​From the Epicenter of Corporate Governance, Internal Audit Exposes Weaknesses

​It is not often when a new report reveals information that is truly startling or exposes a previously unknown wrinkle to an area as well studied as corporate governance. But such was the case last week when The IIA published the American Corporate Governance Index (ACGI), in collaboration with the University of Tennessee's Neel Corporate Governance Center.

The index assigned an unimpressive grade of C+ to corporate governance of publicly traded companies in the United States. At first, the grade may not seem upsetting or even shocking, but that assessment would be wrong. I believe it is indicative of one of the biggest threats to all organizations, not just publicly traded ones: a poor understanding of the value of strong governance.

It is important to understand that the ACGI is an index, not simply a survey report, and one that's scored based on eight Guiding Principles of Corporate Governance. And those principles were designed specifically to make achieving sound corporate governance aspirational. In other words, every organization should strive to meet each of the principles at the highest level (A+).

As I wrote in a blog post introducing the principles last month, attaining the highest level of conformance should be motivated by a sincere desire of an organization's leadership to do the right thing, not simply because it is on a list to be checked off. What's more, the principles must be taken as a whole. I believe the cause of many of the scandals of the past decade was rooted in organizations whose governance was ineffective. Too many corporate boards are simply going through the motions, or worse, are asleep at the wheel!

The ACGI report includes seven key findings, which offer significant insight into the health of corporate governance. Based on the findings, the diagnosis is not good.

One in 10 index companies scored an F. It is particularly disturbing to me that 10% of publicly traded companies suffer from significant corporate governance dysfunction. Skeptics might note that the number of business failures in any given year is probably higher than 1 in 10, but that is not the point. Governance failure is not synonymous with business bankruptcies. Businesses can come and go for any variety of reasons, including low capitalization or new competition, but organizations can operate for years with poor corporate governance. All the while, they contribute to inefficiencies and questionable practices that have an effect well beyond the organization.

Companies are willing to sacrifice long-term strategy in favor of short-term interests. The focus on the short term is nothing new, but the index actually captures just how pervasive the thinking is. Companies scored a D (67) on the all-too-telling statement, "Your company is not willing to sacrifice long-term strategy for the benefit of short-term interests."

More than one-third of board members are not willing to offer contrary opinions or push back against the CEO. According to the survey behind the ACGI, more than a third of board members would fail to push back against a hypothetical CEO who wants to delay reporting negative news. That reflects an issue about which I've written many times: There is too much civility in the modern boardroom. As I wrote in a blog post last year:

My examination of high-profile governance failures in recent years has convinced me that, far too often, ineffective board oversight is at the root of corporate scandals. Too many boards are reluctant to question management. Too often, boards are content to say, "We hired a great CEO. We're going to step back and let him or her do their job."

Boards fail to verify the accuracy of information they receive. The ACGI gave a D (67) to board members asking whether information presented to them is accurate and complete. Another recently released IIA report, OnRisk 2020: A Guide to Understanding, Aligning, and Optimizing Risk, had a similar finding. In that report, organizations' ability to provide information that is complete, timely, transparent, accurate, and relevant was rated lower by CAEs than by executive management or the board.

Independent boards drive stronger governance. One ACGI finding offers positive news on the value of board independence. Our analysis found that the ACGI score is higher, on average, among companies with a higher percentage of independent board members. Additionally, ACGI scores are lower when CEO-chairman duality is not balanced by a high level of board independence.
 
Greater regulation does not correlate with stronger governance. While CAEs assigned the highest overall rating to the principle that boards should ensure conformance to "legal requirements, regulatory expectations, and ethical norms," the ACGI did not find that higher regulation led to better governance. Indeed, it noted no statistically valid differences among industries that are minimally, moderately, or heavily regulated.

That suggests that organizations approach regulatory compliance as a checkbox function, where the focus is more on meeting legal requirements and regulatory expectations and less on conforming to ethical norms.

Companies are vulnerable to corporate governance weaknesses or failures. The survey found that about a fifth of organizations (21%) report that they audit the full system of corporate governance annually. On the positive side, internal audit performs such full-system audits in a majority of those cases (75%). However, most organizations (55%) only "informally keep an eye on" various governance components, according to the ACGI.

That finding is particularly troubling, because it reflects how uncommon it is for organizations to grasp the overall governance picture. I believe that final finding exposes the root cause of many of the decade's biggest scandals.

Governance weaknesses in any area — compliance, ethics, financial controls — are more likely to remain unknown when organizations don't have a holistic understanding of governance across the enterprise.

With reporting relationships to management and the board, internal auditors stand at the epicenter of corporate governance. They can play a vital role in support of strong and effective corporate governance. Not only can internal auditors uncover governance weaknesses, they also can help educate stakeholders about the importance of understanding and nurturing sound corporate governance throughout the organization. Let's hope that the inaugural ACGI report will serve as a call to action for all of the players in American corporate governance to step up to the challenge.

To learn more about the ACGI's findings, read "U.S. Companies Score Low on Governance" on InternalAuditor.org. As always, I look forward to your comments.