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Keeping score.


Note: The following article highlights some key concepts in CMA Canada's recently published management accounting practice guideline on corporate governance. The new guideline applies the principles of the balanced scorecard in corporate governance to enable a company to strengthen its internal and external accountability. The scorecard approach goes beyond looking at board structures and relationships--the inputs--and encourages companies to focus on setting measurable governance objectives, and to report on their success in achieving these objectives.

The collapse of multi-billion dollar organizations and the resultant impact on stock markets around the world is forcing companies to adopt effective corporate governance practices as a means of strengthening accountability and restoring investor trust. However, much of the focus is on the introduction of new rules and regulations intended to:

* strengthen and regulate the audit function;

* improve accounting standard-setting;

* curb executive greed; and

* strengthen codes of personal and corporate ethics. It remains to be seen whether these regulations will in fact be implemented and, if so, whether they will result in boards that are more effective in delivering results. New externally mandated requirements should be considered as tools for effective governance, but not as ends in themselves. They should be thought of as necessary ingredients for good governance, but not sufficient to ensure effectiveness.

Enron, for example, complied with all conventional corporate governance standards as far as form went. The company had separated the chair and CEO positions, and had a high quality audit committee. As well, Enron had an independent nominating committee for board directors, and the majority of directors were independent. Nevertheless the company failed--spectacularly. Certainly this failure involved corrupt and/or incompetent auditors doing unethical things, as well as a complete collapse of corporate ethics. But it also involved a board that did not understand how the company made money, and the risks that were inherent in each line of the business.

The role of strategic performance management in good governance

What has become clear is that spectacular failures of corporations will continue if the focus is exclusively on mandating structural changes in the operations of boards without judging whether such changes improve performance. It appears that, in many failed corporations, it was the board's strategic performance measurement processes that were broken, not the structure itself. This resulted in inadequate board oversight and control.

The impact of poor strategic decision making on a company's capitalization and stock prices can be enormous--witness the disastrous consequences of poorly planned expansions at Nortel and Vivendi.

One of the major outputs of good governance is establishing boards that understand the strategy of the organization and the risks associated with that strategy, then ensuring that control systems are put in place to flag issues that surpass risk thresholds.

The approach to corporate governance must therefore broaden from defining the requirements of effective governance to observing governance outcomes. For example, it's relatively easy for a poorly governed company to separate the CEO and board chair positions. This might be a good first step, but it doesn't necessarily lead to more effective corporate governance. Boards need processes to ensure they are getting the right strategic performance information to determine whether the corporation is on track to meet the expectations of all shareholders.

This need to improve the quality of the information provided to boards is a dramatic departure from most existing company practices. As an example, examination of information about alternative strategies considered by management (including comparative analysis), as well as best-, worst- and most-likely case scenarios that will enable boards to independently assess the level of risk involved, are beyond what many boards currently consider. It requires a fuller and more consultative role for board members in addition to their oversight responsibilities.

New informational needs force senior managers to share more information with the board and open more decisions to discussion and evaluation. It requires a secure and confident CEO to provide for full disclosure and discussion of information and critical management decisions. But it also provides more value for the company. Board members need to ask tough questions and challenge the CEO and top management team. If they don't, the value and effectiveness of the governance process is certainly in doubt. Companies and shareholders don't need another rubber stamp. They need an active, involved, qualified, and effective board of directors.

An increased strategic role for the board will also have a significant impact on the skills and knowledge board members will require. In addition to financial literacy, other broader business knowledge, including strategy formulation and implementation, will be important. Furthermore, just as board members need to be knowledgeable about accounting and strategy, they will also need expertise and personal qualities such as integrity, business sense, sound judgment, communication skills, and commitment. All of these are necessary to develop high performance boards. Educational and training programs for board members should be a continuing part of corporate learning activities, and broader competencies should be considered in the screening and selection process for potential board members.

Obviously board members will be asked to take a far more active and time-consuming role than previously. The number of boards that any individual can participate in will be smaller, and the compensation must be commensurate with the increased effort. Board members need to know the company and industry well, and do significant additional preparation to be fully engaged in the challenges and potential solutions to company issues. To fully understand more than one or two companies in different industries will occupy the available time of most directors. Existing executives will also have to consider whether they have any available time to sit on other company boards, given the time constraints of their own executive positions outside board responsibilities.

Compensation for the strategic board member

This higher level of involvement for board members raises questions about compensation levels paid to board members of corporations, and the number of boards these people should sit on.

