statements isn’t limited to “the man-in-the-street – it’s not just the retail investor or the “uninitiated” – the very directors who are closest to the action, who have direct access and responsibility for management, and for the financial statements – have lost confidence. Reflect on that.

I can tell you with confidence that the vast bulk of Canadian businesses are well managed, honest and above board. But the wave of corporate scandals has significantly enhanced the perception of risk. Both the reality -- and the perception -- have each contributed to seriously undermined confidence in our capital markets.

And not only have we become very skeptical about financial reporting – perhaps of more fundamental concern, people now also increasingly question the ethics and motives of some people in positions of power and trust.

Enough of the bad news. What is being done about it? Fortunately – much is being done.
Regulators in Canada, the United States and other countries are stepping up to the mark. And so are business people.

A very high profile piece of legislation in the United States, passed in 2002, was the Sarbanes-Oxley Act - which stemmed primarily from the Enron experience. That was the most dramatic legislative reform to hit American capital markets since the Securities Act and Exchange Act of the 1930s. CEOs and chief financial officers of US public companies must now personally provide assurance about their financial filings, their disclosure and their company's internal controls. Audit committees must be completely independent and they must oversee the external auditor's independence. Sarbanes-Oxley raised the bar of expectations of corporate management and imposed criminal penalties for knowingly misleading the markets. The presumption is – and I expect its right – that the thought of a little jail time will focus the mind.

In the United States, we've seen the regulators, the stock exchanges and justice officials become much more active in pursuing questionable practices and dealings. As they should. We’ve seen the perps walk.

Here in Canada, there have been a number of similar developments. An important turning point came in January of this year. The Ontario Securities Commission and other provincial regulators released the new investor confidence rules. These rules have teeth. Like Sarbanes-Oxley, they will raise the bar and hold corporate management, boards of directors and auditors accountable.

The CEOs of all Canadian public companies, and the CFOs, will have to personally certify in each of their interim and annual filings that they have personally reviewed the documents, (ignorance is no longer an excuse), and that based on their knowledge, there are no untrue statements or material omissions. And soon they will also have to personally certify that their internal controls over financial reporting are not only well designed, but also that they are functioning effectively.

There are extensive proposed new rules for audit committees – who may be on them, and what their job is.

Practically, auditors were accountable to management in the past. Today it is clear – they are accountable to Audit Committees. Audit committees will have a written mandate to oversee directly the work of the external auditors, including any non-audit services that they provide. Companies will be required to establish procedures for so-called whistle blowers in the company who may have concerns about accounting or auditing. They will be required to publish their code of conduct.

The Canadian guidelines are, for the most part -- not prescriptive. They recognize that the Canadian corporate landscape is varied, with a great many small companies and a lot that have a dominant shareholder. So companies are advised to implement corporate governance practices flexibly and sensibly to fit their circumstances. But they will have to disclose what they're doing, whether they are following the recommended best practices, and if not, explain why not.

There is an increasing recognition of the value of well-informed Board members, who take the time to fully understand the nature and operations of the businesses they oversee. I expect Directors will be committing significantly more time and energy to their mandate. To serve on an audit committee, they now have to be financially literate. Directors should have access to continuing education to maintain or enhance their abilities.

The accounting profession has also stepped up to the mark to improve standards. As a profession we worked closely with regulators to create the Canadian Public Accountability Board, chaired by former Bank of Canada Governor Gordon Thiessen. This is a totally independent Board – a concept which KPMG strongly supports -to oversee the work of external auditors. It looks at each firm’s standards and will thoroughly review our processes to make sure we are adhering to them. The Board will impose tough sanctions on auditors or audit firms that fall short.

The accounting profession has undertaken other measures. Sweeping new accounting rules are redefining the treatment of a number of items that have been subject to manipulation. The CA profession has created new standards governing the independence of auditors from the clients we serve. There is a new standard coming on the auditor's responsibility for fraud and error.

Not only have the regulators and accounting profession been active -- so have shareholders.
The Canadian Coalition for Good Governance was formed several years ago by a group of Canada's leading institutional investors. These include big pension plans and investment firms that together represent approximately $500 billion in assets. They have a fair bit of clout. The Coalition has published expectations of public companies when it comes to matters such as Board structures and mandates. Their members have spoken out publicly on issues such as executive compensation and practices that they believe may favour management over the shareholders. They also speak directly to companies behind closed doors when a direct approach may be more useful.

Another non-government organization that has recently become more active is the Institute of Corporate Directors. The Institute is supported by firms across Canada, including KPMG.

On of their current priorities is education for directors – in fact they recently established a Corporate Governance College. I’m proud to be able to tell you that KPMG is one of the founding sponsors of the College, and in fact I sit on its Advisory Board. The College is mounting courses for directors across Canada, and I think is already sold out for the next three offerings.

Clearly our directors also see the need for more and better education on how to be an effective director. So far I've been talking about new rules, regulations, standards and recommendations. And certainly that is a necessary first step to rebuilding confidence in our capital markets.

But let’s face it -- it's the people behind the rules and the numbers that count. The spectacular failings we have witnessed may have been facilitated by an inadequate regulatory system, but they were committed by individuals – by people who knew what they were doing and what the potential impact of their actions would be.

It may indeed be far more difficult, but to get to the root issues, we have to deal with the people. The regulators recognize that too. For example, the recent Canadian corporate governance proposals ask that Canadian boards of directors assume explicit responsibility for satisfying themselves as to the integrity of the CEO and other senior officers. Corporate leaders are expected to create a culture of integrity throughout their organizations.

