Why companies fail and how boards respond — student companion

Accounting Ahead | Original study resource | accountingahead.com.au

Why companies fail and how boards

defend against it

MODULE 4 | PART A.1 | STUDENT COMPANION

Companies rarely fail for one sudden reason. The same root causes appear again and again, usually several at

once, and they grow while the people at the top fail to deal with them.

1. Poor strategy

New products or markets without

understanding what drives profit there

2. Ambition and power

Growth pushed faster than the business

can sustain

3. Over-expansion

Acquisitions whose cost and disruption

swamp the promised benefits

4. Dominant chief executive

A board that has stopped challenging

5. Failed internal controls

Complex structures where information

gets stuck

6. Ineffective board

Directors too close to management to

judge it

What makes them worse

Cash strain | a culture of fear or greed | pay that rewards short-term results or risk | wilful blindness: choosing not to know

Early warning signs a director should notice

Root cause Early warning sign A question the board can ask

Poor strategy Growth in markets where margins are thin

or unknown

What evidence shows we understand what

drives profit here?

Ambition and power Targets keep rising faster than capacity Can our people, systems and cash support

this pace?

Over-expansion Acquisitions follow each other before the

last one is bedded down

What did the last acquisition actually deliver

against its plan?

Dominant chief

executive

Directors rarely disagree in the minutes When did we last change management's

proposal?

Failed internal controls Repeated audit findings, late

reconciliations

Which control weaknesses are still open,

and why?

Ineffective board Long tenure, close personal ties to

management

Would an outsider see this board as

independent?

Amplifiers: cash strain (profit is not cash), a culture of fear or greed, pay that rewards short-term results or

risk, and wilful blindness. Wilful blindness counts as knowledge in United States law when a person

believes a fact is highly probable and deliberately avoids confirming it (Global-Tech Appliances v SEB,

2011).

ETHICS & GOVERNANCE | M4 PART A.1 | STUDENT COMPANION

1

Accounting Ahead | Original study resource | accountingahead.com.au

The defences

MODULE 4 | PART A.1 | RISK MANAGEMENT AND INTERNAL CONTROL

Risk management: a continuous cycle

Risk management is the culture, processes and structures an organisation uses to make the most of

opportunities while keeping possible losses under control. The board decides which framework suits the

company.

1. Identify

A long power

failure could

spoil frozen

stock

2. Analyse

How likely? How

costly? Which

customers are

hit?

3. Evaluate

Compare with

the board's risk

appetite: too

high

4. Treat

Backup

generators,

alarms and

insurance

5. Monitor

Test generators

monthly and

track near

misses

6. Communicate

Report results

and trends to the

board

Repeat: risks keep changing

Imagined example: Coastline Cold Storage. Insurance helps, but some losses, such as a damaged relationship with a major customer,

can't be insured.

Internal control: five connected components

Component What it means Coastline Cold Storage example

Control environment Tone at the top, integrity, competence,

clear responsibilities

Directors model and reward honest

reporting

Risk assessment process How the company spots what could go

wrong

Reviewing new cyber threats to freezer

controls

Information system and

communication

The right information reaches the right

people

Freezer alarms go straight to the duty

manager

Control activities Everyday checks: approvals,

reconciliations, separated duties

Nobody can both approve and pay a new

supplier

Monitoring Checking that the system still works Monthly report on overdue

reconciliations

ETHICS & GOVERNANCE | M4 PART A.1 | STUDENT COMPANION

2

Accounting Ahead | Original study resource | accountingahead.com.au

An independent chair

MODULE 4 | PART A.1 | WHO LEADS THE BOARD'S CHALLENGE?

When one person is both chair and chief executive, the person running the company also runs the meeting that

is supposed to hold them to account. Use this flowchart to test a board's leadership structure.

Is the chair also the chief executive? Yes Combined roles

Best fix: separate them. If kept: a lead independent director,

sessions without management, safeguards explained to

shareholders

No

Is the chair an independent director? No Not independent

For example, a recently retired chief executive, who may remain

too close to management

Yes

Independent chair

What the ASX recommendations and the UK code

expect

Why it matters

The chair runs the meeting that holds the chief executive to

account

Source What it says about the chair

ASX recommendations A listed company's chair should be independent, and should not also be its chief

executive.