Bill Dimma, author of the book "Excellence in the Boardroom," gathered information in 2000 on compensation for board members in Canada versus the U.S. He found that the median all-in direct compensation (including meeting fees, retainers, options, etc.) for board members in Canada was $58,500 or US$37,500, versus US$105,000 for board members of U.S. companies. To paraphrase Mark Twain, this level of compensation (certainly for Canadian board members) is probably too much for what they used to do, probably right for what they are doing now, but too low for what they should be doing.

While many observers are critical of board members who receive annual compensation in the hundreds of thousands of dollars, the clearly indefensible position is when board members sit simultaneously on 8 or 10 boards and are unable to make a significant contribution to any of them.

The balanced scorecard for a board of directors

Adopting a balanced scorecard for a board of directors would help address this situation. The balanced scorecard goes beyond looking at board structures and relationships--the inputs--and commits organizations to achieving specific governance objectives supported by measured results.

Corporations need to supplement their reliance on financial performance with new measures boards can use to evaluate corporate leadership, corporate performance, and their own performance as a board on a real-time basis.

It's important to note that financial statements are lagging performance indicators and only convey results once all the activities have been completed. A board must have forward-looking information that will enable it to continuously correct its trajectory to ensure it will hit its target.

This is not a call for micro-management by boards that would disenfranchise both CEOs and their senior management teams. The challenge is to develop systems of strategic performance measurement for boards that enable CEOs to exploit the knowledge, experiences, skill, and intuition that have made them and their board members successful, while providing a means to recognize when things may be going wrong.

The role of an effective board is to provide an independent and knowledgeable sounding board for the CEO to test ideas and strategies. Armed with the necessary information, a board can provide independent and competent advice to:

* provide a viewpoint on changes in the competitive landscape that have been missed by the CEO and his/her senior staff, and on whether the corporation's value proposition remains competitive in light of these changes;

* provide an independent and knowledgeable sounding board to test ideas and strategies; and

* provide a clear, credible and independent voice that can help avoid common pitfalls such as escalation of commitment, which makes CEOs blind to the failure of current strategies.

This requires a CEO who is a good listener and open to advice.

Getting boards to take a more active and objective oversight role will reassure stakeholders that the board has the processes in place to ask the right questions and to monitor management effectively. Such practices will help convince skeptics that executives and directors will act first to fulfill their obligations to shareholders and other stakeholders.

In this context, boards should measure performance and success by more than changes in stock value. They must consider a broad range of performance indicators that are in line with a company's mission, vision, and values, and are consistent with the company's long-term interests.

This new information should include both leading and lagging performance indicators, and both financial and non-financial indicators of success. Even the financial indicators should include a much broader set of indicators than are currently used. For example, if the performance measures are all focused on short-term financial indicators, neither board members nor shareholders should be surprised if managers strive for short-term performance goals and not the company's long-term financial interests.

The balanced scorecard is a strategic performance management system that links performance to strategy using a multidimensional set of financial and non-financial performance measures. It focuses on better understanding the causal relationships and links within organizations and the levers that can be pulled to improve corporate governance. Figure 1 indicates where the balanced scorecard fits into the drivers of corporate performance.

The traditional model for a balanced scorecard developed by Robert Kaplan and David Norton has four dimensions that relate to the core values of the company:

* Financial-focuses on shareholder interests and demonstrates whether the strategy has succeeded financially;

* Customer-measures that reflect how the company is creating customer value through its strategies and actions;

* Internal businesses processes-measures that indicate how well a company performs on its key internal systems and processes; and

* Organizational learning and growth-measures that show how well a company is prepared to meet the challenges of the future through its organizational and human assets.

These four dimensions connect through chains of cause and effect. They reinforce each other, jointly contributing to measuring the accomplishment of corporate strategy and the creation of corporate value.

By developing a balanced scorecard for improving and evaluating board performance, boards should be able to both understand and identify the cause-effect relationships of their actions on shareholder value, thus focusing attention on the drivers of corporate success. The balanced scorecard can help establish the drivers of good board performance and how its performance, distinct from the CEO's performance, affects shareholder value and more importantly, the levers that boards can pull to improve both board and corporate performance.

The balanced scorecard measures would cascade down the organization and become part of the management reporting process, rather than act as an additional stream of information required only by the board. This would substantially reduce the cost of developing a balanced scorecard only for a board of directors.

While there will be a great deal of overlap between a balanced scorecard for a CEO and a board member, there are differences. The board's scorecard would contain unique measures of:

* board/CEO relations;

* succession planning;

* training programs for directors;

* screening processes for directors;

* board systems and structure; and

* reviewing the strategic plan.

Improving the performance of corporate boards and CEOs

To improve the performance of corporate boards and CEOs, the balanced scorecard has to set performance measures designed to evaluate corporate performance--of both the CEO and the board.

The challenge is to develop appropriate measures to evaluate both long-term and short-term corporate performance. and distinguish the performance of the corporation from that of the CEO.

