Three Essential Corporate Governance Practices

In my last post, I walked through the implications of running a company without corporate governance. Assuming good corporate governance is beneficial, this post trims it down to three essential practices. Together, these three practices will improve decision making, while creating clear accountability.  The three suggestions are delegation of authority, budgeting and monthly reports. 

1. Delegation of Authority

In my experience, the biggest risk area for misuse or waste of resources is related to the authorization to spend and the executing of contracts. Staff members are not sure what they are authorized to do and tend to assume they have the authority. “Hey, I’m a Vice President; surely I can approve this expenditure.”

The risk becomes magnified at the management level where large commitments to spending occur. This is where the decisions get made that make or break overall shareholder returns. A couple of bad capital allocation decisions and best-in-class results can become middling.

The solution is a crystal-clear Delegation of Authority, which is a document that spells out operational, administrative, financial and personnel-related authority limits by position. It is a document that assumes that ultimate authority to act resides with the Board of Directors. The Board then delegates authority on a variety of items to the CEO and other officers of the company, who in turn may delegate authority to members of their staff.

A well-written Delegation of Authority gives each individual a framework to then manage his piece of the business. It makes it clear to each individual what contracts he can execute, what the maximum dollars to which he can commit the company to and what ability he has to hire staff.

To draft a Delegation of Authority, think about operational, administrative, financial and human resource decisions.

The Delegation of Authority should clearly answer the above questions and provide a framework to answer new questions that arise. Once approved by the Board of Directors, the Delegation of Authority is a document that should be updated periodically to cover new matters.

2. Budgeting

For these purposes, I will include in the definition of budgeting: forecasts, project economics and related numerical analysis. These are vital tools to evaluate performance, plan the future and estimate shareholder returns. Most importantly, these are tools that should be used in decision making.

The budget is a fundamental entity level control document. The budget details both approved activities and approved dollars. Amazingly, this is not always obvious with a tendency to spend the necessary dollars to complete the approved activities. If a company ensured that they restricted activity to those activities and dollars approved, its governance would be greatly enhanced.

The budget as prepared by management and presented to the Board of Directors must include an identification and thorough discussion of the key assumptions, including risks associated therewith. The recommended decision case assumptions should be supported by analysis of historical experience, experience of other companies under similar circumstances, or analogous experience of the company or of other companies.

It is that last sentence in the paragraph above where many companies fail. Management wants to proceed with a project and will reverse engineer the assumptions to make the numbers go around. The assumptions will appear plausible, but plausibility should not be the test. Increased rigor around assumptions will improve decision making greatly.

The economic modelling a company does as part of its project analysis should tie into it budget model. The computations should include IRR, NPV or some similar rate of return calculation. The analysis ought to include a look at what the project, acquisition, or divestiture does to the overall company performance. Does the project improve or worsen overall company returns?

When I think about project economics I start with an understanding of the returns of my company’s current operations. Assuming the ability to invest further in current operations, any new project needs to have better economics. I am not sure how to define better, but I always assume new project economics are optimistic. The numbers would need to be clearly better to garner my support.

3. Monthly report

The best way to improve something is to report on it. A company’s corporate governance will improve if management is forced to document successes and failures and report them. The monthly report is a tool to hold management accountable and to keep the Board apprised of the company’s activities and results.

There is not a single correct way to put together a monthly month. Tying back to the first two items, the monthly report should document the company’s immediately past and future planned activities. It should also document results against budget*.  There should also be an internal controls section where the CFO notes any deviations from the Delegation of Authority and any other control issues arising during the month.

* In my last role, we reported preliminary results on a fairly aggregated level against budget. A more fulsome monthly financial package and analysis would follow the monthly report in due course.

The following is a rough outline of the monthly report we used to issue at a previous job.

President’s Observations:

The first section contained a really high level overview of results, an overview of general market conditions, a status update on previous month priorities and an indication of priorities for the upcoming month. The last item was key as it represented management documenting its planned activities for the future. Each month we would have to speak to our progress on each item.

Health, Safety and Environment Update:

In the oil business, HS&E is an important issue (same is true for any manufacturing company). We placed the update right up front to convey the importance of the topic to management. Any incidents were disclosed along with relevant remedial work.

Internal Controls and Fraud:

Similar to HS&E, we put the internal controls section up front to stress the importance and set the tone of the organization. I would disclose any and all breaches of internal controls and internal policy, no matter the significance or the individual involved. It was always framed as such: what occurred, what should have occurred and what we are doing to remediate. In the next monthly report I would provide an update.

Finance Update:

An overview of the cash situation, debt situation and a general departmental update.

Personnel Update:

A summary of any staff changes during the prior month.

Operations Update:

If our monthly report was twelve pages, the operations update would probably be nine pages. The section contained a reasonable overview of results for the past month against budget. We started with a table summarizing key numbers such as sales volumes, revenue and expenses. A fairly detailed discussion of activity and the results followed.

The section also contained an update from the other departments in the company. For an oil company, that included land, engineering and exploration. Each provided an overview of activity and near term priorities.

Business Development:

We ended the monthly report with an update on business development activities. Although our company was not really active with respect to acquisitions, we were committed to evaluating every opportunity that arose. This section would be somewhat vague due for confidentiality reasons. We were pretty clear on opportunities we did not like but vague on those still under consideration.

Wrapping up

Show me a well run company and I will point out the company’s good corporate governance practices. The three items discussed in this post will help set the foundation for improving any company’s governance.

To read more on this topic, check out my book which can serve as a “do it yourself” handbook. I am also happy to consult with company’s that are not happy with their results and are looking to improve.