UK code The roles of chair and chief executive should not be held by the same person.

International principles Separation is good practice but not compulsory; where the roles are combined, explain

the safeguards, such as a lead independent director.

Caution A retiring chief executive who becomes chair may remain too close to management.

Silicon Valley Bank: Federal Reserve review, 28 April 2023. Boeing: board release 11 October 2019; In re Boeing Co. Derivative

Litigation (Del. Ch., September 2021); settlement of US$237.5 million (November 2021). Carillion: joint report of the UK House of

Commons Work and Pensions and BEIS committees, May 2018. Coastline Cold Storage is imagined.

ETHICS & GOVERNANCE | M4 PART A.1 | STUDENT COMPANION

3

Accounting Ahead | Original study resource | accountingahead.com.au

Practice questions

MODULE 4 | PART A.1 | TRY THESE BEFORE THE WORKED ANSWERS

Question 1 - diagnose Summit Home Builders

Imagine Summit Home Builders Ltd, a listed company. In three years it bought four smaller builders in two new

states, all funded by borrowing. The new businesses' systems were never properly combined. The founder is

both chair and chief executive, and board papers come only from him. Executive bonuses depend on revenue

growth. Suppliers are being paid later and later, although reported profit keeps rising. (a) Identify at least four

root causes or amplifiers. (b) Recommend three governance responses.

ETHICS & GOVERNANCE | M4 PART A.1 | STUDENT COMPANION

4

Accounting Ahead | Original study resource | accountingahead.com.au

Question 2 - was Mei wilfully blind?

Imagine Mei, finance manager at Westlake Freight Ltd. Internal audit tells her that a sales manager may be

booking fake freight orders before year-end. She thinks this is very likely true, but asks internal audit to hold its

detailed report until after the annual report is signed, so that nobody can say she knew. Apply the two-part test

for wilful blindness. What should she have done?

Question 3 - match the weakness to the component

Match each weakness to one of the five components of internal control: (a) the chief executive jokes that rules

are for junior staff; (b) there is no process for identifying new cyber threats; (c) the same clerk sets up new

suppliers and approves their payments; (d) branch managers can't get timely sales data to head office; (e)

nobody checks whether monthly reconciliations are actually done.

ETHICS & GOVERNANCE | M4 PART A.1 | STUDENT COMPANION

5

Accounting Ahead | Original study resource | accountingahead.com.au

Worked answers

MODULE 4 | PART A.1 | WORKED ANSWERS - ATTEMPT THE QUESTIONS FIRST

Question 1 - Summit Home Builders

Over-expansion: four acquisitions in three years in new states, with systems never combined.

Dominant chief executive and ineffective board: the founder chairs the board and controls its information.

Pay that rewards the wrong thing: bonuses tied to revenue growth encourage growth at any cost.

Cash strain: suppliers paid later and later even though profit is rising - profit is not cash.

Debt: borrowing to fund expansion raises the stakes if the integration fails.

Possible responses: appoint an independent chair (or at least a lead independent director); require independent

board papers, including cash flow and integration reports; pause acquisitions until systems are combined;

rebalance bonuses towards long-term, cash and risk measures; ask the audit committee and internal audit to

test controls in the acquired businesses.

Question 2 - Mei

Part one: she believes there is a high probability that fake orders are being booked. Part two: she takes a

deliberate step, delaying the report, to avoid confirming it. Both parts are met, so under the wilful blindness

approach she would be treated as knowing. She should have obtained the report, escalated it to the chief

financial officer and audit committee, and made sure the revenue was investigated and corrected before the

accounts were signed.

Question 3 - components

Weakness Component

(a) Rules are for junior staff Control environment (tone at the top)

(b) No process for new cyber threats Risk assessment process

(c) Same clerk sets up and pays suppliers Control activities (separation of duties)

(d) Sales data doesn't reach head office Information system and communication

(e) Nobody checks reconciliations are done Monitoring

Common slip: treating internal control as a set of documents. A control that exists on paper but is ignored,

or that incentives reward people for bypassing, gives no protection.

ETHICS & GOVERNANCE | M4 PART A.1 | WORKED ANSWERS

6