Both the board and the CEO start with the same balanced scorecard information. As a result, the board should have access to and receive the same financial and non-financial performance measures that the CEO receives to evaluate overall corporate performance. This enables both parties to observe the process of CEO decision making, and provides additional information to determine board meeting agendas and the issues board members wish to discuss.

Boards can also assess the success of both the formulation and implementation of strategy. They must then evaluate corporate performance and adapt future strategies accordingly. Typically boards are provided with traditional accounting-based performance measures such as earnings and return on investment. But financial accounting has a limited value as a strategic management tool. Often, it actually hampers decision making because it focuses on historical figures. Traditional financial measures are lagging indicators, measuring current and past performance, but not adequately predicting future performance or motivating behaviour that will achieve future performance goals.

Boards need to know if the strategy is working--financial numbers alone rarely provide this information. Performance measures must include leading indicators that give insight into the organization's ability to improve its competitive position in the future. Where financial measures once constituted the foundation of performance measurement, increasingly they are seen as only part of a set of comprehensive measures used to assess corporate performance.

These comprehensive measures focus on the corporation's value proposition and the factors that create long-term value. The objectives are to:

* keep the focus on core processes;

* keep the focus on critical success variables;

* signal where performance is headed;

* identify which critical factors warrant attention; and

* link performance to rewards

Monitoring and evaluating the performance of the CEO

In too many companies, CEO evaluations are performed in a perfunctory manner. CEOs have appointed many or most of the board members, and the boards are neither independent nor assertive enough to critically evaluate the CEO's performance. Yet ensuring that the corporation has the right person at its helm is a major board responsibility.

When boards develop open and honest evaluations of CEOs, they can provide important feedback on both strengths and weaknesses, and on suggestions on performance improvement. But this requires independence and effort.

The evaluation process also requires a careful analysis of both CEO performance and corporate performance, recognizing that there can be significant differences. It is the board's responsibility to differentiate between CEO and corporate performance through the development of adequate measurement and evaluation systems.

Given the recent concerns over excessive executive compensation, conducting a rigorous performance evaluation and linking it to compensation can provide improved governance and accountability on the part of both CEOs and boards. In addition it will also provide the board with early warning signals of problems that could affect organizational performance.

A useful reference for evaluating CEO performance has been developed by Medtronic Inc., the global medical technology company. It uses the following nine dimensions to assess its CEO:

1. Leadership (including vision)

2. Strategic planning (including resource allocation)

3. Financial results (both short-and long-term)

4. Succession planning (for top management)

5. Human resources (including recruitment, training, and retention)

6. Communications (effective communications)

7. External (contribution to the community)

8. Board (facilitates board governance and policies)

9. Style of management (role model motivating top performance).

The evaluation process should be interactive, encouraging open discussion of issues, rather than just simplistic diagnostics. The process should also be conducted often enough to quickly identify and correct any potential problems.

Monitoring and evaluating the performance of the board

To improve accountability to a broad range of stakeholders, boards are increasingly implementing monitoring and evaluating systems to assess their own performance, both collectively and individually. This presents an opportunity for boards to examine how they are protecting and creating shareholder value. It should identify specific opportunities, directions for improvement, and standards of performance. The focus is on how to improve the board's inputs and processes so that its contribution to overall corporate performance can be increased.

Only 40% of major North American companies conduct formal evaluations of their board, and individual board member evaluations are even less frequent. Even when evaluations are conducted, they are often only self-evaluations, or lack the vigor necessary to make significant improvements in board performance. They rarely focus on the inputs, the process, the outputs--all of which are necessary to make significant improvements in board and company performance.

Consequently, a balanced scorecard for a board of directors should encompass a broad range of performance indicators that measure success in achieving specific company objectives, including long-and short-term financial targets, corporate governance and accountability, stakeholder needs, ethical behaviour, risk identification and management, performance evaluation systems, strategic plans, board member training and skill requirements, and CEO and senior management succession planning. Such a scorecard is described in some detail in CMA Canada's recently published management accounting practice guideline on measuring and improving the performance of company boards and CEOs.

Achieving effective corporate governance and accountability for results will not only be critical in our current environment, but also in the long-term best interests of organizations and their stakeholders. Adoption of a balanced scorecard for the board of directors can do much to help companies fulfill these goals.

R.W. Dye, CMA, FCMA, LLD is the president and CEO of CMA Canada.
COPYRIGHT 2002 Society of Management Accountants of Canada
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2002 Gale, Cengage Learning. All rights reserved.

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Author:Dye, R. W.
Publication:CMA Management
Geographic Code:1CANA
Date:Dec 1, 2002
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