The Canadian Coalition for Good Governance says that the number 1 standard for a good director is to "demonstrate integrity and high ethical standards."

The recent CICA proposals on auditing similarly stress the importance of an organization fostering a culture of honesty and ethical behaviour. This is a culture that is rooted in a strong set of core values that provide the foundation for employees as to how the entity conducts its business.

I spoke about the KPMG survey of corporate directors. Here is a quote from one of the respondents. He said,

"No one should continue as a director of a public company without complete confidence as to the integrity of the CEO and CFO, and as to there being a culture of honesty and forthrightness in the company."

He’s got it right – and this is the theme we are seeing again and again as regulators, business people and professionals are striving to rebuild confidence – the fundamental importance of personal integrity.

To rebuild confidence, each of us who play a role in the capital market -one by one - has to focus on working and acting in the best interests of those who rely on us, and in the best way we possibly can.

In the business community we need to rebuild a culture that firmly establishes the principles of integrity, ethics and accountability. That's why individual organizations - in both the private and the public sectors -- need core values, basic principles, codes of conduct, and, sometimes, complex procedures. It is the organization’s commitment to integrity – in both what it says and what it does – that sends the message to its people as to what is acceptable, and expected behaviour.

Let me illustrate briefly by talking about my own profession, auditing. As you know, an external auditor is charged with giving an opinion on the fairness of the financial information supplied by management to the shareholders and others. We provide assurance that the statements provide a fair and balanced disclosure of an organization’s financial performance and financial situation.

When we perform an audit, we don't just look at the numbers. Because we recognize that in the process of providing audit assurance, we have to depend on others - and on their judgment calls. Management is responsible for preparing the financial statements and those statements include a great many assumptions and estimates based on their knowledge of their own organization and industry.

And so we start an audit by considering the people who create the numbers and make the decisions. We're interested in their characteristics and motivations, in their ethics and reputation. We consider our past experience with them. We study their internal policies. We evaluate the tone set for the organization by their senior executives.

In fact, even before we take on a new audit client, we have to know who we are dealing with - management, board members, and their ethics and reputation. We do background checks on the executives. We consult with the company’s former auditors, their bankers, and their lawyers. We evaluate a company's ethics and culture. It is a very subjective process – sometimes we have to rely on a bit of “gut instinct” – and we consult with others internally. And then, unfortunately, sometimes we do resign from accounts, and we do reject new client opportunities -- if we don’t like what we see.

Similarly during the audit whenever we’re not comfortable, not really sure about a judgment call or an answer we’re given, we resort to one of our best tools -- consultation. Whenever the antenna is raised, whenever something doesn't seem right - or just doesn’t add up or make sense . . . we discuss it with someone else, get another opinion. So now, indulge me as I offer you some advice. What I’ve just talked about doesn’t just apply to the auditing profession. As you begin your careers, I encourage you to learn to trust your own instincts and to stop, and challenge yourself when something just doesn’t feel right. So what’s the message? Do what’s right -- be ethical, and associate with ethical people. This sounds pretty obvious, straightforward and simple. But you know what? It's not.

As you move ahead in your careers, you will from time to time be faced with ethical decisions. If the decision is between going over to the dark side or staying in the light, of course the choice is obvious. However, the most difficult ethical dilemmas are in the grey areas. By grey I don't mean shady. I mean issues that are simply not just black or white. Basically honest people can be caught off guard by the complexity of ethical decisions in the grey zone.

Going forward in your careers I encourage you to keep this in mind. You will face decisions or actions that are problematic. Often these may involve what at first glance seem to be minor matters. Minor or not, if you have any concerns, consult -- talk to friends or colleagues whose judgment you trust.

As business students now and decision-makers in the future, I think that what you will find is that there are three qualities of good governance that are as necessary to an organization, as they are to a successful personal career:

1. Knowledge: make sure you have the qualifications necessary for the job you've signed on to do. Don't fudge it or fake it.
2. Commitment: If you've signed up, then give it everything you’ve got -- give the time and energy to the people who are depending on you.
3. Ethics and integrity: The cornerstone of a successful career, and a successful person.

There are rules and regulations for every business career you may choose down the road. But there will also be times when you are called upon to exercise your own personal judgment. Each of you will find that you will have to make professional and ethical decisions in complex situations.

So my advice is this -- build your career with people you trust, an organization that invests in its employees, one with a tone at the top that carries all the way through to the way every person is expected to act. There are a great many very good companies here in Canada. Choose one that you respect and one that will invest in you. And in return, make a real contribution to your employer, its stakeholders and to our community.

As I said when I started, most of you will be involved, in one capacity or another, in Canada's capital markets. I hope some of you will decide to become chartered accountants. Even auditors. But most importantly, choose a career you're going to enjoy. One you find intellectually challenging. And always, always guard your personal and professional reputation fiercely.

You will be held to high standards. The public’s expectations regarding honesty, integrity and transparency have increased considerably. Back to where they should be. This is great, and let’s make sure we don’t disappoint them again.

So as I said at the outset, I am here to ask for your help. No matter which path you choose, your decisions, your actions, your choices will set the tone for Canada’s business community. You will be players in our capital markets. You will be shaping organizations and hiring people. Many of you will attain positions of power and trust.

"Building Confidence" is going to be your job. Do it well.

This speech was given on March 12th at The Roundtable Conference sponsored by Schulich School of Business in Toronto, Ontario. Rob Brower is an auditor with KPMG – www.kpmg.com

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